Represents costs related to our demutualization and initial public offering in 1999.
The following analysis of the consolidated financial condition and results of operations of StanCorp and its subsidiaries should be read in conjunction with the consolidated financial statements and related notes thereto (see “Item 8, “Financial Statements and Supplementary Data”).
We have made in this Form 10-K, and from time to time may make in our public filings, news releases and oral presentations and discussions, certain statements which are not based on historical facts. These statements are “forward-looking” and, accordingly, involve risks and uncertainties that could cause actual results to differ materially from those discussed. Although such “forward-looking” statements have been made in good faith and are based on reasonable assumptions, there is no assurance that the expected results will be achieved. These statements include, without limitation, statements as to future expectations, beliefs, plans, strategies, objectives, events, conditions and financial performance, and are identified by words such as “believes,” “expects,” “intends,” “may,” “will,” “should,” “anticipates,” or the negative of those words or other comparable terminology. In connection with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, we are providing this cautionary statement to identify important factors that could cause actual results to differ materially from those anticipated. The following factors could cause results to differ materially from management expectations as suggested by such forward-looking statements:
Given these uncertainties, you should not place undue reliance on these forward-looking statements. Except to the extent required by the federal securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Also during the first quarter of 2002, The Standard Life Insurance Company of New York received approval from the State of New York Insurance Department to sell group life and accidental death and dismemberment insurance products in New York. The Standard Life Insurance Company of New York is now licensed to provide long term and short term disability, life and accidental death and dismemberment insurance for groups in New York.
The Company’s investment portfolio consists primarily of fixed maturity securities and commercial mortgage loans. Fixed maturity securities are recorded at fair value with net unrealized gains or losses recorded as an increase or decrease to other comprehensive income, net of tax. For all investments, we record impairments when it is determined
that the decline in fair value of an investment below its amortized cost basis is “other than temporary.” We reflect impairment charges in net capital gains or losses and permanently adjust the cost basis of the investment to reflect the impairment.
Factors considered in evaluating whether a decline in value of fixed maturity securities is other than temporary include:
the length of time and the extent to which the fair value has been less than amortized cost;
the amount of the monthly benefit paid to the insured (less deductible income, such as Social Security payments received by the insured).
Certain of these factors could be materially affected by changes in social perceptions about work ethics, emerging medical perceptions and legal interpretations regarding physiological or psychological causes of disability, emerging or changing health issues and changes in industry regulation. Changes in one or more of these factors could require us to increase our reserves. If actual claims experience is materially inconsistent with our assumptions, we could be required to increase our reserves.
Quarterly, we evaluate the appropriateness of the discount rate used to establish new long term disability reserves. We determine the discount rate based on the average new money investment rate for the quarter less a margin to allow for reinvestment risk. If assets are subsequently reinvested at rates that do not exceed the established discount rate on the reserves, we could be required to increase our reserves (see “-Selected Segment Information-Employee Benefits-Insurance Segment,” and “-Liquidity and Capital Resources-Financing Cash Flows- Asset/Liability Matching and Interest Rate Risk Management”).
VOBA represents the discounted future profits of blocks of business acquired through reinsurance transactions. The value of business acquired is amortized in proportion to future premiums or expected future profitability, as appropriate. If actual premiums or expected future profitability are inconsistent with our assumptions, we could be required to make adjustments to VOBA and related amortization.
The provision for income taxes includes amounts currently payable, deferred amounts that result from temporary differences between financial reporting and tax bases of assets and liabilities as measured by current tax rates and laws, and estimated amounts provided for potential adjustments related to Internal Revenue Service examinations of open years, generally when the interpretation of the tax law is unclear. Although estimated amounts are adjusted when appropriate, amounts required to be provided upon the settlement of an examination may differ from amounts previously estimated. Years currently open for audit by the Internal Revenue Service are 1996 through 2001.
The Company has publicly stated financial objectives for premium growth, growth in operating income per diluted common share and operating return on average equity. Operating income is net income excluding after-tax capital gains and losses. The following sets forth our financial objectives and results against those objectives for the year ended December 31, 2002:
Operating return on average equity is targeted to be 13% to 14% by the end of 2003 and 14% to 15% by the end of 2005. Operating return on average equity for 2002 was 12.7%, representing good progress towards our 2003 and 2005 goals, both of which are reaffirmed.
