The Company, through its subsidiaries, underwrites a diverse portfolio of group employee benefit products, primarily disability, group life and excess workers’ compensation insurance. Revenues from this group of products are primarily comprised of earned premiums and investment income. The profitability of group employee benefit products is affected by, among other things, differences between actual and projected claims experience, the retention of existing customers, product mix and the Company’s ability to attract new customers, change premium rates and contract terms for existing customers and control administrative expenses. The Company transfers its exposure to a portion of its group employee benefit risks through reinsurance ceded arrangements with other insurance and reinsurance companies. Accordingly, the profitability of the Company’s group employee benefit products is affected by the amount, cost and terms of reinsurance it obtains. The profitability of those group employee benefit products for which reserves are discounted; in particular, the Company’s disability and primary and excess workers’ compensation products, is also significantly affected by the difference between the yield achieved on invested assets and the discount rate used to calculate the related reserves. The Company continues to benefit from the favorable market conditions which have in recent years prevailed for its excess workers’ compensation products as to pricing and other contract terms for these products; however, due primarily to improvements in the primary workers’ compensation market resulting in lower premium rates in that market, conditions relating to new business production and growth in premiums for these products have been less favorable in recent years. In addition, the Company is presently experiencing more competitive market conditions, particularly as to pricing, for its other group employee benefit products. These conditions may impact the Company’s ability to achieve levels of new business production and growth in premiums for these products commensurate with those achieved in prior years. For these products, the Company is continuing to enhance its focus on the small case niche (insured groups of 10 to 500 individuals), including employers which are first-time providers of these employee benefits, which the Company believes to offer opportunities for superior profitability. The Company is also emphasizing its suite of voluntary group insurance products, which includes, among others, its group limited benefit health insurance product. The Company markets its other group employee benefit products on an unbundled basis and as part of an integrated employee benefit program that combines employee benefit insurance coverages and absence management services. The integrated employee benefit program, which the Company believes helps to differentiate itself from competitors by offering clients improved productivity from reduced employee absence, has enhanced the Company’s ability to market its other group employee benefit products to large employers.
decrease in the Company’s level of net investment income for 2008, due primarily to the adverse performance of those investments whose changes in value, positive or negative, are included in the Company’s net investment income, such as investment funds organized as limited partnerships and limited liability companies, trading account securities and hybrid financial instruments. These market conditions may persist or worsen in the future and may continue to result in significant fluctuations in net investment income, and as a result, in the Company’s results of operations. In addition, during 2008, the Company experienced substantial declines in the carrying values of certain portions of its investment portfolio, as well as significantly increased levels of realized investment losses from declines in market value relative to the amortized cost of certain securities that it determined to be other than temporary. In light of the aforementioned market conditions, losses of this type and magnitude may continue or increase in the future.
In an effort to reduce fluctuations in its net investment income, the Company has repositioned its investment portfolio to reduce its overall holdings of those investments whose changes in value are included in net investment income and, in particular, its holdings of such investments whose performance has demonstrated the highest levels of variability. As part of this effort, the Company has increased its investments in more traditional sectors of the fixed income market such as high credit quality mortgage-backed securities and municipal bonds, whose present spreads have widened to historically high levels due to the market conditions discussed above. In addition, in light of the aforementioned market conditions, the Company is presently maintaining a larger proportion of its portfolio in short-term investments, which totaled $401.6 million at December 31, 2008, as compared to $286.0 million at December 31, 2007. There can be no assurance as to the impact, positive or negative, of the Company’s investment repositioning on its future net investment income or its effect on the future variability in such income.
The following discussion and analysis of the results of operations and financial condition of the Company should be read in conjunction with the Consolidated Financial Statements and related notes included in this report. The preparation of financial statements in conformity with GAAP requires management, in some instances, to make judgments about the application of these principles. The amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period could differ materially from the amounts reported if different conditions existed or different judgments were utilized. A discussion of how management applies certain critical accounting policies and makes certain estimates is presented below in the “Critical Accounting Policies and Estimates” section and should be read in conjunction with the following discussion and analysis of results of operations and financial condition of the Company. In addition, discussions of certain of the uncertainties and contingencies which can affect actual results and could cause future results to differ materially from those expressed in certain forward-looking statements contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations can be found in Part I, Item 1A - Risk Factors. See “Forward-Looking Statements And Cautionary Statements Regarding Certain Factors That May Affect Future Results”.
