Unless otherwise indicated, financial information in the MD&A is presented in accordance with accounting principles generally accepted in the United States of America ("GAAP"). See Note 2 to the Consolidated Financial Statements for additional information regarding the Company's significant accounting policies. In some of our financial tables in this MD&A, we present either percentage changes or "N/M" when those changes are so large as to become not meaningful, and changes in percentages are expressed in basis points ("bps").
We define operating revenues as total revenues excluding realized investment results. We exclude realized investment results from this measure because our portfolio managers may sell investments based on factors largely unrelated to the underlying business purposes of each segment. As a result, gains or losses created in this process may not be indicative of past or future underlying performance of the business.
•Special items, if any, are excluded because management believes they are not representative of the underlying results of operations. See Note 22 to the Consolidated Financial Statements for descriptions of special items. In 2013, adjusted income from operations also excluded the results of the guaranteed minimum income benefit ("GMIB") business prior to the reinsurance transaction with Berkshire Hathaway Life Insurance Company of Nebraska ("Berkshire").
(1) See Consolidated Results of Operations on page 39 for reconciliations of Operating revenues to Total revenues and Adjusted income from operations to Shareholders' net income on a dollar and per share basis.
Shareholders' net income was flat in 2015 compared with 2014 primarily due to higher adjusted income from operations as discussed below offset by lower realized investment gains and the impact of the 2015 special item charges described in our Consolidated financial results on page 40 of this MD&A. Shareholders' net income per share in 2015 and 2014 benefited from the favorable effect of share repurchase.
Global medical customers. Our medical customer base increased in 2015, primarily driven by growth in our targeted market segments and the acquisition of QualCare Alliance Networks, Inc. Excluding customers from our limited benefits business that we were required to exit in 2014, our medical customer base increased in 2014 compared with 2013, primarily due to growth in our targeted market segments.
Further discussion of detailed components of revenues and expenses can be found in the "Consolidated Results of Operations" section of this MD&A beginning on page 39. For further analysis and explanation of individual segment results, see the "Segment Reporting" section of this MD&A beginning on page 48.
On July 23, 2015, we entered into a definitive agreement to merge with Anthem, subject to certain terms, conditions and customary operating covenants, with Anthem continuing as the surviving company. Upon closing, our shareholders will receive $103.40 in cash and 0.5152 of a share of Anthem common stock for each common share of the Company. The closing price of Anthem common stock on February 24, 2016 was $130.75. At special shareholders' meetings held in December 2015, Cigna shareholders approved the merger with Anthem and Anthem shareholders voted to approve the issuance of shares of Anthem common stock according to the merger agreement. Consummation of the merger remains subject to certain customary conditions, including the receipt of certain necessary governmental and regulatory approvals and the absence of a legal restraint prohibiting the consummation of the merger. See Note 3 to the Consolidated Financial Statements for additional details. In addition, see Item 1A. - Risk Factors in this Form 10-K for risks to our business due to the proposed merger.
Management expects this transaction to close in the second half of 2016
The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act ("Health Care Reform") and the implementing regulations have resulted in broad changes that are meaningfully impacting the industry, including relationships with customers and health care providers, the design of products and services, and pricing and delivery systems. In 2014, there were changes resulting from the implementation of Health Care Reform regulations including public exchanges, a non-deductible industry tax in addition to fees and assessments, and minimum medical loss ratio requirements for Medicare Advantage and Medicare Part D plans. In both 2014 and 2015, there were ongoing payment reductions for Medicare Advantage plans by the Centers for Medicare & Medicaid Services ("CMS"). Collectively, these changes have had a significant impact on our business and customers, requiring adjustments to our business model to mitigate their effects on our results of operations and cash flows.
See Note 2(R) to the Consolidated Financial Statements for a description of and our accounting policy for these programs that commenced in 2014.
In 2015, shareholders' net income included after-tax benefits of approximately $250 million related to the 2015 coverage year risk mitigation programs, consisting of approximately $100 million for reinsurance and approximately $75 million each for the risk adjustment and risk corridor programs. After-tax benefits reported below for each program in 2015 also included the effects of updates to 2014 coverage year amounts based on CMS data received in June 2015.
The following table presents the after-tax benefits to shareholders' net income from these programs for the years ended December 31, 2015 and 2014 and our net receivable balances as of December 31, 2015 and 2014.
(2) Net receivables for the risk adjustment and risk corridor programs are reported in premiums, accounts and notes receivable. For the reinsurance program, receivables are reported in reinsurance recoverables.
•Realized investment results. In 2015, realized investment results decreased compared with 2014, primarily due to higher impairment losses on certain externally managed fixed maturities, particularly within the energy sector, that have an increased probability of sale prior to recovery of amortized cost. These impairments were driven by increased market yields. The significant decrease in 2014, compared with 2013, resulted primarily from the absence of large gains on sales of fixed maturities in 2013 related to funding the reinsurance transaction with Berkshire. See Note 14 to the Consolidated Financial Statements for additional information.
•Global Health Care medical costs. The increases in both 2015 and 2014 were primarily due to customer growth in our government business and, to a lesser extent, medical cost inflation.
•Other benefit expenses. The increase in 2015 compared with 2014 was primarily due to business growth in our Group Disability and Life and Global Supplemental Benefits segments. The decrease in other benefit expenses in 2014 compared with 2013 resulted from the absence of the charges recorded in the first quarter of 2013 associated with the reinsurance agreement with Berkshire ($727 million pre-tax), partially offset by continued business growth in the Global Supplemental and Group Disability and Life segments.
•Mail order pharmacy costs. The increases in both 2015 and 2014 are primarily due to increased volume, primarily for specialty medications (injectables), from our higher customer base, and home delivery utilization as well as higher unit costs.
•Other operating expenses. The increase in 2015 compared with 2014 was primarily due to business growth, strategic investments across our segments and special items described below. In 2014, the increase in other operating expenses over 2013 was largely driven by new taxes and fees assessed under Health Care Reform and business growth in all of our ongoing segments.
•Special items. See Note 22 to the Consolidated Financial Statements for additional details about special items.
•Consolidated effective tax rate. The increases in the consolidated effective tax rate in both 2015 and 2014 were primarily driven by the non-deductible health insurance industry tax assessed under Health Care Reform. This tax was first assessed in 2014 and increased in 2015. See Note 19 to the Consolidated Financial Statements for additional details.
Consolidated short-term investments increased in 2015 compared with 2014 as a result of higher net purchases of short-term investments at the parent company level. The decrease in short-term investments in 2014 compared with 2013 resulted from the Company's investment mix shift toward longer-term holdings.
• maintaining appropriate levels of cash, cash equivalents and short-term investments; • using cash flows from operating activities; • selling investments; • matching investment durations to those estimated for the related insurance and contractholder liabilities; and • borrowing from affiliates, subject to applicable regulatory limits.
• debt service and dividend payments to shareholders; • pension plan funding; and • repurchases of common stock.
• maintaining appropriate levels of cash and various types of marketable investments; • collecting dividends from its subsidiaries; • using proceeds from issuance of debt and equity securities; and • borrowing from its subsidiaries.
Cash flows from operating activities increased in 2015 compared with 2014 primarily driven by the volume and timing of government reimbursements and pharmacy considerations.
Cash used in financing activities decreased in 2015 compared with 2014, primarily reflecting lower share repurchases. Cash used in financing activities increased in 2014 compared with the same period in 2013, primarily due to higher share repurchases.
Interest expense reported above for the year ended 2015 excludes losses on the early extinguishment of debt.
The weighted average interest rate for outstanding short-term debt (primarily commercial paper) was 0.69% at December 31, 2015 and 0.27% at December 31, 2014.
At December 31, 2015, there was approximately $1.4 billion in cash and investments available at the parent company level. In 2016, the parent company's combined cash obligations are expected to be approximately $365 million to pay for interest, commercial paper maturities and dividends.
We maintain a capital management strategy to retain overseas a significant portion of the earnings from our foreign operations. These
undistributed earnings are deployed outside of the U.S. in support of the liquidity and capital needs of our foreign operations. As of December 31, 2015, undistributed earnings were approximately $2.2 billion. If repatriated, approximately $310 million of cash and cash equivalents held overseas would be subject to additional tax expense representing the difference between the U.S. and foreign tax rates. This strategy does not materially limit our ability to meet our liquidity and capital needs in the U.S. Cash and cash equivalents in foreign operations are held primarily to meet local liquidity and surplus needs with excess funds generally invested in longer duration, high quality securities.