Net income increased $5.0 million, or 4.7%, in 2002 compared to 2001 and $11.3 million, or 11.9%, in 2001 compared to 2000. The increase in 2002 resulted primarily from premium growth and favorable claims experience in the Employee Benefits-Insurance segment partially offset by net capital losses of $19.7 million. The increase in 2001 resulted primarily from premium growth and stable claims experience in the Employee Benefits-Insurance segment and increased income contribution from the Individual Insurance segment as a result of the acquisition of a block of individual disability insurance business. Net income in 2001 included $5.0 million in pre-tax charges related to the terrorist events of September 11, 2001. (See “-Net Capital Losses” and “-Selected Segment Information.”)
Net investment income, which is affected by changes in interest rates and levels of invested assets, increased $32.2 million, or 9.2%, in 2002 compared to 2001. The increase was primarily due to an increase in average invested assets of 10.0% in 2002 compared to 2001, offset in part by declining portfolio yields. The increase in average invested assets included assets from debt offering proceeds and the acquisition of the TIAA block of business (see “-Business Developments”). The portfolio yield for fixed maturity securities decreased to 6.22% at December 31, 2002, from 6.79% at December 31, 2001. The portfolio yield for commercial mortgage loans decreased to 7.94% at December 31, 2002 from 8.22% at December 31, 2001.
Benefits to policyholders include changes in the liability for future policy benefits and claims, and are affected by claims experience, which can fluctuate significantly from period to period. Benefits to policyholders and interest credited increased $94.3 million, or 8.6%, in 2002 compared to 2001, and $75.8 million, or 7.4%, in 2001 compared to 2000. The increases resulted primarily from business growth, as evidenced by premium growth, in the Employee Benefits-Insurance segment. Policyholder benefits and interest credited for 2002 included results from the acquisition of the TIAA block of business effective October 1, 2002, and for 2001 included $5.0 million incurred as a result of the terrorist events of September 11, 2001.
Beyond premium growth, the most significant drivers of policyholder benefits are claims experience and the assumptions used to establish related reserves. We measure these factors for our disability businesses with a benefit ratio. Our expected benefit ratio differs by segment. For the Employee Benefits-Insurance segment, our expected benefit ratio is 82% to 84%. For 2002, 2001, and 2000, the benefit ratios for this segment were 80.5%, 82.1% and 82.1%, respectively. The decrease in this ratio in 2002 resulted from very favorable claims experience. Claims experience can fluctuate widely from period to period. (See “-Selected Segment Information.”)
In addition to operating expenses for the TIAA block of business, operating expenses were higher in 2002 due to
increased benefit costs for our own employees. We are in the process of analyzing the structure of overall benefit packages for cost and competitiveness and expect to execute plans during 2003 that will reduce increases in benefit costs, which would otherwise have been incurred. After the integration of the TIAA block of business is complete, we expect our operating expenses to be closer to historical levels as measured as a percent of premiums.
Commissions and bonuses primarily represent sales-based compensation, and vary depending on the product, whether the sale is in its first year or a renewal year, and other factors. Commissions tend to fluctuate with premiums, but not directly, due to the structure of various commission programs. Commissions and bonuses increased $14.3 million, or 12.1%, for 2002 compared to 2001, and $15.6 million, or 15.2%, for 2001 compared to 2000. The increases for both comparable periods were primarily due to sales growth in the Employee Benefits-Insurance and Individual Insurance segments. (see “-Selected Segment Information”).
The net deferral and amortization of acquisition costs reduced expenses in 2002, 2001 and 2000 by $21.0 million, $19.6 million, and $7.8 million, respectively. The 2002 and 2001 net amounts deferred were primarily a result of the sale of the life insurance block of business, the acquisition of a block of individual disability insurance business and the growth in new sales.
Amortization of VOBA in 2002, 2001 and 2000 was $5.2 million, $3.3 million, and $0.7 million, respectively. Amortization for all years included amortization of the VOBA related to the Minnesota Life block of business, which was acquired effective October 1, 2000. Amortization for 2002 also included $2.1 million related to the acquisition of the block of business from TIAA in the fourth quarter (see “-Selected Segment Information”).
Total income taxes differ from the amount computed by applying the federal corporate tax rate of 35% because of the net result of permanent differences and the inclusion of state and local income taxes, net of the federal benefit. The combined federal and state effective tax rates were 35.5%, 35.6%, and 32.9% for 2002, 2001, and 2000, respectively. The higher effective rates in 2002 and 2001 compared to 2000 resulted primarily from a change in our tax return filing status. Income taxes also include estimated amounts provided for potential adjustments resulting from Internal Revenue Service examinations of open years.