Summary of Results. Net income was $36.7 million, or $0.75 per diluted share, in 2008 as compared to $164.5 million, or $3.19 per diluted share, in 2007. Net income in 2008 and 2007 included net realized investment losses, net of the related income tax benefit, of $57.3 million, or $1.17 per diluted share, and $1.2 million, or $0.02 per diluted share, respectively. Net income in 2008 benefited from growth in income from the Company’s core group employee benefit products, and, due to the market conditions discussed above, was adversely impacted by realized investment losses and a significant decrease in net investment income. See “Introduction”. Core group employee benefit products include disability, group life, excess workers’ compensation, travel accident and dental insurance. See “Group Employee Benefit Products” in Part I, Item 1 - Business. Premiums from these core group employee benefit products increased 7% in 2008 and the combined ratio (loss ratio plus expense ratio) for group employee benefit products was 92.2% in 2008 and 92.4% in 2007. Realized investment losses in 2008 and 2007 included losses, net of the related income tax benefit, of $51.1 million, or $1.04 per diluted share, and $2.7 million, or $0.05 per diluted share, respectively, due to the other than temporary declines in the market values of certain fixed maturity and other securities. Net investment income decreased in 2008 from 2007 due to a lower tax equivalent weighted average annual yield on invested assets of 3.2% in 2008 as compared to 6.2% in 2007.
Premiums from the Company’s other core group employee benefit products increased 10% to $1,045.8 million in 2008 from $951.7 million in 2007, primarily reflecting a 9% increase in premiums from the Company’s group disability products, a 10% increase in premiums from the Company’s group life products, new business production, and a decrease in premiums ceded by the Company to reinsurers for these products. During 2008, premiums from the Company’s group life products increased to $402.9 million from $364.8 million in 2007, primarily reflecting new business production and a decrease in premiums ceded by the Company to reinsurers. During 2008, premiums from the Company’s group disability products increased to $572.6 million from $527.5 million in 2007, primarily reflecting new business production. Premiums from the Company’s turnkey disability business were $50.3 million and $49.8 million in 2008 and 2007, respectively. New business production for the Company’s other core group employee benefit products was $263.1 million in 2008 as compared to $262.7 million in 2007. New business production includes only directly written business, and does not include premiums from the Company’s turnkey disability business. The level of production achieved from these other core group employee products also reflects the Company’s focus on the small case niche (insured groups of 10 to 500 individuals) which resulted in a 7% increase in production based on the number of cases sold as compared to 2007. The Company continues to implement price increases for certain existing group disability and group life insurance customers.
Non-core group employee benefit products include LPTs, primary workers’ compensation, bail bond insurance, workers’ compensation reinsurance and reinsurance facilities. See “Group Employee Benefit Products” and “Reinsurance” in Part I, Item 1 - Business. Premiums from non-core group employee benefit products were $33.0 million in 2008 as compared to $39.7 million in 2007, primarily due to a lower level of premium from LPTs, which are episodic in nature.
Deposits from the Company’s asset accumulation products were $245.1 million in 2008 as compared to $107.1 million in 2007. This increase in deposits is primarily due to increased sales of the Company’s multi-year rate guarantee products. Deposits from the Company’s asset accumulation products, consisting of new annuity sales and issuances of funding agreements, are recorded as liabilities rather than as premiums. The Company is continuing to maintain its discipline in setting the crediting rates offered on its asset accumulation products in 2009 in an effort to achieve its targeted interest rate spreads on these products.
Net Investment Income. Net investment income in 2008 was $134.9 million as compared to $270.5 million in 2007. This decrease reflects a decrease in the tax equivalent weighted average annual yield on invested assets to 3.2% in 2008 from 6.2% in 2007. This decrease in yield was primarily due to declines in value totaling $107.4 million in the Company’s investments in investment funds organized as limited partnerships and limited liability companies, trading account securities and hybrid financial instruments which resulted from adverse market conditions for financial assets during 2008. See “Introduction”. This adverse performance was partially offset by a 4% increase in average invested assets to $4,728.1 million in 2008 from $4,555.2 million in 2007.
Net Realized Investment Losses. Net realized investment losses were $88.2 million in 2008 as compared to $1.9 million in 2007. The Company monitors its investments on an ongoing basis. When the market value of a security declines below its amortized cost, the decline is included as a component of accumulated other comprehensive income or loss, net of the related income tax benefit and adjustment to cost of business acquired, on the Company’s balance sheet, and if management judges the decline to be other than temporary, the decline is reported as a realized investment loss. Due to the adverse market conditions for financial assets during 2008, the Company recognized $78.6 million of losses due to the other than temporary declines in the market values of certain fixed maturity and other securities in 2008 as compared to $4.1 million of such losses in 2007. See “Introduction”. The Company’s investment strategy results in periodic sales of securities and, therefore, the recognition of realized investment gains and losses. During 2008 and 2007, the Company recognized $(9.6) million and $2.2 million, respectively, of net (losses) gains on the sales of securities.