Unfunded Pension Plan Liability. As of December 31, 2015, our unfunded pension liability was $953 million, reflecting a decrease of approximately $150 million from December 31, 2014. The decrease in the unfunded liability reflected an increase of approximately 40 basis points in the weighted average assumed discount rate, and changes to our mortality assumptions based on an updated pension mortality table. In 2016, we do not expect to make any pension contributions, as there are no contributions required under the Pension Protection Act of 2006. See Note 9 for additional information regarding our pension plans.
We are contingently liable for various contractual obligations entered into in the ordinary course of business. The maturities of our primary contractual cash obligations, as of December 31, 2015, are estimated to be as follows:
• Insurance liabilities. Contractual cash obligations for insurance liabilities, excluding unearned premiums, represent estimated net benefit payments for health, life and disability insurance policies and annuity contracts. Recorded contractholder deposit funds reflect current fund balances primarily from universal life insurance customers. Contractual cash obligations for these universal life contracts are estimated by projecting future payments using assumptions for lapse, withdrawal and mortality. These projected future payments include estimated future interest crediting on current fund balances based on current investment yields less the estimated cost of insurance charges and mortality and administrative fees. Actual obligations in any single year will vary based on actual morbidity, mortality, lapse, withdrawal, investment and premium experience. The sum of the obligations presented above exceeds the corresponding insurance and contractholder liabilities of $20 billion recorded on the balance sheet because the recorded insurance liabilities reflect discounting for interest and the recorded contractholder liabilities exclude future interest crediting, charges and fees. We manage our investment portfolios to generate cash flows needed to satisfy contractual obligations. Any shortfall from expected investment yields could result in increases to recorded reserves and adversely impact results of operations. The amounts associated with the sold retirement benefits and individual life insurance and annuity businesses, as well as the reinsured workers' compensation, personal accident and supplemental benefits businesses, are excluded from the table above as their related net cash flows associated with them are not expected to impact our cash flows. The total amount of these reinsured reserves excluded is approximately $5 billion. The expected future cash flows for GMDB and GMIB contracts included in the table above (within future policy benefits and other long-term liabilities) do not consider any of the related reinsurance arrangements.
• Other long-term liabilities. This table includes estimated payments for GMIB contracts, pension and other postretirement and postemployment benefit obligations, supplemental and deferred compensation plans, interest rate and foreign currency swap contracts, and certain tax and reinsurance liabilities. These items are presented in accounts payable, accrued expenses and other liabilities in our Consolidated Balance Sheets.
Purchase obligations. As of December 31, 2015, purchase obligations consisted of estimated payments required under contractual arrangements for future services and investment commitments as follows:
At the acquisition date, goodwill represents the excess of the cost of businesses acquired over the fair value of their net assets.
Fair value of a reporting unit was estimated using models and assumptions that we believe a hypothetical market participant would use to determine a current transaction price. The significant assumptions and estimates used in determining fair value include the discount rate and future cash flows. A range of discount rates was used, corresponding with the reporting unit's weighted average cost of capital, consistent with that used for investment decisions considering the specific and detailed operating plans and strategies within the reporting units. Projections of future cash flows were consistent with our annual planning process for revenues, claims, operating expenses, taxes, capital levels and long-term growth rates. In addition to these assumptions, we considered market data to evaluate the fair value of each reporting unit.
In our Government operating segment (which is a reporting unit) we contract with CMS and various state governmental agencies to provide managed health care services, including Medicare Advantage plans and Medicare-approved prescription drug plans. Estimated future cash flows for this business incorporated the potential effects of Medicare Advantage reimbursement rates for 2016 and beyond as discussed in the "Overview" section of this MD&A. Revenues from the Medicare programs are dependent, in whole or in part, upon annual funding from the federal government through CMS. This evaluation was updated to consider management's assessment of the impact of the CMS sanctions discussed in Note 23 to the Consolidated Financial Statements. Funding for these programs is dependent on many factors including general economic conditions, continuing government efforts to contain health care costs and budgetary constraints at the federal level and general political issues and priorities.
If we do not achieve our earnings objectives or the cost of capital rises significantly, the assumptions and estimates underlying these impairment evaluations could be adversely affected and result in future impairment charges that would negatively impact our operating results. The fair value estimate of our Government reporting unit could decrease by approximately 30% before an indication of impairment of goodwill occurs. Changes in the funding for our Medicare programs by the federal government, or our inability to resolve the matters arising from the CMS Notice in a timely and satisfactory manner, could materially reduce revenues and profitability in our Government reporting unit and have a significant impact on its fair value.
See Note 9 to the Consolidated Financial Statements for assumptions and methods used to estimate pension liabilities.
The discount rate is typically the most significant assumption in measuring the pension liability. We develop the discount rate by applying actual annualized yields at various durations from a discount rate curve constructed from high quality corporate bonds. If discount rates for the qualified and nonqualified pension plans decreased by 50 basis points, the accrued pension benefit liability would increase by approximately $205 million as of December 31, 2015 resulting in an after-tax decrease to shareholders' equity of approximately $135 million.
Global Health Care medical costs payable Medical costs payable for the Global Health Care segment include both reported claims and estimates for losses incurred but not yet reported.
Liabilities for medical costs payable as of December 31 were as follows (in millions):
In 2015, actual experience differed from our key assumptions as of December 31, 2014, resulting in $210 million of favorable incurred costs related to prior years' medical costs payable or 1.3% of the current year incurred costs as reported in 2014. In 2014, actual experience differed from our key assumptions as of December 31, 2013, resulting in $159 million of favorable incurred costs related to prior years' medical claims, or 1.0% of the current year incurred costs reported in 2013. Specifically, the favorable impact is due to faster than expected completion factors and lower than expected medical cost trends, both of which included an assumption for moderately adverse experience.
Assessment of "other-than-temporary" impairments of fixed maturities To determine whether a fixed maturity's decline in fair value below its amortized cost is other than temporary, we must evaluate the expected recovery in value and our intent to sell or the likelihood of a required sale of the fixed maturity prior to an expected recovery. To make this determination, we consider a number of general and specific factors including the regulatory, economic and market environments, length of time and severity of the decline, and the financial health and specific near term prospects of the issuer.
See Notes 2 (C) and 11 to the Consolidated Financial Statements for additional discussion of our review of declines in fair value, including information regarding our accounting policies for fixed maturities.
The following section of this MD&A discusses the results of each of our reporting segments. In these segment discussions, we present "operating revenues," defined as total revenues excluding realized investment results. We exclude realized investment results from this measure because our portfolio managers may sell investments based on factors largely unrelated to the underlying business purposes of each segment. As a result, gains or losses created in this process may not be indicative of past or future underlying performance of the business. See Note 22 for the components of each segment's operating revenues.
We use "adjusted income from operations" as our principal financial measure of operating performance because management believes it best reflects the underlying results of our business operations and permits analysis of trends in underlying revenue, expenses and profitability. Beginning on January 1, 2015, we define adjusted
As described in the Segment Reporting introduction on page 48, the performance of the Global Health Care segment is measured using adjusted income from operations. See Note 22 to the Consolidated Financial Statements for the calculation of adjusted income from operations for each segment. The key factors affecting adjusted income from operations for this segment are:
•operating expense as a percentage of operating revenues (operating expense ratio); and
•medical costs as a percentage of premiums (medical care ratio or "MCR") for our commercial and government businesses.
Adjusted income from operations increased in 2015 compared with 2014, reflecting U.S. Commercial business growth, including increased contributions from pharmacy, stop loss and other specialty products. Results in 2015 also reflect the impact of increased investments in business initiatives.
Operating revenues. The increase in operating revenues in 2015, compared with 2014 is primarily due to a higher customer base in our government segment, as well as revenue growth in specialty businesses and higher premiums in the U.S. commercial segment reflecting rate actions on most risk products primarily to recover underlying medical cost trends.
As required by Health Care Reform, we exited the limited benefits business effective December 31, 2013. Excluding this impact, our medical customer base increased in 2014 compared with 2013, primarily driven by continued growth in our targeted market segments.
Adjusted income from operations increased in 2015 compared with 2014 primarily due to business growth and lower acquisition costs, partially offset by the unfavorable impact of foreign currency movements and higher expense ratios as discussed below.
The increase in adjusted income from operations in 2014 compared with 2013 was driven in part by a lower acquisition cost ratio and continuing business growth, primarily in South Korea, partially offset by a higher loss ratio driven by a business mix shift and higher incurred claims. 2014 results also included favorable tax-related items of $21 million recorded in the third quarter of 2014.
Loss ratios increased in 2015 and 2014 compared with each prior year. The increase is due primarily to a business mix shift toward products with higher expected loss ratios in South Korea and the U.S.