The Employee Benefits-Insurance segment’s products are designed for groups ranging in size from two lives to over 150,000 lives. Through this segment, the Company is a leading provider of group disability and group life insurance products, serving more than 32,500 employer groups representing more than 6 million employees. The Employee Benefits-Insurance segment also sells group dental insurance and accidental death and dismemberment insurance. Our group insurance products are marketed by 157 sales representatives and managers. We plan to increase our sales force to 175 by the end of 2003 and 200 by the end of 2005. As the largest of the Company’s three segments, Employee Benefits-Insurance premiums accounted for 92.8%, 91.7%, and 88.3% of the Company’s total premiums for 2002, 2001, and 2000, respectively.
In force premium distribution by industry, geography, and customer size for all products as of December 31, 2002 was as follows (including the TIAA block of business):
Premiums for the Employee Benefits-Insurance segment increased 13.3% in 2002 compared to 2001, and 15.0% for 2001 compared to 2000, excluding experience rated refunds. In 2002, premiums were increased by $40.9 million related to the TIAA block of business acquired effective October 1, 2002, and were decreased by $4.4 million due to a new reinsurance agreement entered into with Ameritas effective June 1, 2002 (see “-Business Developments”). Excluding premiums from the TIAA block of business, and adjustments to premiums from experience rated refunds and the dental reinsurance agreement, premiums grew 10.1% in 2002 compared to 2001, and 15.0% for 2001 compared to 2000. The decreased rate of growth for the comparative periods was primarily due to economic conditions, including slower employment and wage growth and reduced employee benefit budgets on the part of employer groups primarily due to increased medical costs (see “-Consolidated Results of Operations”).
Net investment income for the segment increased $19.7 million, or 10.5%, for 2002 compared to 2001, and $22.1 million, or 13.4%, for 2001 compared to 2000. The increases primarily resulted from an increase in average invested assets supporting the segment of 10.0% and 12.2% for the respective periods offset in part by declining portfolio yields. The increase in average invested assets included assets from debt offering proceeds and the acquisition of the TIAA block of business. (See “-Consolidated Results of Operations-Net investment Income”.)
Also affecting benefits to policyholders is the new money rate on our investments, which is the basis of the rate used
to discount future long term disability payments to their present value when establishing reserves for newly incurred claims. Changes in reserves are included in policyholder benefits and therefore affect the benefit ratio. Each quarter, we determine the discount rate used to establish new reserves based on our average new money investment rate for the quarter less a margin to allow for reinvestment risk should our assets and liabilities not be well matched for this product. It has been our practice to maintain a 50 to 75 basis point margin between our average new money investment rate for the quarter and the discount rate used to establish reserves over a 12 month period. Given the current low interest rate environment, and correspondingly lower reinvestment risk, our targeted margin range for newly incurred claims will be 20 to 30 basis points over a 12 month period as long as our average new money investment rate is less than 6%.
In the recent period of declining interest rates, our discount rate has been correspondingly decreasing, with downward adjustments in the discount rate of 25 basis points in the first and third quarters of 2002 and the third quarter of 2001. In the fourth quarter of 2002, the discount rate was decreased 50 basis points. Each 25 basis point adjustment increases or decreases current policyholder benefits approximately $3 million per quarter.
Operating expenses were 14.5%, 13.2% and 13.6% of premiums for 2002, 2001 and 2000, respectively. Operating expenses in 2002 included transition and integration costs for the acquisition of the TIAA block of business, as well as increased employee benefit costs for our employees (see “-Consolidated Results of Operations”).
Commissions and bonuses increased $8.7 million, or 9.7%, in 2002 compared to 2001, and $7.6 million, or 9.2%, in 2001 compared to 2000. Increases for both comparative periods were due primarily to increased sales and renewal commissions.
The net increase in deferred acquisition costs and VOBA was $2.7 million for 2002, compared to $3.6 million for 2001, and $5.9 million for 2000. The net amount deferred in 2002 included $2.1 million of amortization related to the VOBA recorded in connection with the acquisition of the block of business from TIAA in the fourth quarter. Prospectively, annual amortization of VOBA related to the acquisition of the block of business from TIAA will be approximately $9.8 million in 2003, $8.2 million in 2004, and $7.1 million in 2005.
Income before income taxes for the segment increased $18.3 million, or 13.9%, in 2002 compared to 2001, and $15.3 million, or 13.2%, in 2001 compared to 2000.
