The Company occupies two connected buildings totaling 840,000 square feet in Chattanooga, Tennessee. The office building and substantially all of the surrounding 25 acres of land used for employee parking are owned by the Company, including an employee parking garage and a 27-unit apartment building for corporate use. In addition, approximately 123,000 square feet of office space is leased and occupied in a nearby office building.
The Company owns and occupies approximately 547,000 square feet of office space in Columbia, South Carolina. The buildings are located on approximately 47 acres with a portion developed for employee parking.
The Company also owns office buildings in the United Kingdom and Argentina, which serve as the home offices of Unum Limited and Boston Compania Argentina de Seguros SA, respectively. The property in the United Kingdom is located in Dorking, with approximately 70,000 square feet of office space located on approximately 55 acres with a portion developed for employee parking. In addition, approximately 37,400 square feet of office space is leased
and occupied in two office buildings located in Bristol and Basingstoke. The facility in Argentina is approximately 23,000 square feet of space within a condominium in Buenos Aires.
The Company has restated its previously issued financial statements for the years ended December 31, 2001 and 2000. See Note 1 of the “Notes to Consolidated Financial Statements” for further information concerning the restatement.
As noted in Item 8, Note 1 of the “Notes to Consolidated Financial Statements”, effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets. In accordance with SFAS 142, goodwill is no longer amortized but is subject to annual impairment tests. Prior to January 1, 2002, goodwill was amortized on a straight-line basis over a period not to exceed 40 years. Had amortization of goodwill been excluded from income for the years ended December 31, 2001, 2000, 1999 and 1998, income (loss) before federal income tax and extraordinary loss would have been $787.8 million, $849.0 million, $(140.6) million, and $948.2 million, respectively; net income (loss) would have been $561.5 million, $560.3 million, $(159.6) million, and $644.5 million, respectively; and net income (loss) per common share assuming dilution would have been $2.30, $2.31, $(0.67), and $2.66, respectively.
During 2001 and 2000, the Company recorded other than temporary impairments on certain of its fixed maturity securities based on values that included their quoted market prices, as well as to give effect to analysis by the Company with respect to certain issuers of securities that perhaps was not reflected in those market prices. After discussions with the staff of the Securities and Exchange Commission’s Division of Corporation Finance, the Company has concluded that not relying solely on quoted market prices for its other than temporary impairment charges was an erroneous interpretation of Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, and, accordingly, is restating its previously issued financial statements for the years ended December 31, 2001 and 2000 to adjust the amounts recorded during 2001 and 2000 on these securities such that the other than temporary impairments are based on the then quoted market prices. The non-cash adjustments did not impact the Company’s total stockholders’ equity in any period because the Company had already recorded the unrealized effect of the decreased market value of its fixed maturity securities through stockholders’ equity in the appropriate periods.
The two primary categories of liabilities for policy and contract benefits are policy reserves for claims not yet incurred and claim reserves for claims that have been incurred and have future benefits to be paid. Policy reserves equal the present value of the difference between future policy benefits and expenses and future premiums, allowing a margin for profit. These reserves are applicable for the majority of the Company’s business, which is traditional non-interest sensitive in nature. The claim payments are estimated using assumptions established when the policy was issued. Ordinarily, generally accepted accounting principles require that these assumptions not be subsequently modified unless the policy reserves are determined to be inadequate. Throughout the life of the policy, the reserve is based on the original assumptions used for the policy’s issue year.
A claim reserve is established when a claim is incurred or is estimated to have been incurred but not yet reported to the Company. Policy reserves for a particular policy continue to be maintained after a claim reserve has been established for as long as the policy remains in force. Claim reserves generally equal the Company’s estimate, at the current reporting period, of the present value of the liability for future benefits and expenses to be paid on a claim. A claim reserve for a specific claim is based on assumptions derived from the Company’s actual historical experience as to claim duration as well as the specific characteristics of the claimant such as benefits available under the policy, the covered benefit period, and the age and occupation of the claimant. Consideration is given to historical trends in the Company’s experience and to expected deviations from historical experience that result from changes in benefits available, changes in the Company’s risk management policies and procedures, and other economic, environmental, or societal factors. Reserves for claims that are estimated to have already been incurred but that have not yet been reported to the Company are based on factors such as historical claim reporting patterns, the average cost of claims, and the expected volumes of incurred claims.
Deferred costs related to group and individual disability products are amortized over a twenty-year period. For costs deferred in 2002, approximately 75 percent and 90 percent of the original deferred costs related to group disability products are expected to be amortized by years ten and fifteen, respectively. For individual disability policies, approximately 45 percent and 75 percent of the original deferred costs are expected to be amortized by years ten and fifteen, respectively. Deferred costs for group life products are amortized over a fifteen-year period, with approximately 85 percent of the cost expected to be amortized by year ten. Deferred costs for group and individual long-term care
products are amortized over a twenty-year period, with approximately 60 percent and 80 percent of the original deferred costs expected to be amortized by years ten and fifteen, respectively. For costs deferred in 2002, the period of amortization has not changed from the period used for costs deferred in previous years, but the expected proportion of costs amortized in the early years of the life of the policy has been accelerated due to recent Company experience relative to persistency.
• The time period during which there has been a significant decline in value.
• Bid and offering prices and the level of trading activity.
Based on this review of the entire investment portfolio, individual investments may be added to or removed from the Company’s “watch list”, which is a list of securities subject to enhanced monitoring and a more intensive review. The Company also determines if its investment portfolio is overexposed to an issuer that is showing warning signs of deterioration and, if so, the Company makes no further purchases of that issuer’s securities and may seek opportunities to sell securities it holds from that issuer to reduce the Company’s exposure. The Company monitors below-investment-grade securities as to individual exposures and in comparison to the entire portfolio as an additional credit risk management strategy, looking specifically at the Company’s exposure to individual securities currently classified as below-investment-grade.
Private placement fixed maturity securities with a carrying value of approximately $3.7 billion, or 13.4 percent of total fixed maturity securities at December 31, 2002, do not have readily determinable market prices. For these securities, the Company uses internally prepared valuations combining matrix pricing with vendor purchased software programs, including valuations based on estimates of future profitability, to estimate the fair value. Additionally, the Company obtains prices from independent third-party brokers to establish valuations for certain of these securities. All such investments are classified as available-for-sale. The Company’s ability to liquidate its positions in some of these securities could be impacted to a significant degree by the lack of an actively traded market, and the Company may not be able to dispose of these investments in a timely manner. Although the Company believes its estimates reasonably reflect the fair value of those securities, the key assumptions about the risk-free interest rates, risk premiums, performance of underlying collateral (if any), and other factors involve significant assumptions and may not reflect those of an active market. The Company
believes that generally these private placement securities carry a credit quality comparable to companies rated Baa or BBB by major credit rating organizations.
As of December 31, 2002, the key assumptions used to estimate the fair value of private placement fixed maturity securities included the following:
• Risk free interest rates of 2.73 percent for five-year maturities to 4.76 percent for 30-year maturities were derived from the current yield curve for U.S. Treasury Bonds with similar maturities.
• An additional five basis points were added to the risk free rates for foreign investments.
• Additional basis points were added as deemed appropriate for certain industries and for individual securities in certain industries that are considered to be of greater risk.
Increasing the 30 basis points added to the risk free rate for lack of liquidity by 1.5 basis points, increasing the five basis points added to the risk free rates for foreign investments by one basis point, and increasing the additional basis points added to each industry considered to be of greater risk by one basis point would have decreased the December 31, 2002 net unrealized gain in the fixed maturity securities portfolio by approximately $1.3 million. Historically, the Company’s realized gains or losses on dispositions of its private placement fixed maturity securities have not varied significantly from amounts estimated under the valuation methodology described above.
• The assessment of a borrower’s ability to meet its contractual obligations will change.
This discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto contained herein in Item 8. In the following financial statements and discussions of operating results by segment, “operating revenue” includes premium income, net investment income, and other income. “Operating income” or “operating loss” excludes federal income tax, net realized investment gains and losses, extraordinary losses, and cumulative effects of accounting principle changes.These alternative measures of “revenue” and “income” or “loss” differ from revenue and
income (loss) before federal income tax as presented in statements of income prepared in accordance with accounting principles generally accepted in the United States (GAAP) due to the exclusion of before tax realized investment gains and losses.The Company believes operating revenue and operating income or loss excluding realized investment gains and losses are useful measures of performance. The Company’s investment focus is on investment income to support its insurance liabilities as opposed to the generation of realized investment gains and losses, and a long-term focus is necessary to maintain profitability over the life of the business. Realized investment gains and losses are dependent on market conditions and not necessarily related to decisions regarding underlying business. However, income excluding realized investment gains and losses does not replace net income as a measure of the Company’s profitability. Due to factors discussed under “Risk Factors - Investments” contained herein in Item 1 and the Company’s exposure to below-investment-grade fixed maturity securities, as discussed in a subsequent section of this Management’s Discussion and Analysis, the Company may experience realized investment losses. The realization of investment gains and losses will affect future earnings levels as the underlying business is long-term in nature and requires that the Company be able to sustain the assumed interest rates in its liabilities.