The Company may recognize additional losses due to other than temporary declines in security market values in the future, and such losses may be significant, particularly if the adverse financial market conditions described above were to persist or worsen. See Part I, Item 1A -Risk Factors and “Introduction”. The extent of such losses will depend on, among other things, future developments in the global economy, financial and credit markets, credit spreads, interest rates, the outlook for the performance by the issuers of their obligations under such securities and changes in security values. The Company continuously monitors its investments in securities whose fair values are below the Company’s amortized cost pursuant to its procedures for evaluation for other than temporary impairment in valuation. See “Critical Accounting Policies and Estimates” for a description of these procedures, which take into account a number of factors. It is not possible to predict the extent of any future changes in value, positive or negative, or the results of the future application of these procedures, with respect to these securities. For further information concerning the Company’s investment portfolio, see “Liquidity and Capital Resources - Investments”.
Loss on Redemption of Junior Subordinated Deferrable Interest Debentures. During 2008, the Company recognized a pre-tax loss of $0.6 million on the redemption of the 2003 Junior Debentures underlying the 2003 Capital Securities of the Trust. On August 15, 2008, the Trust redeemed the $20.0 million liquidation amount of 2003 Capital Securities concurrently with the redemption by the Company of the underlying 2003 Junior Debentures held by the Trust. The redemption price was $1,000.00 per 2003 Capital Security plus accrued dividends. As a result, the $20.6 million principal amount of the 2003 Junior Debentures ceased to be outstanding and dividends on the 2003 Junior Debentures ceased to accrue.
During 2007, the Company recognized a pre-tax loss of $2.2 million from the redemption of the Junior Debentures underlying the Capital Securities of Delphi Funding. On March 27, 2007, Delphi Funding redeemed the remaining $36.0 million liquidation amount of Capital Securities concurrently with the redemption by the Company of the underlying Junior Debentures held by Delphi Funding. The redemption price was $1,046.55 per Capital Security plus accrued dividends. As a result, the $103.1 million principal amount of the Junior Debentures ceased to be outstanding and dividends on the Capital Securities ceased to accrue.
Premium and Fee Income. Premium and fee income in 2007 was $1,304.2 million as compared to $1,156.6 million in 2006, an increase of 13%. Premiums from core group employee benefit products increased 14% to $1,227.9 million in 2007 from $1,081.7 million in 2006. This increase reflects normal growth in employment and salary levels for the Company’s existing customer base, price increases, new business production and improved persistency. Premiums from excess workers’ compensation insurance for self-insured employers increased 6% to $276.2 million in 2007 from $260.0 million in 2006. This increase was primarily due to the continuing substantial level of demand for this product. Excess workers’ compensation premiums in 2007 included $3.5 million of 2006 policy year premiums from Canadian policies assumed by SNCC in the first quarter of 2007 under the aforementioned Renewal Rights Agreement. Excess workers’ compensation new business production, which represents the amount of new annualized premium sold, was $30.1 million in 2007, including $3.4 million from the Renewal Rights Agreement, compared to $57.2 million in 2006, including $25.8 million from such agreement. The retention of existing customers in 2007 remained strong.
Non-core group employee benefit products include LPTs, primary workers’ compensation, bail bond insurance, workers’ compensation reinsurance and reinsurance facilities. See “Group Employee Benefit Products” and “Reinsurance” in Part I, Item 1 - Business. Premiums from non-core group employee benefit products were $39.7 million in 2007 as compared to $42.5 million in 2006, primarily due to a lower level of premium from LPTs, which are episodic in nature.
Deposits from the Company’s asset accumulation products were $107.1 million in 2007 as compared to $190.7 million in 2006. This decrease in deposits primarily reflects the issuance of $100.0 million of fixed and floating rate funding agreements during the first quarter of 2006 pursuant to a program of the Company under which funding agreement-backed notes are issued to institutional investors by an unconsolidated special purpose vehicle which uses the proceeds to purchase from the Company funding agreements having terms substantially similar to those of the notes. Deposits from the Company’s asset accumulation products, consisting of new annuity sales and issuances of funding agreements, are recorded as liabilities rather than as premiums.