Pre-tax charges of $0.7 million incurred as a result of the terrorist events of September 11, 2001 were excluded from the computation of the benefit ratio for 2001.
Premiums decreased $1.2 million, or 1.5%, in 2002 compared to 2001. When adjusted to exclude reductions to premiums of $6.5 million for the reinsurance agreement covering certain policies in the block of business acquired from Minnesota Life, premiums for this segment grew 6.5%. Premiums decreased $23.6 million, or 22.5%, in 2001 compared to 2000. The decrease was due to the sale of the individual life insurance product line effective January 1, 2001. Premiums for this product line were $70.0 million in 2000. Partially offsetting the decrease was the acquisition of a block of business acquired from Minnesota Life effective October 1, 2000, increasing 2001 premiums $50.2 million compared to 2000.
Beyond premium growth, the most significant drivers of policyholder benefits are claims experience and the assumptions used to establish related reserves. We measure these factors for this segment with a benefit ratio, which is calculated as policyholder benefits divided by premiums. Our expected benefit ratio for this segment was 95% to 105% for 2002 and 2001 (prior to 2001 an expected ratio was not used for this segment as the disability business was
insignificant). For 2002 and 2001, the benefit ratios for this segment were 99.8% and 104.5%, respectively.
The benefit ratio is expected to decline with time as the percentage of the premiums collected from newly issued policies increases relative to the renewal premiums collected from the Minnesota Life disability block. The Minnesota Life block has a higher benefit ratio than the rest of the individual disability business. This is because a large portion of the Minnesota Life benefits are funded from investment income on assets received with the block of business in addition to the renewal premiums. For 2003 our expected range for this segment is 85% to 100%. We will review our expectations for the benefit ratio annually.
Operating expenses as a percentage of revenue were 12.8%, 12.6%, and 11.1% for 2002, 2001, and 2000, respectively. The increase in the percentages for 2002 and 2001 compared to 2000 were primarily a result of a changed cost structure related to the two transactions completed for this segment. In addition, operating expenses were higher in 2002 due to increased benefit costs for our own employees (see “-Consolidated Results of Operations-Operating Expenses”).
Commissions and bonuses increased $4.7 million, or 20.8%, in 2002 compared to 2001, and $7.9 million, or 53.7%, in 2001 compared to 2000, corresponding with related increases in sales discussed above.
The following table sets forth selected financial data for the Retirement Plans segment at or for the years ended December 31:
stable, as was net investment income, which increased $0.8 million, or 1.5%, in 2002 compared to 2001 and $1.4 million, or 2.8%, in 2001 compared to 2000.
The Company began deferring acquisition costs for this segment in 2001. Costs deferred primarily included initial commissions and incentive compensation payouts on newly established plans, and will be amortized over a period of approximately ten years. The net increase in deferred acquisition costs was $2.0 million in 2002 and $0.9 million in 2001.
Operating expenses were 1.5%, 1.3% and 1.3% of average assets under management in 2002, 2001 and 2000, respectively. The increase in 2002 results from higher operating expenses due to an increase in the number of cases in force, investment in this segment’s infrastructure in recent years and increased benefit costs for our own employees.
Net cash used in investing activities was $637.9 million and $649.9 million in 2002 and 2001, respectively. Net cash outflows in 2002 included investments in fixed maturity securities of approximately $550 million related to the acquisition of the block of business from TIAA and record commercial mortgage loan originations totaling $570.8 million. Net cash provided by investing activities in 2002 included an increase in commercial mortgage loan sales. Net cash outflows in 2001 included $137.2 million in cash disbursed related to the sale of the individual life insurance business. The sale involved transferring investments and cash equal to the statutory liabilities ceded, less a ceding commission received by the Company of approximately $90 million. In addition, 2000 investing activities included investment of $452.3 million related to the acquisition of the individual disability insurance business. The acquisition involved receiving cash equal to the statutory liabilities assumed, less a ceding commission paid by the Company of approximately $55 million. (See “-Selected Segment Information.”)
Our fixed maturity securities of $4.13 billion represented 66.8% of our total general account invested assets at December 31, 2002. Approximately 96% of our fixed maturity securities are investment-grade, well above industry averages, and we believe that we maintain prudent diversification across industries, issuers and maturities. During 2002, the Company recorded $21.8 million of after- tax losses on sales of bonds, including $11 million related to WorldCom bonds. We continually monitor credit quality on specific issuers and industry sectors. Our current holdings in potentially troubled sectors are predominantly at the operating company level or secured by assets. The overall portfolio rating for fixed maturity securities was A (Standard & Poor’s) at December 31, 2002.