Transition to the provisions of SFAS 142 required the Company to complete, within the year of adoption, transitional impairment tests of goodwill existing at January 1, 2002, measured as of that date using a fair value approach. The Company had previously, prior to the adoption of SFAS 142, used undiscounted cash flows to determine if goodwill was recoverable. The Company completed the required tests during 2002 and determined the carrying value of its goodwill should be reduced $11.0 million. The charge, net of a $3.9 million tax benefit, was $7.1 million and is reported as a cumulative effect of accounting principle change in the consolidated statements of income. Application of the non-amortization provision increased 2002 earnings $21.3 million before tax and $20.2 million after tax. See Note 1 of the “Notes to Consolidated Financial Statements” contained herein for further discussion.
Continued declines in the performance of equity investment markets combined with steadily increasing pension liabilities have reduced the Company’s pension plan’s funding level. In December 2002, in accordance with the provisions of Statement of Financial Accounting Standards No. 87, Employer’s Accounting for Pensions (SFAS 87), the Company recorded a $145.0 million non-cash minimum pension liability adjustment, net of deferred federal income tax, to accumulated other comprehensive income in stockholders’ equity.
During 2002, the Company acquired whereiwork, a provider of online solutions for insurance enrollment, communications, administration, and analysis, at a price of $2.8 million. This acquisition is intended to strengthen and broaden the Company’s internet-based benefits services currently offered to brokers and employers.
The September 11, 2001 tragedy resulted in a 2001 before-tax charge of $24.0 million, or $15.6 million after tax. This charge included estimated gross ultimate losses from reported and unreported claims of $65.0 million less an estimated $41.0 million recoverable from the Company’s reinsurers. The charge did not include any indirect costs which the Company incurred in developing specialized procedures for filing claims resulting from the attacks and in providing additional support to affected policyholders and group clients. The Company’s reinsurance program provided a significant layer of catastrophic coverage for its individual disability and its group life, accidental death and dismemberment, travel accident, long-term disability, and short-term disability lines of business. The effects on each line of business are disclosed in the following discussions of segment operating results.
In 2001, the Company acquired the assets of EmployeeLife.com, an Internet Capital Group partner company. This acquisition should enhance customer service by offering internet business solutions to help employers efficiently manage and administer employee benefits. The Company also acquired Resource Opportunities, Inc. (ROI), a national provider of medical and vocational case management services. ROI will improve GENEX’s ability to service its customers, in turn benefiting the Company’s insurance customers.
Also in 2001, the Company sold Provident National Assurance Company, an inactive insurance subsidiary. Provident National Assurance Company’s general account liabilities were reinsured by another subsidiary of the Company, and the excess capital and surplus was transferred to the parent to reduce short-term borrowings.
During 2000, the Company entered into a reinsurance agreement under which one of the Company’s insurance subsidiaries will cede through a net quota share reinsurance agreement 50 percent of the group life volume above the aggregate retention limit. The treaties are five-year quota share treaties ceding 25 percent of premium, life volume, and paid claims to each reinsurer. The reinsurance agreements were effective as of October 1, 2000.
The Employee Benefits segment includes group long-term and short-term disability insurance, group life insurance, accidental death and dismemberment coverages, group long-term care, and managed disability.
The Company focuses on integrated selling that combines long-term disability, short-term disability, and group life products. During 2002, 27 percent of all new sales included long-term disability, short-term disability, and group life combined coverage. This compares to 28 percent and 32 percent in 2001 and 2000, respectively. The Company has closely linked its various incentive compensation programs to the achievement of its goals for new sales and persistency.
Sales for Employee Benefits, on both a submitted and effective date basis, are reported in the following chart. Administrative services only (ASO) premium equivalents are now reported separately for long-term and short-term disability as the Company begins to emphasize more ASO and self-insured business in the large case disability market. Certain other prior year amounts have been reclassified to conform to current year reporting.
Sales related to employee benefits can fluctuate significantly due to large case size and timing of sales submissions. In order to give the appropriate focus to the Company’s primary business markets, the Company has national practice groups that focus on large employers, executive benefits, and voluntary benefits. These national practice groups partner with the Company’s sales force and representatives from claims, customer service, and underwriting to present coverage solutions to potential customers and to manage existing customer accounts. The Company expects that this organizational focus on customers will continue to favorably affect sales growth, but management intends to maintain pricing discipline to balance sales growth and profitability, which may slow the rate of long-term sales growth. Existing market share, as well as trends in new sales, are indicators of the Company’s potential for growth in its respective markets and the level of market acceptance of price changes and new products. Negative media attention or downgrades in the financial strength ratings of the Company’s insurance subsidiaries may adversely affect the Company’s ability to grow sales and renew its existing business.
Persistency during 2002 for the overall block of group long-term disability on average improved from that experienced in 2001, but the persistency for group life and accidental death and dismemberment was lower than the prior year. Persistency for short-term disability, after adjusting for cases transferring from fully insured to ASO, improved over the prior year. Persistency for group long-term and short-term disability, as well as group life and accidental death and dismemberment, was lower for certain issue years when compared to the persistency expected at the time the business was written. This resulted in additional amortization of deferred policy acquisition costs of $22.1 million for 2002. The additional amortization related to persistency in 2001 and 2000 was $41.5 million and $34.1 million, respectively. It is expected that persistency for the foreseeable future may continue to be lower than historical levels, particularly in certain issue years as the Company places increased emphasis on retaining profitable business.
The Company’s renewal programs have generally been successful at retaining business that is relatively more profitable than business that terminated. It is expected that the additional premium and related profits associated with renewal activity will continue to emerge. The Company intends to maintain a disciplined approach in the re-pricing of renewal business, while balancing the need to maximize persistency and retain producer relationships. This disciplined approach may lead to lower profit margins on affected renewal cases than originally planned.
Group disability reported operating revenue of $3,602.8 million for 2002 compared to $3,352.7 million for 2001. Operating income was $333.0 million for 2002 and $336.9 million for 2001. Operating income for 2001 included $7.3 million for losses related to September 11, 2001.
Partially offsetting the growth in operating revenue was an increase in the benefit ratio from 84.1 percent in 2001 to 84.4 percent in 2002. Group disability also experienced a slight increase in its commission ratio and increased operating expenses. Additional amortization of deferred policy acquisition costs related to persistency decreased in 2002 relative to 2001, but expected amortization, as determined when the costs were initially capitalized, continues to increase year over year due to the continued growth in the deferred policy acquisition cost asset balance related to new sales growth in the block of business.
A critical part of the Company’s strategy for group disability involves executing its renewal program and managing persistency, both of which management expects will have a positive effect on future profitability. The Company has implemented a pricing strategy in the group disability line wherein prices may increase or decrease by market segment, as appropriate, to respond to current claim experience and other factors and assumptions, although pricing changes typically lag by several quarters the changes in actual claim experience.
The 2002 benefit ratio for group disability was higher than in 2001, with the increase attributable to long-term disability. Both submitted and paid claim incidence for group long-term disability increased from 2001. This continues to be driven in part by economic trends, including lower consumer confidence. Industry segments contributing to the increased submitted incidence levels include wholesale/retail and manufacturing. Claim recovery rates for group long-term disability in 2002 were lower than 2001 but were higher than 2000 and continued to be above historical levels. Continued lower claim recovery rates could require reserves to be increased. Payments to settle claims in litigation increased in 2002 compared to 2001 as did the number of new lawsuits filed.
Positive effects on 2001 operating income were a $152.3 million operating revenue increase and a change in the benefit ratio from 87.1 percent in 2000 to 84.1 percent in 2001, excluding losses related to September 11 for 2001 and the $65.6 million reserve increase for 2000. The commission ratio also improved slightly relative to 2000. Negatively affecting 2001 operating income was an increase in the operating expense ratio in 2001 compared to 2000. Persistency during 2001 on the overall block of group disability improved over 2000, with long-term disability persistency at 84.9 percent compared to 81.6 percent in 2000 and short-term disability at 82.1 percent versus 80.7 percent in 2000. The 2001 results include $26.3 million of additional amortization of deferred policy acquisition costs for certain policy issue years necessitated by the higher level of group long-term and short-term disability terminations experienced during 2001 relative to that which was expected for those issue years at the time the business was written. The additional amortization during 2000 was $25.8 million. For both 2001 and 2000, the disability business retained was relatively more profitable than the business that terminated.