Net Realized Investment Losses. Net realized investment losses were $1.9 million in 2007 as compared to $0.9 million in 2006. The Company monitors its investments on an ongoing basis. When the market value of a security declines below its amortized cost, the decline is included as a component of accumulated other comprehensive income or loss, net of the related income tax benefit and adjustment to cost of business acquired, on the Company’s balance sheet, and if management judges the decline to be other than temporary, the decline is reported as a realized investment loss. In 2007 and 2006, the Company recognized $4.1 million and 4.2 million, respectively, of losses due to the other than temporary declines in the market values of various fixed maturity and other securities. The Company’s investment strategy results in periodic sales of securities and, therefore, the recognition of realized investment gains and losses. During 2007 and 2006, the Company recognized $2.2 million and $3.3 million, respectively, of net gains on the sales of securities.
As a holding company that does not conduct business operations in its own right, substantially all of the assets of the Company are comprised of its ownership interests in its insurance subsidiaries. In addition, the Company held approximately $30.1 million of financial resources at the holding company level at December 31, 2008, primarily comprised of investments in fixed maturity securities available for sale, short-term investments and in investment subsidiaries whose assets are primarily invested in investment funds organized as limited partnerships and limited liability companies. Financial resources available at the holding company level have decreased by $85.9 million since December 31, 2007, due primarily to the utilization of such resources during the fourth quarter of 2008 to make capital contributions to the Company’s insurance subsidiaries, and a substantial portion of the remaining resources consists of investments having significantly limited liquidity. Other sources of liquidity at the holding company level include dividends paid from subsidiaries, primarily generated from operating cash flows and investments. During 2009, the Company anticipates that its insurance subsidiaries will be permitted, without prior regulatory approval, to make dividend payments totaling $104.0 million. See “Regulation” in Part I, Item 1 - Business. However, the level of dividends that could be paid consistent with maintaining the insurance subsidiaries’ RBC and other measures of capital adequacy at levels consistent with its current claims-paying and financial strength ratings from rating agencies is likely to be substantially lower than such amount. In general, dividends from the Company’s non-insurance subsidiaries are not subject to regulatory or other restrictions. In addition, the Company is categorized as a well known seasoned issuer under Rule 405 of the Securities Act. As such, the Company has the ability to file automatically effective shelf registration statements for unspecified amounts of different securities, allowing for immediate, on-demand offerings.
maturity date from May 2010 to October 2011. On November 8, 2007, the amount of the facility was increased to the amount of $350 million, and certain financial institutions were added as new lenders, pursuant to a supplement to the Amended Credit Agreement. Borrowings under the Amended Credit Agreement bear interest at a rate equal to the LIBOR rate for the borrowing period selected by the Company, which is typically one month, plus a spread which varies based on the Company’s Standard & Poor’s and Moody’s credit ratings. Based on the current levels of such ratings, the spread is currently equal to 62.5 basis points.
The Amended Credit Agreement contains various financial and other affirmative and negative covenants, along with various representations and warranties, considered ordinary for this type of credit agreement. The covenants include, among others, a maximum Company consolidated debt to capital ratio, a minimum Company consolidated net worth, minimum statutory risk-based capital requirements for RSLIC and SNCC, and certain limitations on investments and subsidiary indebtedness. As of December 31, 2008, the Company was in compliance in all material respects with the financial and various other affirmative and negative covenants in the Amended Credit Agreement. At December 31, 2008, the Company had $207.0 million of outstanding borrowings and $143.0 million of borrowings remaining available under the Amended Credit Agreement.
During the third quarter of 2008, the Company recognized a pre-tax loss of $0.6 million on the redemption of the 2003 Junior Debentures underlying the 2003 Capital Securities of the Trust. On August 15, 2008, the Trust redeemed the $20.0 million liquidation amount of 2003 Capital Securities concurrently with the redemption by the Company of the underlying 2003 Junior Debentures held by the Trust. The redemption price was $1,000.00 per 2003 Capital Security plus accrued dividends. As a result, the $20.6 million principal amount of the 2003 Junior Debentures ceased to be outstanding and dividends on the 2003 Junior Debentures ceased to accrue. The Company utilized borrowings under its Amended Credit Agreement and cash on hand to fund such redemption.