The commercial mortgage loan portfolio is collateralized by properties located in the Western region representing 57.4% of the portfolio, the Central region representing 23.9% of the portfolio, and the Eastern region representing 18.7% of the portfolio. Commercial mortgage loans in California account for 38.6% of our commercial mortgage loan portfolio at December 31, 2002. Due to this concentration, we are exposed to potential losses resulting from the risk of an economic downturn in California as well as to certain catastrophes, such as earthquakes, that may affect the region. Although we diversify our commercial mortgage loan portfolio within California by both location and type of property in an effort to reduce earthquake exposure, such diversification may not eliminate the risk of such losses. We do not require earthquake insurance for properties on which we make commercial mortgage loans, but do consider the potential for earthquake loss based upon seismic surveys and structural information specific to each property when new loans are underwritten.
the industry average and consistent with our experience in other states. However, if economic conditions in California worsen, we may experience a higher delinquency rate on the portion of our commercial mortgage loan portfolio located in California, which may have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
In the normal course of business, the Company commits to fund commercial mortgage loans generally up to 90 days in advance. At December 31, 2002, the Company had outstanding commitments to fund commercial mortgage loans with fixed interest rates ranging from 6.00% to 8.25%, totaling $118.2 million. The commitments may have fixed expiration dates or other termination clauses and generally require payment of a fee. The Company evaluates each customer’s credit worthiness individually and may terminate a commitment based on the financial condition of the borrower. Additionally, a small percentage of borrowers allow their commitments to expire without being drawn upon. The Company currently has no commitments consisting of standby letters of credit, guarantees, standby repurchase obligations, or other related commercial commitments.
Financing cash flows consist primarily of policyholder fund deposits and withdrawals, borrowings and repayments on the line of credit, borrowings and repayments on long- term debt, repurchase of common stock, and dividends paid on common stock. Net cash provided by financing activities was $252.0 million for 2002 compared to $123.7 million for 2001. Net cash provided by financing activities in 2002 reflects our initial public debt offering of $250.0 million, higher deposits into the retirement plans segment general account assets, which reflects increased consumer interest in fixed-rate investments compared to equity investments, offset by repayment of outstanding borrowings on the line of credit.
The Company has a $100.0 million unsecured line of credit available through May 31, 2003. The Company is not required to maintain compensating balances, but pays a commitment fee. The interest rate, which is based on current market rates, was 1.98% at December 31, 2002. Under the credit agreement, the Company is subject to customary covenants, including limitations on indebtedness and maintenance of minimum equity, statutory surplus, and risk-based capital. At December 31, 2002, the Company was in compliance with all such covenants. At December 31, 2002, there were no outstanding borrowings on the line of credit. At December 31, 2001, $81.3 million was outstanding on the line of credit.
StanCorp filed a $1.0 billion shelf registration statement with the SEC, which became effective on July 23, 2002, registering common stock, preferred stock, debt securities, and warrants. On September 25, 2002 we completed an initial public debt offering of $250.0 million of 6.875%, 10-year senior notes pursuant to the shelf registration statement. The principal amount of the senior notes is payable at maturity and interest is payable semi-annually in April and October, beginning in 2003. Approximately $200 million of the debt offering proceeds were used to fund the acquisition by Standard of the TIAA block of business including the $75 million ceding commission and $125 million to maintain Standard’s risk-based capital at the Company’s targeted level. The remaining proceeds were used to pay our annual dividend to shareholders, to fund a modest level of share repurchases and for general corporate purposes. Standard & Poor’s, Moody’s Investors Service, Inc., Fitch, Inc. and A.M. Best Company are among the third parties that provide debt ratings on our senior debentures. As of December 31, 2002 ratings from these
The amount available for payment of dividends by Standard in 2003 without approval of the Oregon Department is $80.8 million payable after February 25, 2003. In February 2003, Standard’s board of directors approved and paid a dividend of $65 million to StanCorp. There is no amount available for payment of dividends by The Standard Life Insurance Company of New York in 2003.