Acquisition cost ratios decreased in both 2015 and 2014 compared with each prior year. The decline in each year's ratio largely represents a shift toward higher premium products with lower acquisition costs primarily in South Korea and the U.S.
South Korea is the single largest geographic market for our Global Supplemental Benefits segment. South Korea generated 50% of the segment's revenues and 75% of the segment's earnings in 2015. In 2015, our Global Supplemental Benefits segment operations in South Korea represented 4% of our total consolidated revenues and 9.6% of shareholders' net income.
• benefit expenses as a percentage of premiums (loss ratio); and
The increase in adjusted income from operations in 2014 compared with 2013 reflected favorable life results, higher net investment income and a lower expense ratio partially offset by higher disability claim costs largely due to a lower discount rate. Disability claim costs were lower in 2013 in part due to the $29 million favorable after-tax effect of a higher discount rate on claims incurred in 2013, resulting from the reallocation of higher yielding assets to the disability and life portfolio that had previously supported liabilities in the run-off reinsurance business. The favorable after-tax effects of reserve reviews were $52 million in 2014 and $60 million in 2013.
Operating revenues. The increases in both 2015 and in 2014 reflected premiums from new business growth due to disability and life sales. Net investment income also increased in both 2015 and in 2014 primarily due to higher average assets partially offset by lower yields.
The loss ratio decreased in 2015 compared with 2014 due to lower life claim incidence. The loss ratio increased in 2014 compared with 2013 due to higher disability claim costs including the effect of a lower discount rate, partially offset by lower life new claim incidence.
Operating expense ratio. The operating expense ratio was flat in 2015 compared with 2014 and lower in 2014 compared to 2013 driven by effective cost management.
Cigna's corporate-owned life insurance ("COLI") business contributes the majority of earnings in Other Operations. Cigna's Other Operations segment also includes the results from the run-off reinsurance and settlement annuity businesses, as well as the remaining deferred gains recognized from the sale of the individual life insurance and annuity and retirement benefits businesses.
Operating revenues. The decrease in operating revenues in 2015 compared with 2014 is largely due to lower net investment income driven by lower investment yields and, to a lesser extent, lower premiums in COLI driven by favorable experience-rating impacts.
Corporate reflects amounts not allocated to operating segments, including net interest expense (defined as interest on corporate debt less net investment income on investments not supporting segment operations), interest on uncertain tax positions, certain litigation matters, intersegment eliminations, compensation cost for stock options, expense associated with our frozen pension plans and certain overhead and project costs.
The following table reflects our fixed maturity portfolio by type of issuer as of December 31, 2015 and 2014.
The fixed maturity portfolio increased modestly during 2015, reflecting a strategic increase in investment in fixed maturities, partially offset by decreased valuations due to the impact of increased market yields. Although overall asset values are well in excess of amortized cost, there are specific securities with amortized cost in excess of fair value by $219 million in aggregate as of December 31, 2015. See Note 11 to the Consolidated Financial Statements for further information.
As of December 31, 2015, $17.5 billion, or 89%, of the fixed maturities in our investment portfolio were investment grade (Baa and above, or equivalent), and the remaining $2.0 billion were below investment grade. The majority of the bonds that are below investment grade are rated at the higher end of the non-investment grade spectrum. These quality characteristics have not materially changed from the prior year.
Our investment in state and local government securities, with an average quality rating of Aa2 is diversified by issuer and geography with no single exposure greater than $30 million. We assess each issuer's credit quality based on a fundamental analysis of underlying financial information and do not rely solely on statistical rating organizations or monoline insurer guarantees.
As of December 31, 2015, corporate fixed maturities included private placement investments of $5.2 billion that are generally less marketable than publicly-traded bonds. However, yields on these investments tend to be higher than yields on publicly-traded bonds with comparable credit risk. We perform a credit analysis of each issuer, diversify investments by industry and issuer and require financial and other covenants that allow us to monitor issuers for deteriorating financial strength and pursue remedial actions, if warranted. Corporate fixed maturities include $341 million of investments in companies that are domiciled or have significant business interests in Italy, Ireland, and Spain. These investments have an average quality rating of Baa3 and are diversified by industry sector, including approximately 6% invested in financial institutions. Corporate fixed maturities also include investments in the energy and
Our commercial mortgage loans are fixed rate loans, diversified by property type, location and borrower. Loans are secured by high quality commercial properties and are generally made at less than 70% of the property's value at origination of the loan. Property value, debt service coverage, quality, building tenancy and stability of cash flows are all important financial underwriting considerations. We hold no direct residential mortgage loans and do not securitize or service mortgage loans.
We completed an annual in-depth review of our commercial mortgage loan portfolio during the second quarter of 2015. This review included an analysis of each property's year-end 2014 financial statements, rent rolls, operating plans and budgets for 2015, a physical inspection of the property and other pertinent factors. Based on property values and cash flows estimated as part of this review and subsequent fundings and repayments, the portfolio's average loan-to-value ratio improved to 58% at December 31, 2015, from 63% as of December 31, 2014, and the portfolio's average debt service coverage ratio also improved to 1.78 at December 31, 2015 from 1.66 as of December 31, 2014. These improvements reflect payoffs of loans with below average debt service coverage ratios and high loan to value ratios, as well as increased operating income and value across most underlying properties. See Note 11 to the Consolidated Financial Statements for further information.
The $1.9 billion commercial mortgage loan portfolio consists of approximately 65 loans. The portfolio includes three impaired loans with a carrying value totaling $98 million, net of $15 million in reserves, that are classified as problem or potential problem loans. We have $205 million of loans maturing in the next twelve months. Given the quality and diversity of the underlying real estate, positive debt service coverage and significant borrower cash investment or equity value averaging 30%, we remain confident that borrowers will continue to perform as expected under their contract terms.
•for commercial mortgages, deterioration of debt service coverage below 1.0 or value declines resulting in estimated loan-to-value ratios increasing to 100% or more. We recognize interest income on problem bonds and commercial mortgage loans only when payment is actually received because of the risk profile of the underlying investment. The amount that would have been reflected in net income if interest on non-accrual investments had been recognized in accordance with the original terms was not significant for 2015 or 2014.
•Foreign currency exchange rate risk of the U.S. dollar primarily to the South Korean won, Euro, Chinese yuan renminbi, Taiwan dollar and British pound. An unfavorable change in exchange rates reduces the carrying value of net assets denominated in foreign currencies.
• Use of derivatives. We use derivative financial instruments to minimize certain market risks. In 2014, we entered into interest rate swap contracts to convert a portion of our interest rate exposure on long-term debt from fixed rates to variable rates to more closely align interest expense with interest income received on our cash equivalent and short-term investment balances. See Notes 2(C) and 12 to the Consolidated Financial Statements for additional information about financial instruments, including derivative financial instruments.
•a hypothetical increase in market interest rates, primarily for fixed maturities and commercial mortgage loans, partially offset by liabilities for long-term, largely fixed-rate debt; and
•a hypothetical strengthening of the U.S. dollar to foreign currencies, primarily for the net assets of foreign subsidiaries denominated in a foreign currency. Management believes that actual results could differ materially from these examples because:
The effect of a hypothetical increase in interest rates was determined by estimating the present value of future cash flows using various models, primarily duration modeling. The impact of a hypothetical increase to interest rates at December 31, 2015 was greater than that at December 31, 2014 reflecting increased purchases of longer duration assets, partially offset by valuation decreases resulting from higher market yields of fixed maturities during 2015.
The effect of a hypothetical strengthening of the U.S. dollar relative to the foreign currencies held by us was estimated to be 10% of the U.S. dollar equivalent fair value. Our foreign operations hold investment assets, such as fixed maturities, cash, and cash equivalents, that are generally invested in the currency of the related liabilities. The effect of a hypothetical 10% strengthening in the U.S. dollar to foreign currencies at December 31, 2015 was greater than that effect at December 31, 2014 due to increased amounts of investments that are primarily denominated in the South Korean won.
Leases (Accounting Standards Update ("ASU") 2016-02). The Financial Accounting Standards Board ("FASB") amended lease accounting requirements to begin recording assets and liabilities arising from leases on the balance sheet. The new guidance will also require significant additional disclosures about the amount, timing and uncertainty of cash flows from leases. This new guidance will become effective beginning January 1, 2019 using a modified restatement approach for leases in effect as of and after the date of adoption. Early adoption and certain practical expedients to measure the effect of adoption will also be allowed. While the Company is evaluating this new guidance to determine its timing and method of adoption and the estimated effects on its consolidated financial statements, assets and liabilities arising from leases are expected to increase based on the present value of remaining estimated lease payments at the time of adoption.