The following table summarizes the Company’s significant contractual obligations at December 31, 2008 and the future periods in which such obligations are expected to be settled in cash. The 2033 Senior Notes and 2007 Junior Debentures are assumed to be repaid on their respective maturity dates. Additional details regarding these obligations are provided in the notes to the Consolidated Financial Statements, as referenced in the table:
Sources of liquidity available to the Company on a parent company-only basis, including the undistributed earnings of its subsidiaries and additional borrowings available under the Amended Credit Agreement, are expected to exceed the Company’s current and long-term cash requirements. The Company from time to time engages in discussions with respect to acquiring blocks of business and insurance and financial services companies, any of which could, if consummated, be material to the Company’s operations.
The principal liquidity requirements of the Company’s insurance subsidiaries are their contractual obligations to policyholders and other financing sources and operating expenses. The primary sources of funding for these obligations, in addition to operating earnings, are the marketable investments included in the investment portfolios of these subsidiaries. The Company actively manages its investment portfolio in an effort to match its invested assets and related liabilities. The Company regularly analyzes the results of its asset/liability matching through cash flow analysis and duration matching under multiple interest rate scenarios. See “Asset/Liability Management and Market Risk.” Therefore, the Company believes that these sources of funding will be adequate for its insurance subsidiaries to satisfy on both a short-term and long-term basis these contractual obligations throughout their estimated or stated period. However, if such contractual obligations were to arise more rapidly or in greater amounts than anticipated in the Company’s asset/liability matching analysis, the Company could be required to sell securities earlier than anticipated, potentially resulting in the realization of capital losses, particularly in light of the adverse market conditions described above (see Part I, Item 1A - Risk Factors and “Introduction”), or to borrow funds from available credit sources, in order to fund the payment of such obligations. In any of such events, the Company’s results of operations, liquidity and financial condition could be materially adversely affected.
Share Repurchase Program. On November 7, 2007, the Company’s Board of Directors authorized a new share repurchase program under which up to 1,500,000 shares of the Company’s Class A Common Stock may be repurchased. This program replaced the share repurchase program previously in effect. On February 22, 2008, the Company’s Board of Directors authorized a 1,000,000 share increase in such new share repurchase program and on May 7, 2008, the Company’s Board of Directors authorized a further 1,000,000 share increase in such program. Share repurchases are effected by the Company in the open market or in negotiated transactions in compliance with the safe harbor provisions of Rule 10b-18 under the Securities Exchange Act of 1934. Execution of the share repurchase program is based on management’s assessment of market conditions for its common stock and other potential uses of and requirements for capital. In 2008, the Company repurchased 1,533,800 shares of its Class A Common Stock at a total cost of $42.7 million with a volume weighted average price of $27.86 per share. In 2007, the Company repurchased 695,500 and 966,200 shares of its Class A Common Stock under its former and new share repurchase program, respectively, at a total cost of $62.4 million with a volume weighted average price of $37.56 per share. At December 31, 2008, the repurchase of 1,000,000 shares remained authorized under the new share repurchase program.
Investments. The Company’s overall investment strategy emphasizes safety and liquidity, while seeking the best available return, by focusing on, among other things, managing the Company’s interest-sensitive assets and liabilities and seeking to minimize the Company’s exposure to fluctuations in interest rates. The Company’s investment portfolio, which totaled $4,654.9 million at December 31, 2008, consists primarily of investments in fixed maturity securities, short-term investments, mortgage loans and equity securities. The Company’s investment portfolio also includes investments in investment funds organized as limited partnerships and limited liability companies, trading account securities and hybrid financial instruments, which collectively totaled $330.4 million at December 31, 2008. This amount reflects the Company’s repositioning of its investment portfolio during 2008 so as to reduce its holdings of these types of investments. See “Introduction”. During 2008, the market value of the Company’s investment portfolio, in relation to its amortized cost, decreased by $511.5 million from year-end 2007, before the related increase in the cost of business acquired of $46.2 million and an increase in the income tax provision of $165.8 million. At December 31, 2008, gross unrealized appreciation and gross unrealized depreciation, before the related income tax expense or benefit and the related adjustment to cost of business acquired, with respect to the fixed maturity securities in the Company’s portfolio totaled $78.5 million (of which $77.3 million was attributable to investment grade securities) and $627.1 million (of which $535.2 million was attributable to investment grade securities), respectively. In addition, the Company recognized pre-tax
net investment losses of $88.2 million in 2008. The weighted average credit rating of the securities in the Company’s fixed maturity portfolio having ratings by nationally recognized statistical rating organizations was “AA” at December 31, 2008. While ratings of this type are intended to address credit risk, they do not address other risks, such as prepayment and extension risks, which are discussed below. See “Forward-Looking Statements and Cautionary Statements Regarding Certain Factors That May Affect Future Results” and Part I, Item 1A - Risk Factors for a discussion of various risks relating to the Company’s investment portfolio.