The fundamentals underlying risk results in the group disability line continued to exhibit overall improvement in 2001, as demonstrated by the lower benefit ratio. Claim recovery rates in 2001 continued to be above historical levels but the increase in the claim recovery rates slowed, as expected, as the Company had fully implemented the improvements to its claim processes. Both submitted and paid claim incidence for long-term disability increased over recent years, with a portion of the increase attributable to industries affected by the weaker economy. However, in comparing 2001 results with 2000, there was no significant increase in the types of claims normally associated with a weaker economy. For short-term disability, both the average claim duration and paid incidence increased from 2000. The average weekly indemnity continued to increase as well, but the premium per life grew in 2001 at a slightly higher level.
As discussed under “Cautionary Statement Regarding Forward-Looking Statements,” certain risks and uncertainties are inherent in the Company’s business. Components of claims experience, including, but not limited to, incidence levels and claims duration, may be worse than expected. Management monitors claims experience in group disability and responds to changes by periodically adjusting prices, refining underwriting guidelines, changing product features, and strengthening risk management policies and procedures. The Company expects to price new business and re-price existing business, at contract renewal dates, in an attempt to mitigate the effect of these and other factors, including interest rates, on new claim liabilities. Given the competitive market conditions for the Company’s disability products, it is uncertain whether pricing actions can entirely mitigate the effect.
The Company, similar to all financial institutions, has some exposure in a severe and prolonged economic recession, but management believes that the Company is well positioned to continue to endure the current economic downturn. Many of the Company’s products can be re-priced, which would allow the Company to reflect in its pricing any fundamental change which might occur in the risk associated with a particular industry or company within an industry. Although approximately 30 percent of the Company’s overall block of group disability business is in the manufacturing and wholesale/retail industry segments, which tend to be economically sensitive, the Company has a well-diversified book of insurance exposure, with no disproportionate concentrations of risk in any one industry. Because of changes made in recent years through the application of best practices in the claims organization, the Company believes it can respond to increased levels of submitted claims which might result from a further slowing economy.
Group life, accidental death and dismemberment, and long-term care reported 2002 operating revenue of $1,938.4 million, an 8.6 percent increase over 2001, due to increases in premium income and net investment income. Operating income was $245.7 million in 2002 compared to $179.2 million in 2001. Results for 2001 included a net increase in benefits of $6.7 million related to September 11, 2001.
Premium growth in 2002 relative to 2001 was attributable to favorable renewal results, strong sales results in 2001, and stable persistency. Persistency for group life, while improved from 2000 levels, was less favorable during 2002 than in 2001, with persistency of 83.9 percent compared to 84.6 percent for 2001. For accidental death and dismemberment, persistency was 82.4 percent for 2002 and 83.0 percent for 2001. The amortization of deferred policy acquisition costs for 2002 includes $9.2 million of additional amortization due to the higher level of terminations for group life products experienced during 2002 than expected at the time the policies were written. The results for 2001 included $15.2 million of additional amortization, with the unfavorable variance of actual to expected terminations occurring primarily in the group life product line.
The Company has implemented several actions in the group life line of business, including tighter underwriting guidelines and pricing changes, and is developing case specific remedial plans for under-performing business. The Company believes these actions will improve profitability for group life, but it is uncertain whether these actions will restore the profitability that this line of business has historically reported. As a result of these actions, it is expected that the sales growth rate in this business may continue at a lower level than that experienced in recent years.
Accidental death and dismemberment reported an increase in operating income for 2002 relative to 2001. The benefit ratio for accidental death and dismemberment decreased from 2001 as a result of lower incidence, partially offset by an increase in the average paid claim size. This line also benefited from reduced commission and expense ratios. The Company is discontinuing the sales of certain accidental death and dismemberment products but expects there may be continued volatility in this line of business. Results for 2001 for accidental death and dismemberment included a net increase in benefits of $3.7 million related to September 11, 2001.
Offsetting the 2001 operating revenue increase was an increase in the benefit ratio and operating expense ratio when compared to the previous year reporting period. The amortization of deferred policy acquisition costs for 2001 includes $15.2 million of additional amortization due to the higher level of terminations for group life and accidental death and dismemberment products experienced than expected at the time the policies were written. The unfavorable variance of actual to expected terminations occurred primarily in the group life product line. Although the overall block of group life business experienced favorable persistency compared to the previous year, certain issue year business did not persist at the levels expected when the business was issued. The additional amortization during 2000 was $8.3 million.
The overall individual disability results continue to be negatively affected by the business issued during the mid-1990s and prior years. The interest adjusted loss ratio for recently issued business is significantly below the ratio for the older block, even in the more poorly performing market segments and product lines. The business issued in the mid-1990s and prior years experienced a significantly higher increase in the interest adjusted loss ratio during 2002 relative to 2001 than did the newer block of business. The higher interest adjusted loss ratio on the older business is driven by higher incidence and lower claim recoveries relative to more recently issued business. For the recently issued business, the majority of market segments experienced increases in the interest adjusted loss ratios during 2002 compared to 2001. Most of the market segments in the recently issued business are still performing within expectations. The improvement in recently issued business reflects the substantial product, distribution, and underwriting changes made during that time period. The “Old” individual disability block generally consists of those policies in force prior to the Company’s substantial changes in product offerings, pricing, distribution, and underwriting. The Company continues to review internal and external alternatives, including reinsurance, for improving the overall results in its individual disability line of business, particularly as related to business issued in the mid-1990s and prior years.
Operating revenue was $2,615.8 million for 2001 compared to $2,585.6 million in 2000. Operating income in the individual disability line of business was $274.8 million in 2001, a decrease of 3.7 percent over the prior year. Included in the results for 2001 was a $10.0 million increase in benefits related to September 11, 2001. Excluding this $10.0 million loss, operating income would have been essentially level with 2000.
The benefit ratio of 107.7 percent for 2001 was slightly higher than the 2000 ratio of 106.6 percent. The interest adjusted loss ratio was 63.6 percent and 63.4 percent for 2001 and 2000, respectively. Submitted and paid claim incidence rates for the overall individual disability line of business increased from 2000 and were higher than recent historical incidence rates. The claim recovery rate for 2001 increased compared to the 2000 results. Individual disability also benefited from a slightly improved commission ratio for 2001 as compared to 2000, but the operating expense ratio increased.
The overall individual disability results for 2001 were also negatively affected by the business issued during the mid-1990s and prior years. The interest adjusted loss ratios for later issue years are significantly below the overall ratio of 63.6 percent, even in the more poorly performing market segments and product lines.
Operating revenue for individual long-term care was $270.3 million, a 27.6 percent increase over 2001. Premium income increased $52.1 million for 2002 compared to 2001, primarily due to new sales growth. New annualized sales for long-term care were $63.7 million for 2002, compared to $53.8 million for the prior year and $47.7 million for 2000. Net investment income continues to increase due to the growth in invested assets supporting this line of business. Persistency in this line of business remains high and stable. Changes in the product offering during 2003 may slow the growth in sales relative to historical trends.
The Voluntary Benefits segment includes the results of products sold to employees through payroll deduction at the workplace. These products include life insurance and health products, primarily disability, accident and sickness, critical illness, and cancer.
For 2001, all of the product lines reported an increase in premium income and net investment income over 2000. The life and disability product lines both reported a marginal increase in the benefit ratio relative to 2000. The increase for life was due primarily to an increase in the size of the average paid claim. Claim payments for disability increased due to an increase in the average monthly indemnity and a lengthening of the duration of claims, but the incidence rates remained stable. The benefit ratio for the other line was higher in 2001 compared to 2000
due partially to the poor results from the block of business which was reinsured in the fourth quarter of 2001 and also due to an increase in the average claim size for the Company’s other cancer products.
As previously discussed, during 2001 the Company reinsured on a 100 percent indemnity coinsurance basis certain cancer policies written by the Company’s subsidiary, Colonial Life & Accident Insurance Company. The transaction closed during the fourth quarter with an effective date of November 1, 2001. The Company ceded approximately $113.6 million of reserves to the reinsurer. The $12.3 million before-tax gain on this transaction was deferred and is being amortized into income based upon expected future premium income on the policies ceded.
The Company’s reinsurance operations include the reinsurance management operations of Duncanson & Holt, Inc. (D&H) and the risk assumption, which includes reinsurance pool participation; direct reinsurance which includes accident and health (A&H), long-term care (LTC), and long-term disability coverages; and Lloyd’s of London (Lloyd’s) syndicate participations. During 1999, the Company concluded that these operations were not solidly aligned with the Company’s strength in the disability insurance market and decided to exit these operations through a combination of a sale, reinsurance, and/or placing certain components in run-off. In 1999, the Company sold the reinsurance management operations of its A&H and LTC reinsurance facilities and reinsured the Company’s risk participation in these facilities. The Company also decided to discontinue its London accident reinsurance pool participation beginning in year 2000. With respect to Lloyd’s, the Company implemented a strategy which limited participation in year 2000 underwriting risks, ceased participation in Lloyd’s underwriting risks after year 2000, and managed the run-off of its risk participation in open years of account of Lloyd’s reinsurance syndicates.