Disclosures about Short-Duration Insurance Contracts (ASU 2015-09). In May 2015, the FASB issued final guidance to enhance disclosure requirements for short-duration insurance contracts. The disclosures require more transparent information about an insurance entity's initial claim estimates and subsequent adjustments to those estimates, methodologies and judgments in estimating claims, and the timing, frequency and severity of claims. The impact of adoption is limited to increased disclosures including most insurance liabilities of the Global Health Care and Group Disability and Life segments. The Company plans to adopt the new disclosures, as required, in its 2016 annual financial statements.
reported as of December 31, 2014 have been retrospectively adjusted. The effect was not material to either caption.
Revenue from Contracts with Customers (ASU 2014-09). In May 2014, the FASB issued new revenue recognition guidance that will apply to various contracts with customers to provide goods or services, including the Company's non-insurance, administrative services contracts. It will not apply to certain contracts within the scope of other GAAP, such as insurance contracts. This new guidance introduces a model that requires companies to estimate and allocate the expected contract revenue among distinct goods or services in the contract based on relative standalone selling prices. Revenue is recognized as goods or services are delivered. This new method replaces the current GAAP approach of recognizing revenue that is fixed and determinable primarily based on contract terms. In addition, extensive new disclosures will be required including the presentation of additional categories of revenues and information about related contract assets and liabilities. This new guidance must be implemented on January 1, 2018; early adoption is permitted only as of January 1, 2017. The Company may choose to adopt these changes through retrospective restatement with or without using certain practical expedients or with a cumulative effect adjustment on adoption. The Company continues to monitor developing implementation guidance and evaluate these new requirements for its non-insurance customer contracts to determine its method and timing of implementation and any resulting estimated effects on its financial statements.
Investment Company Accounting (ASU 2013-08). Effective January 1, 2014, the Company adopted the FASB's amended accounting guidance to change the criteria for reporting as an investment company, clarify the fair value measurement used by an investment company and require additional disclosures. This guidance also confirms that parent company accounting for an investment company should reflect fair value accounting. While this guidance applies to certain of the Company's security and real estate partnership investments, its adoption did not have a material impact on the Company's financial statements.
• If the net present value of projected future cash flows of a fixed maturity (based on qualitative and quantitative factors, including the probability of default, and the estimated timing and amount of recovery) is below the amortized cost basis, that difference is recognized as an impairment loss. For mortgage and asset-backed securities, estimated future cash flows are also based on assumptions about the collateral attributes including prepayment speeds, default rates and changes in value. Commercial mortgage loans. These loans are made exclusively to commercial borrowers at a fixed rate of interest. Commercial mortgage loans are carried at unpaid principal balances or, if impaired, the lower of unpaid principal or fair value of the underlying real estate. If the fair value of the underlying real estate is less than unpaid principal of an impaired loan, a valuation reserve is recorded. Commercial mortgage loans are considered impaired when it is probable that the Company will not collect amounts due according to the terms of the original loan agreement. The Company monitors credit risk and assesses the impairment of loans individually and on a consistent basis for all loans in the portfolio. The Company estimates the fair value of the underlying real estate using internal valuations generally based on discounted cash flow analyses. Certain commercial mortgage loans without valuation reserves are considered impaired because the Company will not collect all interest due according to the terms of the original agreements; however, the Company expects to recover the unpaid principal because it is less than the fair value of the underlying real estate.
Short-term investments. Security investments with maturities of greater than 90 days but less than one year from time of purchase are classified as short-term, available for sale and carried at fair value, that approximates cost.
•Other products are expensed as incurred. Deferred policy acquisition costs also include the value of business acquired with certain acquisitions.
Each year, deferred policy acquisition costs are tested for recoverability. For universal life and other individual products, management estimates the present value of future revenues less expected payments. For group health and accident insurance products, management estimates the sum of unearned premiums and anticipated net investment income less future expected claims and related costs. If management's estimates of these sums are less than the deferred costs, the Company reduces deferred policy acquisition costs and records an expense. The Company recorded amortization for policy acquisition costs of $286 million in 2015, $289 million in 2014 and $255 million in 2013 primarily in other operating expenses.
Other assets consist primarily of guaranteed minimum income benefits ("GMIB") assets and various other insurance-related assets. The Company's other intangible assets include purchased customer and producer relationships, provider networks and trademarks. The fair value of purchased customer relationships and the amortization method were determined as of the dates of purchase using an income approach that relies on projected future net cash flows including key assumptions for the customer attrition rate and discount rate. The Company amortizes other intangibles on an accelerated or straight-line basis over periods from five to 30 years. Management revises amortization periods if it believes there has been a change in the length of time that an intangible asset will continue to have value. Costs incurred to renew or extend the terms of these intangible assets are generally expensed as incurred. See Notes 8 and 10 for additional information.
Liabilities for contractholder deposit funds primarily include deposits received from customers for investment-related and universal life products and investment earnings on their fund balances. These
The Company consistently estimates incurred but not yet reported losses using actuarial principles and assumptions based on historical and projected claim incidence patterns, claim size and the expected payment period. The Company recognizes the actuarial best estimate of the ultimate liability within a level of confidence, consistent with actuarial standards of practice that the liabilities be adequate under moderately adverse conditions.
The Company discounts certain unpaid claim liabilities because benefit payments are made over extended periods. Substantially all of these liabilities are associated with the group long-term disability business. Discount rate assumptions for that business are based on projected investment returns for the asset portfolios that support these liabilities and range from 4.4% to 5.7%. Discounted liabilities were $3.7 billion at December 31, 2015 and $3.9 billion at December 31, 2014.
and emerging trends that may impact key assumptions. The estimation process involves considerable judgment, reflecting the variability inherent in forecasting future claim payments. These estimates are highly sensitive to changes in the Company's key assumptions, specifically completion factors and medical cost trends. See Note 5 for further information.
Premiums for group life, accident and health insurance and managed care coverages are recognized as revenue on a pro rata basis over the contract period. Benefits and expenses are recognized when incurred, and for our Global Health Care business, medical costs are presented net of pharmaceutical manufacturer rebates. For experience-rated contracts, premium revenue includes an adjustment for experience-rated refunds based on contract terms and calculated using the customer's experience (including estimates of incurred but not reported claims).
•A three-year (2014-2016) reinsurance program is designed to provide reimbursement to insurers for high cost individual business sold on or off the public exchanges. The reinsurance entity established by the U.S. Department of Health and Human Services ("HHS") is funded by a per-customer reinsurance fee assessed on all insurers, Health Maintenance Organizations ("HMOs") and self-insured group health plans, excluding certain products such as Medicare Advantage and Medicare Part D. Only non-grandfathered individual plans are eligible for recoveries if claims exceed a specified threshold, up to a reinsurance cap. Reinsurance contributions associated with non-grandfathered individual plans are reported as a reduction in premium revenue, and estimated reinsurance recoveries are established with an offsetting reduction in Global Health Care medical costs. Reinsurance fee contributions for other insured business are reported in other operating expenses. Final recoverable amounts are determined and settled with HHS in the year following the policy year.
•A premium stabilization program is comprised of two components: 1) a permanent component that reallocates funds from insurers with lower risk populations to insurers with higher risk populations based on the relative risk scores of participants in non-grandfathered plans in the individual and small group markets, both on and off the exchanges. We estimate our receivable or payable based on the risk of our members compared to the risk of other members in the same state and market, considering data obtained from industry studies and HHS; and 2) a temporary (2014-2016) component designed to limit insurer gains and losses by comparing allowable medical costs to a target amount as defined by HHS. This program applies to individual and small group qualified health plans, operating on and off the exchanges. Variances from the target amount exceeding certain thresholds may result in amounts due to or due from HHS.
• Charges for mortality, administration and policy surrender are recognized in premiums as earned. Administrative fees are considered earned when services are provided. Benefits and expenses for universal life products consist of benefit claims in excess of policyholder account balances. Expenses are recognized when claims are incurred, and income is credited to policyholders in accordance with contract provisions.
The deferred income tax provision generally represents the net change in deferred income tax assets and liabilities during the year, exclusive of amounts reported as adjustments to accumulated other comprehensive income or amounts initially recorded due to business combinations. The current income tax provision generally represents the estimated amounts due on the various income tax returns for the year reported plus the effect of any uncertain tax positions. Uncertain tax positions are evaluated in accordance with GAAP.
The Company computes basic earnings per share using the weighted-average number of unrestricted common and deferred shares outstanding. Diluted earnings per share also includes the dilutive effect of outstanding employee stock options and unvested restricted stock granted after 2009 using the treasury stock method and the effect of strategic performance shares. See Note 4 for additional information.