The Company’s financial instruments are exposed to financial market volatility and potential disruptions in the market that may result in certain financial instruments becoming less valuable. Financial market volatility includes interest rate risk. In accordance with Item 305 of Regulation S-K of the SEC, the Company has analyzed the estimated loss in fair value of certain market sensitive financial assets held at December 31, 2002 and 2001, given a hypothetical 10% increase in interest rates, and related qualitative information on how the Company manages interest rate risk. The interest rate sensitivity analysis was based upon the Company’s fixed maturity securities and commercial mortgage loans held at December 31, 2002 and 2001. For the fixed maturity securities portfolio, the analyses estimated the reduction in fair value of the portfolio utilizing a duration-based analysis that assumes a hypothetical 10% increase in treasury rates. For commercial mortgage loan portfolios, the analyses estimated the reduction in fair value by discounting expected cash flows at theoretical treasury spot rates in effect at December 31, 2002 and 2001. The analyses discounted cash flows using an average of possible discount rates to provide for the potential effects of interest rate volatility. The analyses did not provide for the possibility of non-parallel shifts in the yield curve, which would involve discount rates for different maturities being increased by different amounts. The actual decrease in fair value of the Company’s financial assets that would have resulted from a 10% increase in interest rates could be significantly different from that estimated by the model. The hypothetical reduction in the fair value of the Company’s financial assets that resulted from the model was estimated to be $80 million and $113 million at December 31, 2002 and 2001, respectively.
Insolvency regulations exist in many of the jurisdictions in which subsidiaries of the Company do business. Such regulations may require insurance companies operating within the jurisdiction to participate in guaranty associations. The associations levy assessments against their members for the purpose of paying benefits due to policyholders of impaired or insolvent insurance companies. Association assessments levied against the Company from January 1, 2000 through December 31, 2002 aggregated $0.5 million. At December 31, 2002, the
The Terrorism Risk Insurance Act of 2002 provides for federal government assistance to property and casualty insurers in the event of material losses due to terrorist acts on behalf of a foreign person or foreign interest. The legislation also provides for the United States Treasury Department to conduct an expedited study to determine if there should be federal assistance for group life insurers in the event of material losses due to terrorist acts. Group life insurance represents a significant portion of our revenues and operating income. Concentration of risk is inherent in the group life insurance products we offer. We have group life insurance exposure to certain customers in amounts in excess of catastrophe reinsurance coverage. Without government assistance, terrorist acts could have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
StanCorp and its subsidiaries are involved in various legal actions and other state and federal proceedings. (See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements.”)
See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 1, Summary of Significant Accounting Policies.”
We have audited the accompanying consolidated balance sheets of StanCorp Financial Group, Inc. and subsidiaries (the “Company”) as of December 31, 2002 and 2001, and the related consolidated statements of income and comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
StanCorp Mortgage Investors originates, underwrites and services small commercial mortgage loans for investment portfolios of our insurance subsidiaries. It also generates fee income from the origination and servicing of commercial mortgage loans sold to institutional investors. As of December 31, 2002, StanCorp Mortgage Investors was servicing $1.99 billion in commercial mortgage loans for subsidiaries of StanCorp. Commercial mortgage loans serviced for other institutional investors and associated capitalized mortgage servicing rights totaled $672.9 million and $0.7 million, respectively, at December 31, 2002.
The consolidated financial statements include StanCorp and its subsidiaries. All significant intercompany balances and transactions have been eliminated. Certain 2001 and 2000 amounts have been reclassified to conform with the current presentation.
Commercial mortgage loans are stated at amortized cost less a valuation allowance for uncollectible amounts.
Income statement activity for deferred acquisition costs was as follows for the years ended December 31:
Property and equipment are stated at cost less accumulated depreciation. The Company provides for depreciation of property and equipment using the straight-line method over the estimated useful lives, which are
generally 40 years for properties, and from three to ten years for equipment. Leasehold improvements are amortized over the estimated useful life of the asset, not to exceed the life of the lease. Depreciation expense for 2002, 2001 and 2000 was $11.6 million, $9.0 million and $9.1 million, respectively. The Company reviews property and equipment for impairment when circumstances or events indicate the carrying amount of the asset may not be recoverable and recognizes a charge to earnings if an asset is impaired.
Future policy benefits and claims. For most of our product lines, we establish and carry as a liability actuarially determined reserves that are calculated to meet our obligations for future policy benefits and claims. These reserves do not represent an exact calculation of our future benefit liabilities, but are instead estimates based on assumptions concerning a number of factors, including: the amount of premiums that we will receive in the future; the rate of return on assets we purchase with premiums received; expected claims; expenses; and persistency, which is the measurement of the percentage of policies remaining in force from year to year. In particular, our long term disability reserves are sensitive to assumptions regarding the following factors: claim incidence rates; claim termination rates; market interest rates used to discount reserves; age and gender of the claimant; time elapsed since disablement; contract provisions and limitations; and the amount of the monthly benefit paid to the insured (less deductible income, such as Social Security payments received by the insured).