During 2001, the reinsurance pools and management operations reported operating income of $0.1 million compared to an operating loss of $32.7 million in 2000. Included in the 2000 results were $37.4 million of charges related to the Company’s London accident reinsurance pool participation. During 1999, the Company recorded charges of $270.1 million resulting from its decision to exit these pools, but at that time there was insufficient information to fully evaluate all of the exposures. During 2000, additional changes to fund these exposures and provide for the run-off of its participation resulted in a claim reserve adjustment of $21.9 million and uncollectible receivables and loss provisions of $15.5 million.
Total operating revenue for individual life and corporate-owned life insurance was $42.1 million, $42.7 million, and $236.1 million in 2002, 2001, and 2000, respectively. Operating income for the same periods was $41.6 million, $38.9 million, and $49.6 million.
Group pension, health insurance, individual annuities, and other closed lines of business had operating revenue of $159.9 million, $201.3 million, and $219.4 million in 2002, 2001, and 2000 and operating income of $7.2 million, $14.3 million, and $26.4 million. Decreases in operating revenue and income are expected to continue as these lines of business wind down. Included in these amounts are the Company’s operating results for its operations in Argentina, which produced operating revenue of $18.4 million, $47.1 million, and $40.2 million in 2002, 2001, and 2000 and operating income of $0.1 million, $1.1 million, and $2.7 million in each of those three years. As previously mentioned, the Company in 2001 wrote off the remaining goodwill balance of $5.4 million related to its operations in Argentina. The goodwill write-off is included in the Corporate segment operating results. The net assets related to the Argentina operations were approximately $1.8 million at December 31, 2002.
Operating revenue in the Corporate segment was $35.6 million in 2002, $44.6 million in 2001, and $48.1 million in 2000. The Corporate segment reported operating losses of $154.5 million in 2002, $169.2 million in 2001, and $49.5 million in 2000. The improvement in 2002 relative to 2001 was due primarily to a reduction in interest and debt expense as well as the cessation of goodwill amortization due to the adoption of SFAS 142. Results for 2000 were positively affected by the gain of $116.1 million on the pension plan transaction. See Note 9 of the “Notes to Consolidated Financial Statements” for further discussion of the Company’s pension plan.
The amortization of goodwill was $26.6 million in 2001 and $22.3 million in 2000. Included in the 2001 amortization was a $5.4 million write-down of goodwill related to the Company’s Argentina operations. See previous discussion under “Other Segment Operating Results.”
The Company’s investment philosophy is also designed to take advantage of the expertise it has developed over the years in the below-investment-grade fixed maturity market. This allows the Company to attain higher yield and increase diversification of assets while at the same time not substantially increasing its asset risk profile. As noted in the investment policy discussion below, the Company’s investments in this asset category are subject to limits and closely monitored.
The Company reported a before-tax net realized investment loss of $315.0 million, comprised of gross gains of $208.2 million and gross losses of $523.2 million, of which $454.4 million related to write-downs on fixed maturity and equity securities. These write-downs were recognized as a result of management’s determination that the value of certain fixed maturity and equity securities had other than temporarily declined during the applicable quarter of 2002, as well as the result of further declines in the values of fixed maturity and equity securities that had initially been written down in a prior period. The value of the securities was determined to have other than temporarily declined or to have further declined from the initial impairment based on the factors discussed herein in “Critical Accounting Policies.” Due to the current negative credit market environment and the associated economic uncertainty, the Company anticipates additional investment losses will occur during 2003.
Company. Approximately 53 percent of the 2002 write-downs were recorded for reasons other than bankruptcy or defaults on principal or interest payments. Due to the circumstances of certain write-downs recorded during 2002, the Company now relies less on the parental support of an issuer in determining whether an other than temporary impairment has occurred.
• $27.8 million loss during the second quarter of 2002 on securities issued by a U.S. based global telecommunications company providing global voice and data services. It was discovered in June 2002 that the company had misclassified certain expenses, materially changing the reported financial condition and profitability of the business. The investment was rated Baa2 just prior to its downgrade to below-investment-grade in the second quarter of 2002. Prior to its write-down, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The circumstances of this impaired investment have no impact on other investments.
• $25.1 million loss during the fourth quarter of 2002 on securities issued by a subsidiary of a U.S. based company engaged in the electricity business in the United Kingdom. As this industry’s operating environment in the United Kingdom weakened over the past few years due to competitive pricing pressures, the company remained encumbered with a number of above-market price power purchase agreements resulting in significant operating losses. The parent company had previously provided equity support and had committed an additional $700.0 million to this subsidiary to be used primarily to renegotiate these contracts. The investment was rated Baa3 just prior to the time the parent company unexpectedly withdrew its promised support in October 2002, which resulted in a downgrade to below-investment-grade. The company defaulted on its October interest payments, and the parent company was subsequently placed in administration in the United Kingdom. Prior to its write-down, the investment had been in an unrealized loss position for a period of greater than three years. The Company holds securities in a related subsidiary and has also recognized an other than temporary impairment loss on that related subsidiary.
• $29.0 million loss during the fourth quarter of 2001 on securities issued by a global integrated telecommunications company, after the company announced in January 2002 that it would be seeking bankruptcy protection. The company had approximately $2 billion of cash as of September 30, 2001, the most recent reporting date prior to the write-down. The investment was originally purchased as part of the Company’s below-investment-grade strategy. Prior to its write-down, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The circumstances of this impaired investment have no impact on other investments.
• $15.0 million loss during the third quarter of 2001 on securities issued by an internet data and web-hosting company, after it was deemed probable in September 2001 that the company might seek to restructure. The investment was originally purchased as part of the Company’s below-investment-grade strategy. Prior to its write-down, the investment had been in an unrealized loss position for a period greater than one year but less than two years. The circumstances of this impaired investment have no impact on other investments.
• $14.8 million loss during the fourth quarter of 2001 on securities issued by a large manufacturer of wheels for automobiles, after the company announced in December 2001 that it would seek bankruptcy protection. The company also announced in September 2001 that it would restate results for the previous year and first quarter of the current year because of accounting errors and issued restated results in the fourth quarter of 2001. The investment was originally purchased as part of the Company’s below-investment-grade strategy. Prior to its write-down, the investment had been in an unrealized loss position for a period of greater than two years but less than three years. The circumstances of this impaired investment have no impact on other investments.
During 2000, the Company reported a net realized investment loss before tax of $53.5 million, including the realized investment loss of $25.9 million on the investment-grade fixed maturity securities transferred to the reinsurer in connection with the individual life and corporate-owned life reinsurance transactions. The loss on these transferred securities was driven by a change in market interest rates and was not attributable to any credit deterioration. Excluding the reinsurance transaction related loss, the Company reported a net gain of $51.0 million in 2000 from the sale of fixed maturity and equity securities. Offsetting this gain was a $132.9 million realized investment loss recognized because the value of certain fixed maturity securities had other than temporarily declined.
The following table provides the distribution of invested assets for the periods indicated. Ceded policy loans of $2.5 billion and $2.3 billion as of December 31, 2002 and 2001, which are reported on a gross basis in the statements of financial condition contained herein in Item 1, are excluded from the table below. The investment income on these ceded policy loans is not included in income.
Fixed maturity securities at December 31, 2002 included $27.2 billion, or 99.1 percent, of bonds and $244.5 million, or 0.9 percent, of redeemable preferred stocks. The following table shows the carrying value (fair value) composition by internal industry classification of the fixed maturity bond portfolio and the associated unrealized gains and losses.
As of December 31, 2002 there were $2.9 billion gross unrealized gains and $1.1 billion gross unrealized losses in the fixed maturity bond portfolio, of which $738.2 million or 69.2 percent of those unrealized losses were concentrated in basic industry, communications, financial institutions, and utilities. The Company’s current view of risk factors relative to these four industries is as follows:
Communications: The communications sector experienced rapid growth and debt financed expansion following the Telecommunications Act of 1996, which encouraged new entrants and competition. By early 2001, capacity greatly exceeded demand, and industry conditions deteriorated rapidly. The result has been numerous bankruptcies and allegations of fraud, some involving large world-class companies. These bankruptcies will result in lower cost structures, which will place additional pressure on the remaining companies. The Company’s strategy has been to focus on the top-tier companies and those with diversified product offerings. The Company expects conditions to remain difficult but show improvement as the economy recovers.
Utilities: This sector, which includes regulated electric utilities, gas transmission and distribution companies, and independent power projects, has been operating in a difficult environment since 2000. The California power crisis in 2000 and 2001 impacted both electric and gas providers outside of California as issues regarding energy trading and a flawed deregulatory model provoked national scrutiny. Enron’s bankruptcy filing in late 2001 exacerbated the issues and resulted in numerous negative rating agency actions as the agencies developed a stricter model for analyzing industry participants. This in turn has contributed to decreased financial liquidity for many of the national utilities and resulted in numerous proposed asset sales as companies attempt to restructure their balance sheets. The Company believes that this sector will stabilize over the intermediate term (one to two years) as the industry works its way through the issues and then improve as the economy rebounds and participants realize the benefits of their current restructuring initiatives.