On July 23, 2015, the Company entered into a merger agreement with Anthem, Inc. ("Anthem") and Anthem Merger Sub Corp. ("Merger Sub"), a direct wholly owned subsidiary of Anthem. The merger agreement provides (a) for the merger of the Company and Merger Sub, with the Company continuing as the surviving corporation and (b) if certain tax opinions are delivered, immediately following the completion of the initial merger, for the surviving corporation to be merged with and into Anthem, with Anthem continuing as the surviving corporation (collectively, the "merger"). Subject to certain terms, conditions, and customary operating covenants, each share of Cigna common stock issued and outstanding immediately prior to the effective time of the merger will be converted into the right to receive (a) $103.40 in cash, without interest, and (b) 0.5152 of a share of Anthem common stock. The closing price of Anthem common stock on February 24, 2016 was $130.75.
The transaction is expected to close in the second half of 2016.
For the year ended December 31, 2015, the Company incurred pre-tax costs of $66 million ($57 million after-tax) directly related to the proposed merger. These costs consisted primarily of fees for financial advisory, legal and other professional services.
The Company completed certain acquisitions during the three years ended December 31, 2015. In accordance with GAAP, the purchase price for each acquisition was allocated to the tangible and intangible net assets acquired based on management's preliminary estimates of their fair values. The results of acquisition activities for these years were not material to the Company's results of operations, liquidity or financial condition.
Medical costs payable for the Global Health Care segment reflects estimates of the ultimate cost of claims that have been incurred but not yet reported, those that have been reported but not yet paid (reported costs in process), and other medical expenses payable that are primarily comprised of accruals for incentives and other amounts payable to health care professionals and facilities, as follows:
Reinsurance and other amounts recoverable reflect amounts due from reinsurers and policyholders to cover incurred but not reported and pending claims for minimum premium products and certain ASO business where the right of offset does not exist. See Note 7 for additional information on reinsurance. For the year ended December 31, 2015, actual experience differed from the Company's key assumptions resulting in favorable incurred costs related to prior years' medical costs payable of $210 million, or 1.3% of the current year incurred costs as reported for the year ended December 31, 2014. Actual completion factors accounted for $62 million, or 0.4%, while actual medical cost trend resulted in $115 million, or 0.7%. The remaining $33 million, or 0.2%, was primarily related to an increase in the 2014 reinsurance reimbursement rate from CMS under Health Care Reform.
For the year ended December 31, 2014, actual experience differed from the Company's key assumptions, resulting in favorable incurred costs related to prior years' medical costs payable of $159 million, or 1.0% of the current year incurred costs as reported for the year ended December 31, 2013. Actual completion factors accounted for $61 million of favorability, or 0.4%, while actual medical cost trend resulted in the remaining $98 million, or 0.6%.
The impact of prior year development on shareholders' net income was $60 million for the year ended December 31, 2015 compared with $53 million for the year ended December 31, 2014. The favorable effect of prior year development for both years primarily reflects low utilization of medical services. Incurred costs related to prior years in the table above do not directly correspond to an increase or decrease to shareholders' net income. The primary reason for the difference is that decreases to prior year incurred costs pertaining to the portion of the liability established for moderately adverse conditions are not considered as impacting shareholders' net income if they are offset by increases in the current year provision for moderately adverse conditions. The determination of liabilities for Global Health Care medical costs payable requires the Company to make critical accounting estimates. See Note 2(N) for further information about the assumptions and estimates used to establish this liability.
The Company is regularly evaluating ways to deliver its products and services more efficiently and at a lower cost. During the fourth quarter of 2013, the Company committed to a plan to increase its organizational efficiency and reduce costs through a series of actions including employee headcount reductions. As a result, the Company recognized a charge in other operating expenses of $60 million pre-tax ($40 million after-tax) in the fourth quarter of 2013, primarily for severance costs. As of December 31, 2015, the remaining balance associated with this plan was not material.
In 2013, the Company entered into an agreement with Berkshire Hathaway Life Insurance Company of Nebraska ("Berkshire") to effectively exit the GMDB and GMIB business via a reinsurance transaction. Berkshire reinsured 100% of the Company's future claim payments in this business, net of retrocessional arrangements existing at that time. The reinsurance agreement is subject to an overall limit with approximately $3.6 billion remaining at December 31, 2015.
This transaction resulted in an after-tax charge to shareholders' net income in the first quarter of 2013 of $507 million ($781 million pre-tax reported as follows: $727 million in other benefit expenses; $54 million in other operating expenses, including $45 million of GMIB fair value loss). The payment to Berkshire under the agreement was $2.2 billion and was funded from the sale of investment assets, tax benefits related to the transaction and available parent cash.
The Company estimates this liability with an internal model based on the Company's experience and future expectations over an extended period, consistent with the long-term nature of this product. Because the product is premium deficient, the Company records increases to the reserve if it is inadequate based on the model. As a result of the reinsurance transaction, reserve increases have a corresponding increase in the recorded reinsurance recoverable, provided the increased recoverable remains within the overall Berkshire limit (including the GMIB assets).
Benefits paid and incurred are net of ceded amounts, including the impact of the 2013 reinsurance transaction with Berkshire. The ending net retained reserve as of December 31, 2015 and December 31, 2014 covers ongoing administrative expenses, as well as the minor claim exposure retained by the Company.
Recoveries were lower in 2013 primarily due to activity related to the Berkshire transaction.
(1)Includes the one-time $23 million benefit of a 2015 acquisition in which the fair value of acquired net assets exceeded the purchase price.
Other property and equipment includes amortization on assets recorded under capital leases of $22 million in 2015 and $20 million in 2014.
As further discussed in Note 23, the Company and the Cigna Pension Plan are defendants in a class action lawsuit. When the plan amendment related to this litigation is adopted, the pension benefit obligation will be updated to reflect benefits resulting from this litigation.
Pension benefits. The Company funds its qualified pension plans at least at the minimum amount required by the Employee Retirement Income Security Act of 1974 and the Pension Protection Act of 2006. For 2016, the Company does not expect to make any contributions to the qualified pension plans because none are required. Future years' contributions will ultimately be based on a wide range of factors including but not limited to asset returns, discount rates, and funding targets.
The Company expects to recognize pre-tax losses of $66 million in 2016 from amortization of the net loss from past experience. This estimate is based on a weighted average amortization period for the frozen and inactive plans that is based on the average expected remaining life of plan participants of approximately 28 years.
As of December 31, 2015, pension plan assets included $3.6 billion invested in the separate accounts of Connecticut General Life Insurance Company and Life Insurance Company of North America, that are subsidiaries of the Company, as well as an additional $332 million invested directly in funds offered by the buyer of the retirement benefits business.
Plan assets in Level 1 include exchange-listed equity securities. Level 2 assets primarily include:
The following table summarizes the changes in pension plan assets classified in Level 3 for the years ended December 31, 2015 and December 31, 2014. Actual return on plan assets in this table may include changes in fair value that are attributable to both observable and unobservable inputs.
Other postretirement benefits. The Company's pre-tax expense for these plans was $8 million for 2015, $9 million for 2014 and $(11) million for 2013. The 2013 benefit was primarily due to a pre-tax curtailment gain of $19 million resulting from the freeze of the postretirement medical plan. Changes in the estimated rate of future increases in the per capital cost of health care benefits would have no material effect on postretirement benefit costs or obligations.
The Company sponsors a 401(k) plan in which the Company matches a portion of employees' pre-tax contributions. Participants in the plan may invest in various funds that invest in the Company's common stock, several diversified stock funds, a bond fund or a fixed-income fund. In conjunction with the action to freeze the domestic defined benefit pension plans, effective January 1, 2010, the Company increased its matching contributions to 401(k) plan participants.
The Company may elect to increase its matching contributions if the Company's annual performance meets certain targets. The Company's expense for these plans was $106 million for 2015, $98 million for 2014 and $91 million for 2013.
The following tables provide information as of December 31, 2015 and 2014 about the Company's financial assets and liabilities carried at fair value. Separate account assets that are also recorded at fair value on the Company's Consolidated Balance Sheets are reported separately under the heading "Separate account assets" as gains and losses related to these assets generally accrue directly to policyholders.