Accounting Pronouncements. In April 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” This pronouncement, among other items, eliminates the requirement to record gains and losses from the early extinguishment of debt as extraordinary items. The provisions of this pronouncement are required to be applied by the Company starting January 1, 2003. We do not expect SFAS No. 145 to have a material impact on our financial statements.
In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” This pronouncement requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan. Costs covered by the standard include lease termination costs and certain employee severance costs that are associated with a restructuring, discontinued operation, plant closing, or other exit or disposal activity. This statement is to be applied prospectively to exit or disposal activities initiated after December 31, 2002. We do not expect SFAS No. 146 to have a material impact on our financial statements.
In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure.” This statement amends SFAS No. 123 to provide alternate methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. This statement is to be applied prospectively to financial statements for fiscal years ending after December 15, 2002, with early application provisions. Effective January 1, 2003, the Company will begin expensing the fair value of stock-based employee compensation on a prospective method. If future option grants remain at the current level, under current FASB rules, the annual impact will reduce operating earnings by approximately $0.06 to $0.08 per diluted share in 2003.
Basic net income per common share was calculated based on the weighted-average number of common shares outstanding. Net income per diluted common share reflects the potential effects of restricted stock grants and exercises of outstanding options. The weighted-average share and share equivalents outstanding used to compute the dilutive effect of common stock options outstanding were computed using the treasury stock method. Net income per diluted common share was calculated as follows:
Carrying amounts and estimated fair values for financial instruments were as follows at December 31:
Liabilities. The fair values of other policyholder funds that are investment-type contracts were estimated using discounted cash flows at the then-prevailing interest rates offered for similar contracts or as the amounts payable on demand less surrender charges at the balance sheet date. The fair value for long-term debt was based on quoted market prices.
Although the Company underwrites commercial mortgages throughout the United States, commercial mortgage loans in California represent a concentration of credit risk. The Company requires commercial mortgage collateral and underwrites loans on either a partial or full recourse basis. The geographic concentration of commercial mortgage loans was as follows at December 31:
7. Liability for Unpaid Claims, Claims Adjustment Expenses and Other Policyholder Funds
Other policyholder funds at December 31, 2002 and 2001 included $710.5 million and $676.9 million, respectively, of employer-sponsored defined contribution and benefit plans deposits and $655.5 million and $555.4 million, respectively, of individual deferred annuity deposits.
StanCorp filed a $1.0 billion shelf registration statement with the Securities and Exchange Commission, which became effective on July 23, 2002, registering common stock, preferred stock, debt securities, and warrants. On September 25, 2002 we completed an initial public debt offering of $250.0 million of 6.875%, 10-year senior notes, pursuant to the shelf registration statement. The principal amount of the senior notes is payable at maturity and interest is payable semi-annually in April and October, beginning in 2003.
The Company has two non-contributory defined benefit pension plans and a postretirement benefit plan. The following table provides a reconciliation of the changes in the plans’ projected benefit obligations and fair value of assets for the years ended and the funded status at December 31:
A minimum pension liability adjustment is required when the actuarial present value of accumulated benefit obligation exceeds plan assets. The accumulated benefit obligation for the defined benefit pension plans was $109.5 million at December 31, 2002.
The assumed health care cost trend rates used in measuring the accumulated postretirement benefit obligation for medical, prescription drugs and HMO were 12.0%, 18.0%, and 13.5%, respectively, in the first year and declined ratably to 5.25% over the next seven years. A one percentage-point change in the assumed health care cost trend rate for medical, prescription drugs and HMO would have the following effect at December 31, 2002:
Eligible executive officers are covered by a non-qualified supplemental retirement plan, which is currently unfunded. The accrued benefit cost was $8.2 million and $6.9 million, respectively, at December 31, 2002 and 2001. Expenses related to the plan were $1.5 million, $1.4 million and $1.1 million in 2002, 2001, and 2000, respectively.
The 1999 Omnibus Stock Incentive Plan authorizes the board of directors of StanCorp to grant eligible employees certain incentive or non-statutory stock options, bonuses and performance stock options, restricted and foreign stock awards, and stock appreciation and cash bonus rights related to StanCorp’s common stock. All options are granted at a stock price of not less than the market value at the date of the option grant and may be exercised for a period not exceeding ten years from the date of the grant. The maximum number of shares of common stock that may be issued under this plan is 1.7 million. All stock options and restricted stock awards granted by the Company have been granted pursuant to this plan.