Of the $1.1 billion in gross unrealized losses at December 31, 2002, $210.6 million or 19.7 percent are related to investment-grade fixed maturity bonds. Unrealized losses on investment-grade fixed maturity securities principally relate to changes in interest rates or changes in market or sector credit spreads which occurred subsequent to the acquisition of the securities. These changes are generally temporary and are not recognized as realized investment losses unless the securities are sold or become other than temporarily impaired. The gross unrealized loss on below-investment-grade fixed maturity bonds was $856.1 million at December 31, 2002, or 80.3 percent of the total gross unrealized loss on fixed maturity bonds. Generally, below-investment-grade fixed maturity securities are more likely to develop credit concerns. The following table shows the length of time the Company’s investment-grade fixed maturity bonds had been in a gross unrealized loss position as of December 31, 2002.
As of December 31, 2002, the Company held investment-grade and below-investment-grade securities with a gross unrealized loss of $10.0 million or greater, as follows:
During the year ended December 31, 2002, the Company realized a loss of $63.0 million on the sale of fixed maturity securities. These securities had a book value of $250.8 million and a fair value of $187.8 million at the time of sale and represented 42 different issuers. Losses representing five percent or more of the total are as follows:
• The Company realized $34.0 million in losses on the sale of securities issued by a U.S. based global telecommunications company providing global voice and data services, representing 54.1 percent of the total realized investment loss on sales of fixed maturity securities in 2002. This company had misclassified certain expenses, materially changing the reported financial condition and profitability of the business. The price of this issuer’s securities dropped significantly in the second quarter of 2002 as the information became public. This company is under multiple investigations, and several senior officers of the issuer have been accused of committing major accounting fraud. These circumstances were significant enough for the Company to change its intent to hold these securities to maturity or recovery. The investment was downgraded to below-investment-grade in the second quarter of 2002, and, at the time of sale, had been in an unrealized loss position for a period of greater than 90 days but less than 180 days. The circumstances of this investment have no impact on other investments.
• The Company realized $5.9 million in losses on the sale of securities issued by an energy services company engaged in offshore seismic surveying and floating energy production, representing 9.3 percent of the total realized investment loss on sales of fixed maturity securities in 2002. Industry conditions in the energy sector, which is cyclical and driven by the supply and demand for oil and gas, had impacted profit margins, and the company lacked liquidity in the near-term. The investment was downgraded to below-investment-grade status in the second quarter of 2002, causing the investment holdings of this issuer to exceed the Company’s individual issuer group limits established by the Company’s board of directors. As a result, the Company sold the securities in order to lower its overall holding of securities issued by this company. At the time of sale, the investment had been in an unrealized loss position for a period of more than three years. The circumstances of this investment have no impact on other investments.
• The Company realized $3.9 million in losses on the sale of a below-investment-grade structured security backed by a pool of high yield bonds, representing 6.1 percent of the total realized investment loss on fixed maturity securities in 2002. The continued high level of defaults in the high-yield market and in this pool in particular continued to impact the credit quality of this investment. A review of the investment led to the conclusion that, while a decline in the level of defaults in the general market was expected, no improvement in the prospects for this structured security was expected. This conclusion resulted from the deterioration of the underlying pool of high yield bonds and the deteriorating performance record of the pool’s manager. The investment was downgraded to below-investment-grade status in the third quarter of 2001 and, at the time of sale, had been in an unrealized loss position for a period of greater than 270 days but less than 360 days.
The Company’s exposure to below-investment-grade fixed maturity securities at December 31, 2002, was $2,872.8 million, representing 10.0 percent of the carrying value of invested assets excluding ceded policy loans, below the Company’s internal limit for this type of investment. The Company’s exposure to below-investment-grade fixed maturities totaled $2,261.7 million at December 31, 2001, or 8.7 percent of invested assets. The year over year increase resulted from downgrades of existing securities that were previously investment-grade rather than the purchase of additional below-investment-grade securities.
The Company has investments in five special purpose entities whose purposes are to support the Company’s investment objectives. These entities are for asset collateralization and contain specific investment securities that do not include the Company’s common stock or debt. These investments are described as follows:
At December 31, 2002, the Company had a retained interest in a special purpose entity trust that was securitized with financial assets consisting of a United States Treasury bond and several limited partnership equity interests. This investment was reported at fair value and included with fixed maturity securities in the consolidated statements of financial condition. The fair value of this investment was derived from the fair value of the underlying assets. The fair value and amortized cost of this investment was $123.5 million and $127.8 million, respectively, at December 31, 2002, and $113.6 million and $122.6 million at December 31, 2001. At December 31, 2002, the Company had capital commitments of $14.1 million to this special purpose entity trust. These funds are due upon satisfaction of contractual notice from the trust. These amounts may or may not be funded during the term of the trust.
The Company’s mortgage loan portfolio was $599.9 million and $941.2 million at December 31, 2002 and 2001, respectively. The mortgage loan portfolio is well diversified geographically and among property types. The incidence of problem mortgage loans and foreclosure activity remains low, and management expects the level of delinquencies and problem loans to remain low in the future. One purchase money mortgage associated with the sale of real estate was added to the Company’s investment portfolio during 2002. For the years 2001 and 2000, the only additions were related to two purchase money mortgages associated with the sale of real estate. The Company sold mortgage loans with a book value of $95.1 million during 2002, resulting in a before-tax realized investment gain of $1.2 million.
The Company has an investment program wherein it simultaneously enters into repurchase agreement transactions and reverse repurchase agreement transactions with the same party. The Company nets the related receivables and payables in the consolidated statements of financial condition as these transactions meet the requirements for the right of offset. As of December 31, 2002, the Company had $499.3 million face value of these agreements in an open position that were offset. The Company also uses the repurchase agreement market as a source of short-term financing. The Company had $235.0 million face value of these contracts that were included in short-term debt in the consolidated statements of financial condition at December 31, 2002.
During 2002, the Company recognized net gains of $45.4 million on the termination of cash flow hedges and reported $42.1 million in other comprehensive income and $3.3 million as a component of realized investment gains and losses. The Company amortized $12.4 million of net deferred gains into net investment income during 2002. The Company’s current credit exposure on derivatives, which is limited to the value of those contracts in a net gain position, was $52.2 million at December 31, 2002. Additions and terminations, in notional amounts, to the Company’s hedging programs for 2002, were $1,029.6 million and $771.9 million, respectively. The notional amount of derivatives outstanding under the hedge programs was $1,382.8 million at December 31, 2002.
The Company’s liquidity requirements are met primarily by cash flows provided from operations, principally in its insurance subsidiaries. Premium and investment income, as well as maturities and sales of invested assets, provide the primary sources of cash. Cash is applied to the payment of policy benefits, costs of acquiring new business (principally commissions), and operating expenses as well as purchases of new investments. The Company has established an investment strategy that management believes will provide for adequate cash flows from operations. Cash flows from operations were $1,786.7 million for the year ended December 31, 2002, as compared to $1,770.6 million and $1,211.5 million for the comparable periods of 2001 and 2000, respectively.
The Company’s source of cash could be negatively impacted by a decrease in demand for the Company’s insurance products or an increase in the incidence of new claims or the duration of existing claims. The Company’s policy benefits are primarily in the form of claim payments, and the Company therefore has minimal exposure to the policy withdrawal risk associated with deposit products such as individual life policies or annuities. Cash flow could also be negatively impacted by a deterioration in the credit market whereby the Company’s ability to liquidate its positions in certain of its fixed maturity securities would be impacted such that the Company might not be able to dispose of these investments in a timely manner. The Company believes that cash flows will be sufficient to meet its liquidity requirements for the next twelve months.
The payment of ordinary dividends to the Company from its insurance subsidiaries is further limited to the amount of statutory surplus as it relates to policyholders. Based on the restrictions under current law, during 2003 $328.5 million is available for the payment of ordinary dividends to the Company from its domestic insurance subsidiaries. Of this amount, $113.1 million is conditional upon approval from the Maine Bureau.
The Company also has the ability to draw a dividend from its United Kingdom-based affiliate, Unum Limited. Such dividends are limited in amount, based on insurance company law in the United Kingdom, which requires a minimum solvency margin. Approximately $94.6 million will be available for the payment of dividends from Unum Limited during 2003.