Fixed maturities and equity securities. Approximately 95% of the Company's investments in fixed maturities and equity securities are classified in Level 2 including most public and private corporate debt and equity securities, federal agency and municipal bonds, non-government mortgage-backed securities and preferred stocks. Because many fixed maturities do not trade daily, third-party pricing services and internal methods often use recent trades of securities with similar features and characteristics. When recent trades are not available, pricing models are used to determine these prices. These models calculate fair values by discounting future cash flows at estimated market interest rates. Such market rates are derived by calculating the appropriate spreads over comparable U.S. Treasury securities, based on the credit quality, industry and structure of the asset. Typical inputs and assumptions to pricing models include, but are not limited to, a combination of benchmark yields, reported trades, issuer spreads, liquidity, benchmark securities, bids, offers, reference data, and industry and economic events. For mortgage-backed securities, inputs and assumptions may also include characteristics of the issuer, collateral attributes, prepayment speeds and credit rating.
Short-term investments are carried at fair value which approximates cost. On a regular basis, the Company compares market prices for these securities to recorded amounts to validate that current carrying amounts approximate exit prices. The short-term nature of the
investments and corroboration of the reported amounts over the holding period support their classification in Level 2.
Other derivatives classified in Level 2 represent over-the-counter instruments such as interest rate and foreign currency swap contracts. Fair values for these instruments are determined using market observable inputs including forward currency and interest rate curves and widely published market observable indices. Credit risk related to the counterparty and the Company is considered when estimating the fair values of these derivatives. However, the Company is largely protected by collateral arrangements with counterparties and determined that no adjustment for credit risk was required as of December 31, 2015 or 2014. Level 2 also includes exchange-traded interest rate swap contracts. Credit risk related to the clearinghouse counterparty and the Company is considered minimal when estimating the fair values of these derivatives because of upfront margin deposits and daily settlement requirements. The nature and use of these other derivatives are described in Note 12.
The Company classifies certain newly issued, privately-placed, complex or illiquid securities, as well as assets and liabilities relating to GMIB, in Level 3. Approximately 4% of fixed maturities and equity securities are priced using significant unobservable inputs and classified in this category.
The following tables summarize the fair value and significant unobservable inputs used in pricing the following securities that were developed directly by the Company as of December 31, 2015 and 2014. The range and weighted average basis point amounts ("bps") for fixed maturity spreads (adjustment to discount rates) and price-to-earnings multiples for equity investments reflect the Company's best estimates of the unobservable adjustments a market participant would make to calculate these fair values.
Significant increases in fixed maturity spreads would result in a lower fair value measurement while decreases in these inputs would result in a higher fair value measurement. Significant decreases in equity price-to-earnings multiples would result in a lower fair value measurement while increases in these inputs would result in a higher fair value measurement. Generally, the unobservable inputs are not interrelated and a change in the assumption used for one unobservable input is not accompanied by a change in the other unobservable input.
GMIB liabilities are reported in the Company's Consolidated Balance Sheets in accounts payable, accrued expenses and other liabilities. GMIB assets associated with these contracts represent net receivables in connection with reinsurance that the Company has purchased from three external reinsurers and are reported in the Company's Consolidated Balance Sheets in other assets, including other intangibles.
The following tables summarize the changes in financial assets and financial liabilities classified in Level 3 for the years ended December 31, 2015 and 2014. Separate account asset changes are reported separately under the heading "Separate account assets" as the changes in fair values of these
• Other operating expenses for amounts related to GMIB assets and liabilities (GMIB fair value gain/loss), except for the impact of changes in non-performance risk. In the tables above, gains and losses included in other comprehensive income are reflected in net unrealized appreciation (depreciation) on securities in the Consolidated Statements of Comprehensive Income.
Fair values and changes in the fair values of separate account assets generally accrue directly to the policyholders and are excluded from the Company's revenues and expenses. At December 31, separate account assets were as follows:
(1) As of December 31, 2015, non-guaranteed separate accounts included $3.6 billion in assets supporting the Company's pension plans, including $1.2 billion classified in Level 3.
(1) As of December 31, 2014, non-guaranteed separate accounts included $3.8 billion in assets supporting the Company's pension plans, including $1.1 billion classified in Level 3.
• corporate and structured bonds valued using recent trades of similar securities or pricing models that discount future cash flows at estimated market interest rates as described above; and
• actively-traded institutional and retail mutual fund investments and separate accounts priced using the daily net asset value that is the exit price. Separate account assets classified in Level 3 include investments primarily in securities partnerships, real estate and hedge funds generally valued based on the separate account's ownership share of the equity of the investee including changes in the fair values of its underlying investments.
Some financial assets and liabilities are not carried at fair value each reporting period, but may be measured using fair value only under certain conditions, such as investments in real estate entities and commercial mortgage loans when they become impaired. Impaired real estate entities and commercial mortgage loans representing less than 1% of total investments were written down to their fair values, resulting in realized investment losses of $16 million, after-tax in 2015 and $10 million, after-tax in 2014.
Contractholder deposit funds, excluding universal life products. Generally, these funds do not have stated maturities. Approximately 65% of these balances can be withdrawn by the customer at any time without prior notice or penalty. The fair value for these contracts is the amount estimated to be payable to the customer as of the reporting date, which is generally the carrying value. Most of the remaining contractholder deposit funds are reinsured by the buyers of the individual life and annuity and retirement benefits businesses. The fair value for these contracts is determined using the fair value of these buyers' assets supporting these reinsured contracts. The Company had reinsurance recoverables equal to the carrying value of these reinsured contracts. These instruments were classified in Level 3 because certain
inputs are unobservable (supported by little or no market activity) and significant to their resulting fair value measurement.
Long-term debt, including current maturities, excluding capital leases. The fair value of long-term debt is based on quoted market prices for recent trades. When quoted market prices are not available, fair value is estimated using a discounted cash flow analysis and the Company's estimated current borrowing rate for debt of similar terms and remaining maturities. These measurements were classified in Level 2 because the fair values are based on quoted market prices or other inputs that are market observable or can be corroborated by market data.
Gross unrealized appreciation (depreciation) on fixed maturities by type of issuer is shown below.
As of December 31, 2015, the Company had commitments to purchase $15 million of fixed maturities, all of which bear interest at a fixed market rate.
There were no available for sale equity securities with a significant unrealized loss reflected in accumulated other comprehensive income at December 31, 2015. Equity securities include hybrid investments consisting of preferred stock with call features that are carried at fair value with changes in fair value reported in other realized investment gains (losses) and dividends reported in net investment income. As of December 31, 2015, fair values of these securities were $52 million and amortized cost was $66 million. As of December 31, 2014, fair values of these securities were $57 million and amortized cost was $69 million.
As of December 31, 2015, the Company had commitments to extend credit under commercial mortgage loan agreements of $5 million.
The following tables summarize the credit risk profile of the Company's commercial mortgage loan portfolio based on loan-to-value and debt service coverage ratios, as of December 31, 2015 and 2014:
The Company's annual in-depth review of its commercial mortgage loan investments is the primary mechanism for identifying emerging risks in the portfolio. The most recent review was completed by the Company's investment professionals in the second quarter of 2015 and included an analysis of each underlying property's most recent annual financial statements, rent rolls, operating plans, budgets for 2015, a physical inspection of the property and other pertinent factors. Based on historical results, current leases, lease expirations and rental conditions in each market, the Company estimates the current year and future stabilized property income and fair value, and categorizes the investments as loans in good standing, potential problem loans or problem loans. Based on property valuations and cash flows estimated as part of this review, and considering updates for loans where material changes were subsequently identified, the portfolio's average loan-to-value ratio improved to 58% at December 31, 2015 from 63% at December 31, 2014. The portfolio's average debt service coverage ratio was estimated to be 1.78 at December 31, 2015, an improvement from 1.66 at December 31, 2014.
The Company will reevaluate a loan's credit quality between annual reviews if new property information is received or an event such as delinquency or a borrower's request for restructure causes management to believe that the Company's estimate of financial performance, fair value or the risk profile of the underlying property has been impacted.
Certain loans were modified during 2015 and 2014. However, these were not considered troubled debt restructures and the impact of such modifications was not material to the Company's results of operations, financial condition or liquidity.
Potential problem mortgage loans are considered current (no payment is more than 59 days past due), but exhibit certain characteristics that increase the likelihood of future default such as the deterioration of debt service coverage below 1.0, estimated loan-to-value ratios increasing to 100% or more, downgrade in quality rating and requests from the borrower for restructuring. In addition, loans are considered potential problems if principal or interest payments are past due by more than 30 but less than 60 days. Problem mortgage loans are either in default by 60 days or more or have been restructured as to terms, which could include concessions on interest rate, principal payment or maturity date. The Company monitors each problem and potential problem mortgage loan on an ongoing basis and updates the loan categorization and quality rating when warranted.
Problem and potential problem mortgage loans, net of valuation reserves, totaled $139 million at December 31, 2015 and $208 million at December 31, 2014.