The weighted-average grant date fair value of the performance shares granted in 2002 was $50.74 per share.
Methods used by the Company to manage risk include, but are not limited to, sound product design and underwriting, effective claims management, disciplined pricing, distribution expertise, broad diversification of risk by geography, industry, customer size and occupation, maintenance of a strong financial position, maintenance of reinsurance and risk pool arrangements, and sufficient alignment of assets and liabilities to meet financial obligations. Insurance over maximum retention limits is routinely ceded to other companies.
Standard established a trust for the benefit of Northwestern Mutual with the market value of assets in the trust equal to Northwestern Mutual’s reinsurance
In March 1998 the NAIC adopted the Codification of Statutory Accounting Principles (“Codification”), which became effective January 1, 2001. Codification standardized regulatory accounting and reporting among state insurance departments. However, statutory accounting principles also will continue to be established by individual state laws and permitted practices. The Company’s adoption of Codification increased statutory capital and surplus as of January 1, 2001 by approximately $6.1 million.
Effective January 1, 2001, Standard sold its individual life insurance business to Protective Life through a reinsurance transaction. Standard received a ceding commission of approximately $90 million and transferred to Protective Life approximately $790 million in assets and corresponding statutory liabilities. If Protective Life were to become unable to meet its obligations, Standard would retain the reinsured liabilities. Therefore, the liabilities remain on Standard’s books and an equal amount is recorded as a recoverable from reinsurer. In accordance with the agreement, Protective Life established a trust for the benefit of Standard with assets in the trust required to be equal to Standard’s reinsurance receivable from Protective Life.
In the normal course of business, the Company is involved in various legal actions and other state and federal proceedings. A number of actions or proceedings were pending as of December 31, 2002. In some instances, lawsuits include claims for punitive damages and similar types of relief in unspecified or substantial amounts, in addition to amounts for alleged contractual liability or other compensatory damages. In the opinion of management, the ultimate liability, if any, arising from the actions or proceedings is not expected to have a material adverse effect on the Company’s business, financial position, results of operations, or cash flows.
During 2002, the Internal Revenue Service (“IRS”) completed an examination of the Company’s federal income tax returns for the years 1996 through 1999. In August 2002, the IRS issued its Examination Report, in which it proposed adjustments to deductions in connection with certain of our group annuity contracts. The proposed adjustments would result in additional taxes payable by the Company for tax years 1996 through 1999. On November 20, 2002, the IRS withdrew the August Examination Report and issued a revised report which substantially reduced the amount of the proposed adjustment. The Company believes it has a strong position, that the IRS’ principal proposed adjustments lack merit, and intends to respond to the revised report by filing a written protest.
Should the IRS prevail on its revised proposed adjustments, however, the amount of the adjustments would be deductible by the Company in taxable years subsequent to 1999. Accordingly, in the event the IRS were to prevail, the Company estimates that it would incur and record an additional charge, net of federal income tax, of not more than $2.2 million relating to these proposed adjustments. The Company believes that it has adequately provided for the ultimate outcome of this examination, and therefore it is not expected to have a material adverse effect on the Company’s business, financial condition, results of operations or cash flows. Due to the now immaterial nature of the additional charge were the IRS to prevail, in future quarters we will no longer make disclosures regarding this contingency.
The Company has a $100.0 million unsecured line of credit available through May 31, 2003. The Company is not required to maintain compensating balances, but pays a commitment fee. The interest rate, which is based on current market rates, was 1.98% at December 31, 2002. Under the credit agreement, the Company is subject to customary covenants, including limitations on indebtedness and maintenance of minimum equity, statutory surplus, and risk-based capital. At December 31, 2002, the Company was in compliance with all such covenants. At December 31, 2002 there were no outstanding borrowings on the line of credit. At December 31, 2001, $81.3 million was outstanding on the line of credit. The Company currently has no commitments consisting of standby letters of credit, guarantees, standby repurchase obligations, or other related commercial commitments.
The Company has certain software maintenance, licensing and telecommunications commitments that expire in various years through 2007, with renewal options for a two-year period. Future minimum payments under these commitments are: 2003, $0.3 million; 2004, $0.08 million; 2005, $0.04 million; 2006, $0.04 million; and 2007, $0.04 million. Total expense for these agreements was $1.2 million, $1.7 million and $1.6 million for the years ended December 31, 2002, 2001, and 2000, respectively.