The amount available during 2002 for the payment of ordinary dividends from the Company’s domestic insurance subsidiaries was $384.9 million, including $121.8 million available with approval from the Maine Bureau. Of the total available, $165.0 million was utilized, including $40.0 million as requested by the Company and approved by the Maine Bureau. The amount available during 2002 from Unum Limited was $27.5 million, none of which was utilized.
restrictions do not limit the amount of dividends available for distribution to the Company from its non-insurance subsidiaries. The Company’s risk-based capital (RBC) ratio for its U.S. insurance subsidiaries, calculated on a weighted average basis using the NAIC Company Action Level formula, was 210 percent and 250 percent at the end of 2002 and 2001, respectively. The decrease in the ratio during 2002 was primarily the result of realized investment losses in the Company’s insurance subsidiaries. Unlike GAAP, statutory accounting does not generally require unrealized gains and losses on fixed maturity securities to be reflected in surplus. Because unrealized losses are not recognized in statutory surplus, the recognition of an impairment write-down or a realized loss on the sale of a security decreases the statutory surplus of the Company’s insurance subsidiaries and therefore decreases the RBC ratios. The individual RBC ratios for the Company’s principal operating subsidiaries ranged from 193 percent to 262 percent at December 31, 2002. Although the individual RBC ratio for each insurance subsidiary continues to be above the range that would require state regulatory action, the Company is reviewing various alternatives to restore the RBC ratios for its insurance subsidiaries to the approximate level of 2001.
During 2001 the Company redeemed its $172.5 million par value 8.8% monthly income debt securities (junior subordinated debt), which were due in 2025 but callable at par in 2000 and thereafter. The early extinguishment of debt resulted in a fourth quarter of 2001 write-off of the remaining deferred debt cost of $4.5 million associated with the issuance of the securities. The extraordinary loss, net of a $1.6 million tax benefit, was $2.9 million.
During 2000, the Company entered into $1.0 billion senior revolving credit facilities with a group of banks. The facilities are split into five-year revolver and 364-day portions. The Company received a 90-day extension on the 364-day portion of the credit facilities which was to expire on October 29, 2002. In connection with that extension, the Company elected to reduce the size of the credit facilities from $1.0 billion to $750.0 million and reduce the size of the commercial paper program to $750.0 million. At December 31, 2002, approximately $750.0 million was available for additional financing under the Company’s revolving credit facilities. On January 27, 2003, the Company elected not to renew the 364-day portion of the credit facilities upon the expiration date for the 90-day extension, retaining only the $472.5 million five-year revolver portion. The Company’s commercial paper program has been similarly reduced in size to $472.5 million.
During the second quarter of 2002, the Company’s board of directors authorized a common stock repurchase program of up to $100.0 million over the next year at prices not to exceed market value. The stock purchases will be used in connection with the Company’s benefit and compensation plans and for other corporate purposes and can be made through the open market or privately negotiated transactions. Under this program, the Company acquired approximately 1.8 million shares of its common stock in the open market during the second quarter at an aggregate cost of approximately $45.0 million. It is not anticipated that further repurchases will be made under the program.
The Company has an agreement with an outside party wherein the Company is provided computer data processing services and related functions. The contract expires in 2010, but the Company may cancel this agreement effective August 2004 or later upon payment of applicable cancellation charges. The aggregate noncancelable contractual obligation remaining under this agreement, as amended, was $158.8 million at December 31, 2002, with no annual payment expected to exceed $58.3 million.
As previously discussed, at December 31, 2002, the Company had capital commitments of $14.1 million to fund a special purpose entity trust in which the Company has a retained interest. The Company also has capital commitments of $18.8 million to fund certain of its private placement fixed maturity securities. The funds are due upon satisfaction of contractual notice from the trustee or issuer. These amounts may or may not be funded during the term of the security.
The Company is exploring various options to improve its capital and risk positions, including but not limited to financing alternatives and various reinsurance opportunities. These actions may result in lower net income or lower net income per common share for the Company in future periods.
Standard & Poor’s Corporation (S&P), Moody’s Investors Service (Moody’s), Fitch, Inc. (Fitch), and A.M. Best Company (AM Best) are among the third parties that provide the Company assessments of its overall financial position. Ratings from these agencies for financial strength are available for the individual U.S. domiciled insurance company subsidiaries. Financial strength ratings are based primarily on U.S. statutory financial information for the individual U.S. domiciled insurance companies. Debt ratings for the Company are based primarily on consolidated financial information prepared using generally accepted accounting principles. Both financial strength ratings and debt ratings incorporate qualitative analyses by rating agencies on an ongoing basis. If the Company were to experience negative operating trends, it could result in a downgrade of the current ratings, which might affect the Company’s ability to sell and retain its business.
These ratings are not directed toward the holders of the Company’s securities and are not recommendations to buy, sell or hold such securities. Each rating is subject to revision or withdrawal at any time by the assigning rating organization, and each rating should be evaluated independently of any other rating.
The Company holds an unrecognized net gain or loss representing cumulative liability and asset gains and losses that have not been recognized in pension expense. As of December 31, 2002, there was an estimated unrecognized loss of approximately $320.0 million in the U.S. Pension plans. As of December 31, 2001, the unrecognized loss was $38.0 million, and as of December 31, 2000, there was a $99.0 million unrecognized gain. The unrecognized loss has increased due to asset market value losses that occurred during 2001 and 2002 and the drop in the year end discount rate from 7.60 percent at 2000, to 7.35 percent at 2001, and to 6.75 percent at 2002. The unrecognized net gain or loss is amortized in the pension expense. Only amounts outside of a corridor (equal to 10 percent of the greater of the projected benefit obligation or market value of assets) are amortized. The 2003 pension expense is expected to include a loss amortization of approximately $20.0 million. This loss amortization was less than $1.0 million in 2002. In 2001 and 2000, the pension expense included gain amortization of $4.0 million and $21.0 million, respectively.
Restatement of Financial Information: During 2001 and 2000, the Company recorded other than temporary impairments on certain of its fixed maturity securities based on values that included their quoted market prices, as well as to give effect to analysis by the Company with respect to certain issuers of securities that perhaps was not reflected in those market prices. After discussions with the staff of the Securities and Exchange Commission’s Division of Corporation Finance, the Company has concluded that not relying solely on quoted market prices for its other than temporary impairment charges was an erroneous interpretation of Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, and, accordingly, is restating its previously issued financial statements for the years ended December 31, 2001 and 2000 and for each of the quarters ending March 31, June 30, and September 30 for for 2002, 2001, and 2000 to adjust the amounts recorded during 2001 and 2000 on these securities such that the other than temporary impairments are based on the then quoted market prices. The non-cash adjustments did not impact the Company’s total stockholders’ equity in any period because the Company had already recorded the unrealized effect of the decreased market value of its fixed maturity securities through stockholders’ equity in the appropriate periods.
Shown below is a comparison of the previously reported and restated amounts for each of the periods affected.
Operations: The Company does business primarily in North America and operates principally in the life and health insurance business. The Employee Benefits segment includes group long-term and short-term disability insurance, group life insurance, accidental death and dismemberment, group long-term care, and managed disability services. The Individual segment includes the individual disability and individual long-term care lines of business. The Voluntary Benefits segment includes products sold to employees through payroll deduction at the work site. These products include life and health insurance products, primarily disability, accident and sickness, critical illness, and cancer. The Other operating segment includes results from products no longer actively marketed, including individual life and corporate-owned life insurance, reinsurance pools and management operations, group pension, health insurance, and individual annuities. The Corporate segment includes investment earnings on corporate assets not specifically allocated to a line of business, corporate interest expense, amortization of goodwill (prior to 2002), and certain corporate expenses not allocated to a line of business. See Note 13 for further information on the operating segments.
Real Estate classified as investment real estate is carried at cost less accumulated depreciation. Real estate acquired through foreclosure is valued at fair value at the date of foreclosure. If investment real estate is determined to be other than temporarily impaired, the carrying amount of the asset is reduced to fair value. Occasionally, investment real estate is reclassified to real estate held for sale when it no longer meets the Company’s investment criteria. Real estate held for sale is valued net of a valuation allowance that reduces the carrying value to the lower of cost less accumulated depreciation or fair value less estimated cost to sell. Accumulated depreciation on real estate was $15.0 million and $17.8 million as of December 31, 2002 and 2001, respectively.
The Company discontinues the accrual of investment income on invested assets when it is determined that collection is uncertain. The Company recognizes investment income on impaired loans when the income is received.
Gains or losses on the termination of ineffective hedges are reported in current operating earnings. In the event a hedged item is disposed of or the anticipated transaction being hedged is no longer likely to occur, the Company will terminate the related derivative and recognize the gain or loss on termination in current operating earnings.
Loss recognition is performed when, in the judgment of management, adverse deviations from original assumptions have occurred and may be likely to continue such that recoverability of deferred policy acquisition costs on a line of business is questionable. Insurance contracts are grouped on a basis consistent with the Company’s manner of acquiring, servicing, and measuring profitability of the contracts. If loss recognition testing indicates that deferred policy acquisition costs are not recoverable, the deficiency is charged to expense. Once a loss recognition adjustment is required, loss recognition testing is generally performed on an annual basis using then current assumptions until the line of business becomes immaterial or results improve significantly. The assumptions used in loss recognition testing represent management’s best estimates of future experience.