The average recorded investment in impaired loans was $126 million during 2015 and $155 million during 2014. Because of the risk profile of the underlying investment, the Company recognizes interest income on problem mortgage loans only when payment is actually received. Interest income that would have been reflected in net income if interest on non-accrual commercial mortgage loans had been accrued in accordance with the original terms was not significant for 2015 or 2014. Interest income on impaired commercial mortgage loans was not significant for 2015 or 2014. See Note 2 for further information on impaired commercial mortgage loans.
Changes in valuation reserves for commercial mortgage loans were not material for the years ended December 31, 2015 and 2014.
Real estate investments and securities partnerships with a carrying value of $277 million at December 31, 2015 and $264 million at December 31, 2014 were non-income producing during the preceding twelve months.
As of December 31, 2015, the Company had commitments to contribute:
• $487 million to entities that hold securities diversified by issuer and maturity date. The Company expects to disburse approximately 40% of the committed amounts in 2016.
The Company uses derivative financial instruments to manage the characteristics of investment assets (such as duration, yield, currency and liquidity) to meet the varying demands of the related insurance and contractholder liabilities (such as paying claims, investment returns and withdrawals) and to hedge interest rate risk of its long-term debt. The Company has written and purchased GMIB reinsurance contracts in its run-off reinsurance business that are accounted for as freestanding derivatives. For information on the Company's accounting policy for derivative financial instruments, see Note 2. Derivatives in the Company's separate accounts are excluded from the following discussion because associated gains and losses generally accrue directly to separate account policyholders.
Using cash flow hedge accounting, fair values are reported in other long-term investments or accounts payable, accrued expenses and other liabilities. Changes in fair value are reported in accumulated other comprehensive income and amortized into net investment income or reported in other realized investment gains and losses as interest or principal payments are received.
Using fair value hedge accounting, the fair values of the swap contracts are reported in other assets, including other intangibles or accounts payable, accrued expenses and other liabilities. As the critical terms of these swaps match those of the long-term debt being hedged, the carrying value of the hedged debt is adjusted to reflect changes in its fair value driven by LIBOR. The effects of those adjustments on other operating expenses are offset by the effects of corresponding changes in the swaps' fair value, including interest expense for the difference between the variable and fixed interest rates.
Under the terms of these contracts, the Company provides upfront margin and settles fair value changes and net interest between variable and fixed interest rates daily with the clearinghouse. Net interest cash flows are reported in operating activities.
As of December 31, 2015 and 2014, the notional values of these derivative instruments were $750 million.
The fair value effects of GMIB contracts on the financial statements are included in Note 10 and their volume of activity is included in Note 23. Cash flows on these contracts are reported in operating activities.
The Company's dynamic hedge programs were discontinued at the time of the Berkshire reinsurance transaction in 2013. These hedge programs generated losses (included in other revenues) of $39 million in 2013.
When the Company becomes involved with a variable interest entity, as well as when the nature of the Company's involvement with the entity changes, the Company evaluates the following to determine if it is the primary beneficiary and must consolidate the entity:
• the Company's ability to direct its activities, receive its benefits and absorb its losses relative to the other parties involved with the entity including its sponsors, equity holders, guarantors, creditors and servicers. In the normal course of its investing activities, the Company makes passive investments in securities that are issued by variable interest entities for which the Company is not the sponsor or manager. These investments are predominantly asset-backed securities primarily collateralized by foreign bank obligations or mortgage-backed securities. The asset-backed securities largely represent fixed-rate debt securities issued by trusts that hold perpetual floating-rate subordinated notes issued by foreign banks. The mortgage-backed securities represent senior interests in pools of commercial or residential mortgages created and held by special-purpose entities to provide investors with diversified exposure to these assets. The Company owns senior securities issued by several entities and receives fixed-rate cash flows from the underlying assets in the pools.
• it has neither the right to receive benefits nor the obligation to absorb losses that could be significant to these variable interest entities. The Company has not provided, and does not intend to provide, financial support to these entities that it is not contractually required to provide. The Company performs ongoing qualitative analyses of its involvement with these variable interest entities to determine if consolidation is required. The Company's maximum potential exposure to loss related to the investment entities is limited to the carrying amount of its investments of $600 million as of December 31, 2015, that are reported in fixed maturities. The Company's combined ownership interests are insignificant relative to the total principal amount issued by these entities. The Company's maximum exposure to loss related to the IPA arrangements is limited to their liability for incurred but not reported medical costs for the Company's Medicare Advantage customers. These liabilities are not material and are generally secured by deposits maintained by the IPAs.
(1) As explained in Note 2(B), in the fourth quarter of 2015, the Company retrospectively adopted ASU 2015-03 that requires debt issuance costs to be netted against the carrying value of the debt. Amounts presented above for 2014 have been retrospectively adjusted to conform to the new guidance. The impact on 2014 balances was not material.
(2) The Company has entered into interest rate swap contracts hedging a portion of these fixed-rate debt instruments. See Note 12 for further information about the Company's interest rate risk management and these derivative instruments.
The Company may redeem the newly issued Notes, at any time, in whole or in part, at a redemption price equal to the greater of:
• The Company redeemed its 2.75% Notes due 2016, including accrued interest from November 15, 2014 through the settlement date of April 13, 2015. The redemption price equaled the present value of the remaining principal and interest payments on the Notes being redeemed, discounted at a rate equal to the 10-year Treasury Rate plus a fixed spread of 30 basis points. The Company paid $626 million including accrued interest and expenses, resulting in a pre-tax loss on early debt extinguishment of $21 million ($14 million after-tax) that was recognized in the second quarter of 2015.
• The Company redeemed its 8.50% Notes due 2019, including accrued interest from November 1, 2014 through the settlement date of April 13, 2015. The redemption price equaled the present value of the remaining principal and interest payments on the Notes
Maturities of long-term debt, excluding capital leases, are as follows (in millions): none in 2016, $250 in 2017, $131 in 2018, none in 2019, $550 in 2020 and the remainder in years after 2020. Maturities of debt under capital lease arrangements are as follows (in millions): $23 in 2016, $12 in 2017, $7 in 2018, $6 in 2019, none in 2020 and the remainder in years after 2020. Interest expense on long-term and short-term debt was $252 million in 2015, $265 million in 2014, and $270 million in 2013. The 2015 expense excludes losses on the early extinguishment of debt.
The Company maintains a share repurchase program authorized by its Board of Directors. Under this program, we may repurchase shares from time to time, depending on market conditions and alternate uses of capital. We may suspend activity under our share repurchase program from time to time and may also remove such suspensions without public announcement. We may also repurchase shares at times when we otherwise might be precluded from doing so under insider trading laws or because of self-imposed trading black-out periods by using a Rule 10b5-1 trading plan.
The Company has authorized a total of 25 million shares of $1 par value preferred stock. No shares of preferred stock were outstanding at December 31, 2015, 2014 or 2013.
Accumulated other comprehensive income (loss) excludes amounts required to adjust future policy benefits for the run-off settlement annuity business and a portion of deferred acquisition costs associated with the corporate-owned life insurance business. Changes in the components of accumulated other comprehensive income (loss) were as follows:
The components of income taxes for the years ended December 31 were as follows:
Consolidated pre-tax income from the Company's foreign operations was approximately 11% of the Company's pre-tax income in 2015, 10% in 2014 and 12% in 2013.
The consolidated effective tax rates of 37.6% in 2015 and 36.6% in 2014 have increased from historical levels due to the health insurance industry tax that took effect in 2014 and that is not deductible for federal income tax purposes. Other matters having a significant impact on the effective tax rate included:
• Completion of IRS examinations/other 2013 impacts. In 2013, the Internal Revenue Service ("IRS") completed its examination of the Company's 2009 and 2010 tax years, resulting in an increase to shareholders' net income of $18 million. In addition, income tax expense was reduced in 2013 due to certain other tax benefits related to the Company's foreign operations.
Included in the consolidated net deferred tax asset of $379 million is approximately $150 million of deferred tax liabilities attributable to foreign jurisdictions, most notably Korea and Taiwan.
The Internal Revenue Service is expected to complete their examination of the Company's 2011 and 2012 consolidated federal income tax returns during the second half of 2016.
The table below summarizes information for stock options exercised during the last three years:
The following table summarizes information for outstanding common stock options at December 31, 2015:
The weighted average fair value of options granted under employee incentive plans was $36.40 for 2015, $23.56 for 2014 and $19.84 for 2013 using the Black-Scholes option-pricing model and the assumptions presented in the following table.