Property and Equipment: Property and equipment is reported at cost less accumulated depreciation, which is calculated on the straight-line method over the estimated useful life. The accumulated depreciation for property and equipment was $387.7 million and $352.7 million as of December 31, 2002 and 2001, respectively.
product line to produce asset cash flows that follow similar timing and amount patterns to those of the anticipated liability payments.
Federal Income Tax: Deferred taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial statement purposes and the amounts used for income tax purposes. Deferred taxes have been measured using enacted statutory income tax rates and laws that are currently in effect. A valuation allowance is established for deferred tax assets when it is more likely than not that an amount will not be realized.
Deferred Gain or Loss on Reinsurance: The Company is a party to various reinsurance agreements. Where applicable, gains or losses on these transactions are deferred and amortized into earnings based upon expected future premium income for traditional insurance policies and estimated future gross profits for interest-sensitive insurance policies. The deferred gain on reinsurance included in other liabilities in the consolidated statements of financial condition at December 31, 2002 and 2001 was $325.5 million and $360.2 million, respectively.
Had the amortization of goodwill been excluded from income for the years ended December 31, 2001 and 2000, income before federal income taxes and extraordinary losses would have been $787.8 million and $849.0 million, respectively, and net income would have been $561.5 million ($2.30 per common share assuming dilution) and $560.3 million ($2.31 per common share assuming dilution), respectively.
Effective January 1, 2002, the Company adopted the provisions of SFAS 144. SFAS 144 supercedes Statement of Financial Accounting Standards No. 121 (SFAS 121), Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, and the accounting and reporting provisions of APB Opinion No. 30 (Opinion 30), Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. Two accounting models existed for long-lived assets to be disposed of under SFAS 121 and Opinion 30. SFAS 144 represents a single accounting model for long-lived assets to be disposed of by sale. The adoption of SFAS 144 did not have a material impact on the Company’s financial position or results of operations.
Effective December 31, 2002, the Company adopted the provisions of SFAS 148. SFAS 148 amends the disclosure provisions of SFAS 123 and APB Opinion No. 28, Interim Financial Reporting, to require additional disclosures of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share. The disclosure provisions of SFAS 148 are applicable to all companies with stock-based employee compensation, regardless of whether compensation is accounted for using the fair value method of SFAS 123 or the intrinsic value method of Opinion 25. The adoption of SFAS 148 had no impact on the Company’s financial position or results of operations.
Statement of Financial Accounting Standards No. 145 (SFAS 145), Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections
SFAS 145 requires that gains and losses associated with debt extinguishments no longer be reported as extraordinary items in statements of income. The Company plans to adopt SFAS 145 effective January 1, 2003 as required. Adoption of this pronouncement is not expected to have an impact on the Company’s financial position or results of operations.
Statement of Financial Accounting Standards No. 146 (SFAS 146), Accounting for Costs Associated with Exit or Disposal Activities
The carrying amounts and fair values of the Company’s financial instruments are as follows:
At December 31, 2002, the Company had a retained interest in a special purpose entity trust that was securitized with financial assets consisting of a United States Treasury bond and several limited partnership equity interests. This investment was reported at fair value and included with fixed maturity securities in the consolidated statements of financial condition. The fair value of this investment was derived from the fair value of the underlying assets. The fair value and amortized cost of this investment was $123.5 million and $127.8 million, respectively, at December 31, 2002 and $113.6 million and $122.6 million at December 31, 2001. At December 31, 2002, the Company had capital commitments of $14.1 million to this special purpose entity trust. These funds are due upon satisfaction of contractual notice from the trust. These amounts may or may not be funded during the term of the trust.
Mortgage loans are impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. The reported investment in mortgage loans considered to be impaired was $6.0 million and $13.1 million, respectively, at December 31, 2002 and 2001. Included in the impaired loans at December 31, 2002 were loans of $6.0 million that had a related allowance for losses of $2.4 million. Included in the impaired loans at December 31, 2001 were loans of $6.4 million that had a related allowance for losses of $2.4 million and loans of $6.7 million which had no related allowance for losses.
To help limit the credit exposure of the derivatives, the Company has entered into master netting agreements with its counterparties whereby contracts in a gain position can be offset against contracts in a loss position. The Company also typically enters into bilateral, cross-collateralization agreements with its counterparties to help limit the credit exposure of the derivatives. These agreements require the counterparty in a loss position to submit acceptable collateral with the other counterparty in the event the net loss position meets or exceeds an agreed upon amount. The Company’s current credit exposure on derivatives, which is limited to the value of those contracts in a net gain position, was $52.2 million at December 31, 2002.
The Company has executed a series of cash flow hedges in the group disability, individual disability, group and individual long-term care, and group single premium annuities portfolios using forward starting interest rate swaps. The purpose of these hedges is to lock in the reinvestment rates on future anticipated cash flows through the year 2006 and protect the Company from the potential adverse impact of declining interest rates on the associated policy reserves. The Company plans on terminating these forward interest rate swaps at the time the projected cash flows are used to purchase fixed income securities.
The Company has also used forward starting swaps to hedge the interest rate on anticipated issuance of debt. The Company recognized a loss of $10.6 million and a gain of $2.8 million during 2002 and 2001, respectively, upon the
The estimated net amortization of value of business acquired for each of the next five years is $42.6 million in 2003, $41.0 million in 2004, $39.5 million in 2005, $38.0 million in 2006, and $37.9 million in 2007. The acquisition and disposition activity reported for 2000 was related to certain reinsurance transactions. See Note 12.
The majority of the net balances are related to disability claims with long-tail payouts on which interest earned on assets backing liabilities is an integral part of pricing and reserving. Interest accrued on prior year reserves has been calculated on the opening reserve balance less one-half year’s cash payments at the average reserve discount rate used by the Company during 2002, 2001, and 2000. The change in the provision during 2002 for incurred claims and claim adjustment expenses related to prior years is attributable to a decrease in claim recovery rates for early duration claims and a slight increase in the claim acceptance rates.
The tragedy of September 11, 2001 resulted in a 2001 before-tax charge of $24.0 million, or $15.6 million after tax. This charge included estimated gross ultimate losses from reported and unreported claims of $65.0 million less an estimated $41.0 million recoverable from the Company’s reinsurers. The charge did not include any indirect costs which the Company incurred in developing specialized procedures for filing claims resulting from the attacks and in providing additional support to impacted policyholders and group clients. The Company’s reinsurance program provides a significant layer of catastrophic coverage for its individual disability and its group life, accidental death and dismemberment, travel accident, long-term disability, and short-term disability lines of business through a group of highly rated major national and international reinsurance organizations.
A reconciliation of the income tax (benefit) attributable to continuing operations computed at U.S. federal statutory tax rates to the income tax expense as included in the consolidated statements of income follows:
Under the Life Insurance Company Tax Act of 1959, life companies were required to maintain a policyholders’ surplus account containing the accumulated portion of current income which had not been subjected to income tax in the year earned. The Deficit Reduction Act of 1984 requires that no future amounts be added after 1983 to the policyholders’ surplus account. Further, any future distributions from the account would become subject to federal income tax at the general corporate federal income tax rate then in effect. The amount of the policyholders’ surplus account at December 31, 2002, is approximately $228.8 million. Future distributions from the policyholders’ surplus account are deemed to occur if a statutorily prescribed maximum for the account is less than the value of the account or if dividend distributions exceed the total amount accumulated as currently taxable income in the year earned. If the entire policyholders’ surplus account were deemed distributed in 2002, this would result in a tax of approximately $80.1 million. No current or deferred federal income taxes have been provided on these amounts because management considers the conditions under which such taxes would be paid to be remote.
The Company’s consolidated statements of income include the following amounts of income subject to foreign taxation and the related foreign income tax expense (credit):
Federal income taxes paid during 2002, 2001, and 2000 were $27.5 million, $127.3 million, and $165.6 million, respectively.
Of the $1,914.0 million of long-term debt at December 31, 2002, $227.0 million will mature in 2005 and $1,687.0 million will mature in 2011 and thereafter.
Interest costs related to these securities are reported in the consolidated statements of income as a component of interest and debt expense. Interest paid on these securities during each of the years ended December 31, 2002, 2001, and 2000 was $22.2 million.
At December 31, 2002, the plan assets include 448,784 shares of the Company’s common stock with a fair value of $7.9 million. The amount of dividends paid during 2002 was immaterial.
For measurement purposes at December 31, 2002, the annual rate of increase in the per capita cost of covered health care benefits assumed for 2003 was 10.0 percent. The rate range was assumed to change gradually to a rate of 5.0 percent for 2009 and remain at that level thereafter. For measurement purposes at December 31, 2001, the annual rate of increase in the per capita cost of covered health care benefits for 2002 was 11.0 percent, and was assumed to gradually decrease to a rate of 5.0 percent in 2008 and remain at that level thereafter.
The Company has several annual incentive plans for certain employees and executive officers that are designed to encourage achievement of certain goals. Compensation cost recognized in the consolidated statements of income for annual incentive plans is $27.5 million, $27.0 million, and $28.8 million for 2002, 2001, and 2000, respectively.
Under the stock plan of 1999, the Company has available up to 17,500,000 shares of common stock for awards to its employees, officers, producers, and directors. Awards may be in the form of stock options, stock appreciation rights, restricted stock awards, dividend equivalent awards, or any other right or interest relating to stock. The number of shares available to be issued as restricted stock or unrestricted stock awards is limited to 3,500,000 shares. The options have a maximum term of ten years after the date of grant. The Company granted 2,500 shares and 158,100 shares of restricted stock during 2002 and 2001 to certain employees with a weighted average grant date value of $28.90 and $27.99, respectively, per common share.
Under the broad-based stock plan of 2001, the Company has available up to 2,000,000 shares of common stock for awards to its employees, officers, consultants, and producers, excluding certain senior officers and directors.
Reinsurance activity is accounted for on a basis consistent with the terms of the reinsurance contracts and the accounting used for the original policies issued. Premium income and benefits and change in reserves for future benefits are presented in the consolidated statements of income net of reinsurance ceded. The total amounts deducted for reinsurance ceded are as follows:
Effective July 1, 2000, the Company entered into various reinsurance agreements with Reassure America Life Insurance Company (Reassure America), an affiliate of Swiss Re Life & Health America Inc., under which Reassure America reinsured on a 100 percent indemnity coinsurance basis substantially all of the individual life insurance and corporate-owned life insurance policies written by the Company’s insurance subsidiaries, as well as a small block of individually underwritten group life insurance. Reassure America has a current A.M. Best rating of A++ (superior). In consideration of the transfer of reserves, the Company received a ceding commission of $601.0 million. Total liabilities of $3,346.8 million and policy loans of $2,040.9 million were assumed by Reassure America. The $388.2 million before-tax and $252.3 million after-tax gain on these transactions was deferred and is being amortized into income based upon expected future premium income on the traditional insurance policies ceded and estimated future gross profits on the interest-sensitive insurance policies ceded.
This reinsurance agreement transfers risk and is accounted for as a long-duration reinsurance contract in accordance with the provisions of Statement of Financial Accounting Standards No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts. The underlying operating results of this contract are reflected in other income, and any realized gain or loss from the sale of assets is reflected as a realized investment gain or loss in the Company’s consolidated statements of income.
Included in miscellaneous assets in the consolidated statements of financial condition at December 31, 2002, is a deposit asset for this reinsurance arrangement of approximately $452.2 million. The deposit asset is comprised of the Company’s experience layer and unrealized gains or losses on the marketable securities held in the trust. Unrealized gains or losses on marketable securities held in the trust and the related effects on claim reserves are included in other comprehensive income (loss) in the equity section of the Company’s consolidated statements of financial condition.
Stockholders’ equity is allocated to the operating segments on the basis of an internal allocation formula that reflects the volume and risk components of each operating segment’s business and aligns allocated equity with the Company’s target capital levels for regulatory and rating agency purposes. The internal formula may result in a “negative” equity and “negative” asset amount remaining in the Corporate segment. This formula is modified periodically to recognize changes in the views of capital requirements.
The Company has an agreement with an outside party wherein the Company is provided computer data processing services and related functions. The contract expires in 2010, but the Company may cancel this agreement effective August 2004 or later upon payment of applicable cancellation charges. The aggregate noncancelable contractual obligation remaining under this agreement is $158.8 million at December 31, 2002, with no annual payment expected to exceed $58.3 million.
In addition, the same plaintiffs’ attorney who had initially filed the class action lawsuits has filed approximately 50 (including the two individual career agents who brought the class action referenced above) individual lawsuits on behalf of current and former Paul Revere sales managers alleging various breach of contract claims. Two of the complaints were subject to arbitration. In June 2001, the first arbitration was heard before a National Association of Securities Dealers panel, and the arbitration panel awarded the plaintiffs $190,000 in compensatory damages with no award for punitive damages, attorneys’ fees, or interest. The second arbitration was cancelled because all of the claims of 43 out of 47 general managers (including the manager subject to arbitration) were settled in July 2002. Partial claims for four general managers remain, along with claims for the two career class representatives. UnumProvident and affiliates believe that they have strong defenses and plan to vigorously defend their position in the remaining cases. Management does not currently expect these suits to materially affect the financial position or results of operations of the Company.
On December 26, 2002 the case of Impress Communications Inc. and Jeff Chiarella v. UnumProvident et al. (Impress) was filed in Los Angeles Superior Court as a purported class action. The plaintiffs in Impress seek representative status of all California policyholders of each of the insurance subsidiaries of the Company who have never filed a claim with the Company and who allegedly were misled into purchasing coverage with the Company without full disclosure of the Company’s alleged improper claim paying practices. The complaint was removed to the United States District Court for the Central District of California on February 7, 2003. The Company strongly denies the allegations in the complaint and will vigorously defend both the substantive and procedural aspects of the litigation.
On February 25, 2003, the case of Thomas P. Davis, et al., v. UnumProvident Corporation, et al., was filed in the United States District Court for the Eastern District of Pennsylvania. The plaintiffs are seeking representative status as a class of disability participants insured under ERISA plans. The complaint alleges that these claimants had their claims improperly denied or terminated and that the Company breached certain fiduciary duties owed to these participants in ERISA plans. The complaint also alleges violations under the federal Racketeer Influenced and Corrupt Organizations Act (RICO). The complaint seeks reversal of claim denials or contract rescissions and re-determination by an independent person of claims of the named plaintiffs and others similarly situated, appointment of a master to oversee certain claim handling matters, and treble damages under RICO. The Company strongly denies the allegations in the complaint and will vigorously defend the litigation.
In certain reinsurance pools associated with the Company’s reinsurance businesses there are disputes among the pool members and reinsurance participants concerning the scope of their obligations and liabilities within the complex pool arrangements, including pools for which subsidiaries of the Company acted either as pool managers or underwriting agents, as pool members or as reinsurers. The Company or the Company’s subsidiaries either have been or may in the future be brought into disputes, arbitration proceedings, or litigation with other pool members or reinsurers of the pools in the process of resolving the various claims. See the reinsurance pools and management section contained in the segment results discussion in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained herein in Item 7.
The Company’s insurance subsidiaries’ statutory combined net income (loss), as reported in conformity with statutory accounting principles as prescribed by the National Association of Insurance Commissioners (NAIC) and adopted by the applicable state laws, for the years ended December 31, 2002, 2001, and 2000, was $(209.7) million, $221.1 million, and $353.5 million, respectively. Statutory combined net gain from operations was $220.7 million, $353.2 million, and $414.8 million for the years ended December 31, 2002, 2001, and 2000, respectively. Statutory capital and surplus at December 31, 2002 and 2001, was $3,253.0 million and $3,378.7 million, respectively.
Restrictions under applicable state insurance laws limit the amount of ordinary dividends that can be paid to the Company from its insurance subsidiaries without prior approval by regulatory authorities. Generally, that limitation, which varies by state of domicile, equals either ten percent of an insurer’s statutory surplus with respect to policyholders as of the preceding year end or the statutory net gain from operations, excluding realized investment gains and losses, of the preceding year. Further, pursuant to the 1999 merger of Unum Corporation with and into Provident Companies, Inc., (of which the Company is the surviving corporation) the Company is required to obtain approval from the Maine Bureau of Insurance regarding payment of ordinary dividends from the Company’s Maine domiciled insurance subsidiary until 2004.
The payment of ordinary dividends to the Company from its insurance subsidiaries is further limited to the amount of statutory surplus as it relates to policyholders. Based on the restrictions under current law, during 2003 $328.5 million is available for the payment of ordinary dividends to the Company from its domestic insurance subsidiaries. Of this amount, $113.1 million is conditional upon approval from the Maine Bureau of Insurance.
The Company also has the ability to draw a dividend from its United Kingdom subsidiary, Unum Limited. Such dividends are limited based on insurance company legislation in the United Kingdom, which requires a minimum solvency margin. The amount available under current law for payment of dividends to the Company from Unum Limited during 2003 is approximately $94.6 million. Regulatory restrictions do not limit the amount of dividends available for distribution to the Company from its non-insurance subsidiaries.
The NAIC and the Company’s insurance subsidiaries’ states of domicile approved a codification of statutory accounting practices effective January 1, 2001, which serves as a comprehensive and standardized guide to statutory accounting principles. The codification changed, to some extent, the accounting practices that the Company’s insurance subsidiaries used to prepare their statutory financial statements. The cumulative effect of the changes in accounting principles adopted to conform to the codification of statutory accounting principles for the Company’s insurance subsidiaries was approximately $45.6 million and was recognized as an increase to statutory surplus as of January 1, 2001.
At December 31, 2002, the Company’s insurance subsidiaries had on deposit with regulatory authorities securities with a book value of $1,444.0 million held for the protection of policyholders.