Restricted stock. The Company awards restricted stock to its employees or directors with vesting periods ranging from two to five years. These awards are generally in one of two forms: restricted stock grants or restricted stock units. Restricted stock grants are the most widely used form and are used for substantially all U.S.-based employees receiving such awards. Recipients of restricted stock grants accumulate dividends and can vote during the vesting period, but forfeit their awards and accumulated dividends if their employment terminates before the vesting date. Awards of restricted stock units are generally limited to overseas employees. A restricted stock unit represents a right to receive a common share of stock when the unit vests. Recipients of restricted stock units are entitled to accumulate hypothetical dividends, but cannot vote during the vesting period. They forfeit their units and accumulated dividends if their employment terminates before the vesting date.
Strategic Performance Shares. The Company awards strategic performance shares to executives and certain other key employees generally with a performance period of three years. Strategic performance shares are divided into two broad groups: 50% are subject to a market condition (total shareholder return relative to industry peer companies) and 50% are subject to performance conditions (2013 and 2014 awards: revenue growth and cumulative adjusted net income; 2015 awards, cumulative adjusted net income). These targets are set by the Committee. At the end of the performance period, holders of strategic performance shares will be awarded anywhere from 0 to 200% of the original grant of strategic performance shares in Cigna common stock.
The fair value of vested strategic performance shares was $119 million in 2015, $57 million in 2014 and $42 million in 2013.
• run-off settlement annuity business. Corporate reflects amounts not allocated to operating segments, such as net interest expense (defined as interest on corporate debt less net investment income on investments not supporting segment operations), interest on uncertain tax positions, certain litigation matters, intersegment eliminations, compensation cost for stock
• Realized investment results are excluded because, as noted above, our portfolio managers may sell investments based on factors largely unrelated to the underlying business purposes of each segment.
• Net amortization of other intangible assets is excluded because it relates to costs incurred for acquisitions and, as a result, it does not relate to the core performance of the Company's business operations. The amortization amount is net of one-time benefits of acquisitions in which the fair value of net assets acquired exceeds the purchase price.
• Special items, if any, are excluded because management believes they are not representative of the underlying results of operations. In 2013, adjusted income from operations also excluded the results of the guaranteed minimum income benefit ("GMIB") business prior to the reinsurance transaction with Berkshire.
For the years ended December 31, 2015, 2014 and 2013, the Company reported the following special item charges:
(1)As disclosed in Note 8, includes a one-time $23 million benefit.
The Company had net receivables from CMS of $1.5 billion as of December 31, 2015 and $0.8 billion as of December 31, 2014. These amounts were included in premiums, accounts and notes receivable and reinsurance recoverables. Receivables from CMS included $0.4 billion as of December 31, 2015 and $0.3 billion as of December 31, 2014 related to government risk mitigation programs in our Commercial business. As a percentage of consolidated revenues, premiums and fees from CMS were 21% in 2015, 21% in 2014 and 22% in 2013. These amounts were reported in the Global Health Care segment.
• all underlying mutual fund investment values remained at the December 31, 2015 value of $944 million with no future returns. The Company has reinsurance coverage in place that covers the exposures on these contracts. Using these hypothetical assumptions, GMIB exposure is $776 million, which is lower than the recorded liability for GMIB calculated using fair value assumptions. See Notes 7, 10 and 12 for further information on GMIB contracts.
The Company had indemnification obligations to lenders of up to $173 million as of December 31, 2015, related to borrowings by certain real estate joint ventures that the Company either records as an investment or consolidates. These borrowings, that are nonrecourse to the Company, are secured by the joint ventures' real estate properties with fair values in excess of the loan amounts and mature at various dates beginning in 2016 through 2021. The Company's indemnification obligations would require payment to lenders for any actual damages resulting from certain acts such as unauthorized ownership transfers, misappropriation of rental payments by others or environmental damages. Based on initial and ongoing reviews of property management and operations, the Company does not expect that payments will be required under these indemnification obligations. Any payments that might be required could be recovered through a refinancing or sale of the assets. In some cases, the Company also has recourse to partners for their proportionate share of amounts paid. There were no liabilities required for these indemnification obligations as of December 31, 2015.
The Company is aware of an insurer that is in rehabilitation. In 2012, the state court denied the regulator's amended petitions for liquidation and set forth specific requirements and a deadline for the regulator to develop a plan of rehabilitation without liquidating the insurer. The regulator has appealed the court's decision. If the actions taken in the rehabilitation plan fail to improve this insurer's financial condition, or if the state court's ruling is overturned on appeal, this insurer may be forced into insolvency. In that event, the Company would be required to pay guaranty fund assessments related to this insurer. Due to the uncertainties surrounding this matter, the Company is unable to estimate the amount of any potential guaranty fund assessments. The Company is monitoring this situation.
The Company is routinely involved in numerous claims, lawsuits, regulatory audits, investigations and other legal matters arising, for the most part, in the ordinary course of managing a health services business. These actions may include benefit disputes, breach of contract claims, tort claims, provider disputes, disputes regarding reinsurance arrangements, employment and employment discrimination-related suits, employee benefit claims, wage and hour claims, privacy, intellectual property claims and real estate-related disputes. There are currently, and may be in the future, attempts to bring class action lawsuits against the industry. The Company also is regularly engaged in IRS audits and may be subject to examinations by various state and foreign taxing authorities. Disputed income tax matters arising from these examinations, including those resulting in litigation, are accounted for under GAAP for uncertain tax positions. Further information on income tax matters can be found in Note 19.
In addition, there is heightened review by federal and state regulators of the health care, disability and life insurance industry business and related reporting practices. Cigna is frequently the subject of regulatory market conduct reviews and other examinations of its business and reporting practices, audits and investigations by state insurance and health and welfare departments, state attorneys general, CMS and the Office of Inspector General ("OIG"). With respect to Cigna's Medicare Advantage business, the CMS and OIG perform audits to determine a health plan's compliance with federal regulations and contractual obligations, including compliance with proper coding practices (sometimes referred to as "Risk Adjustment Data Validation Audits" or "RADV audits") that may result in retrospective adjustments to payments made to health plans. Regulatory actions can result in assessments, civil or criminal fines or penalties or other sanctions, including loss of licensing or exclusion from participating in government programs.
When the Company (in the course of its regular review of pending litigation and legal or regulatory matters) has determined that a material loss is reasonably possible, the matter is disclosed. Such matters are described in the Litigation Matters and Regulatory Matters sections below. In accordance with GAAP, when litigation and regulatory matters present loss contingencies that are both probable and estimable, the Company accrues the estimated loss by a charge to net income. The amount accrued represents the Company's best estimate of the probable loss at the time. If only a range of estimated losses can be determined, the Company accrues an amount within the range that, in the Company's judgment, reflects the most likely outcome; if none of the estimates within that range is a better estimate than any other amount, the Company accrues the minimum amount of the range.
In cases when the Company has accrued an estimated loss, the accrued amount may differ materially from the ultimate amount of the loss. In many proceedings, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount or range of any loss. The Company provides disclosure in the aggregate for material pending litigation and legal or regulatory matters, including accruals, range of loss, or a statement that such information cannot be estimated. As a litigation or regulatory matter develops, the Company monitors the matter for further developments that could affect the amount previously accrued, if any, and updates such amount accrued or disclosures previously provided as appropriate.
CMS actions. In January 2016, CMS issued to the Company a Notice of Imposition of Immediate Intermediate Sanctions ("the Notice"). The Notice requires the Company to suspend certain enrollment and marketing activities for its Medicare Advantage-Prescription Drug and Medicare Part D Plans. The sanctions do not impact the ability of current enrollees to remain covered by the Company's Medicare Advantage-Prescription Drug or Medicare Part D Plans.
Effective November 24, 2015, solely to avoid the costs, risks and uncertainties inherent in litigation, and without admitting any liability or wrongdoing, the Company, the Company's directors, Anthem and Merger Sub entered into a Memorandum of Understanding ("MOU") to settle the Cigna Merger Litigation. Subject to court approval and further definitive documentation in a settlement agreement that will be subject to customary conditions, the MOU resolved the Cigna Merger Litigation and provided that the Company would make certain additional disclosures related to the merger. If the Court approves the settlement, the Cigna Merger Litigation will be dismissed with prejudice and all claims that were or could have been brought in any actions challenging any aspect of the merger, the merger agreement and any related disclosures will be released. In connection with the settlement, subject to the ultimate determination of the Court, plaintiffs' counsel may receive an award of reasonable fees. There can be no assurance that the parties will ultimately enter into a settlement agreement, or that the Court will approve the settlement even if the parties were to enter into such agreement. The MOU may terminate, if, among other reasons, the Court does not approve the settlement or the merger is not consummated for any reason. Following entry into the MOU, the five complaints filed in Delaware were voluntarily dismissed with prejudice.