At December 31, 2008, approximately 27% of the Company’s total invested assets were comprised of corporate fixed maturity securities. Eighty-three percent of the Company’s corporate fixed maturity portfolio, based on fair values, has been rated investment grade by nationally recognized statistical rating organizations. Investment grade corporate fixed maturity securities are distributed among the various rating categories as follows: AAA - 5%, AA - 21%, A - 25%, and BBB - 32%. Corporate fixed maturity securities subject the Company to credit risk and, to a lesser extent, interest rate risk. To manage its exposure to corporate credit risk, the Company attempts to diversify its investments across economic sectors, industry classes and issuers.
Mortgage-backed securities comprised 26% of the Company’s total invested assets at December 31, 2008. Ninety-seven percent of the Company’s mortgage-backed securities portfolio, based on fair values, has been rated as investment grade by nationally recognized statistical rating organizations. Mortgage-backed securities subject the Company to a degree of interest rate risk, including prepayment and extension risk, which is generally a function of the sensitivity of each security’s underlying collateral to prepayments under varying interest rate environments and the repayment priority of the securities in the particular securitization structure, and can subject the Company to credit risk, depending on the nature of the underlying collateral, the characteristics of the underlying borrowers and such repayment priority. The Company seeks to manage this risk by emphasizing the more predictable payment classes and securities with stable collateral. However, due to, among other things, the adverse market conditions described above and adverse performance within the credit-sensitive portion of the Company’s mortgage-backed securities portfolio, the Company experienced significant declines in value of such portfolio during 2008. See Part I, Item 1A - Risk Factors and “Introduction”. At December 31, 2008, the market value of this portfolio was $1,224.9 million, as compared with a total amortized cost of $1,411.2 million.
Asset/Liability Management and Market Risk. Because the Company’s primary assets and liabilities are financial in nature, the Company’s consolidated financial position and earnings are subject to risks resulting from changes in interest rates. The Company seeks to manage this risk by active portfolio management focusing on minimizing its exposure to fluctuations in interest rates by matching its invested assets and related liabilities and by periodically adjusting the
crediting rates on its annuity products and the discount rate used to calculate reserves on the Company’s other products. In its asset/liability matching process, the Company determines and monitors on a quarterly basis the duration of its insurance liabilities in the aggregate and the duration of the investment portfolio supporting such liabilities in order to ensure that the difference between such durations, or the “duration gap,” remains below an internally specified maximum, and similarly determines and monitors the duration gap as between its interest-sensitive liabilities, substantially all of which relate to its asset accumulation products, and the components of its investment portfolio supporting such liabilities in relation to a separate internally specified maximum. As of December 31, 2008, the Company maintained these duration gaps within these maximums. In addition, the Company, at times, has utilized futures and option contracts and interest rate or credit default swap agreements primarily to reduce the risk associated with changes in the value of its fixed maturity portfolio. At December 31, 2008, the Company had no material outstanding futures or option contracts or interest rate or credit default swap agreements. The Company, at times, may also invest in foreign currency denominated fixed maturity securities that expose it to fluctuations in foreign currency rates, and therefore, may hedge such exposure by using currency forward contracts. The Company’s investment in foreign currency denominated fixed maturity securities during 2008 was less than 0.4% of total invested assets.
Reinsurance. The Company cedes portions of the risks relating to its group employee benefit products and variable life insurance products under indemnity reinsurance agreements with various unaffiliated reinsurers. The Company pays reinsurance premiums which are generally based upon specified percentages of the Company’s premiums on the business reinsured. These agreements expire at various intervals as to new risks, and replacement agreements are negotiated on terms believed appropriate in light of then-current market conditions. Reductions in the Company’s reinsurance coverages will decrease the reinsurance premiums paid by the Company under these arrangements and thus increase the Company’s premium income, and will also increase the Company’s risk of loss with respect to the relevant policies. Generally, increases in the Company’s reinsurance coverages will increase the reinsurance premiums paid by the Company under these arrangements and thus decrease the Company’s premium income, and will also decrease the Company’s risk of loss with respect to the relevant policies. See “Group Employee Benefit Products” and “Reinsurance” in Part I, Item 1 - Business.
The Company has no off-balance sheet arrangements (as defined in the rules and regulations of the Securities and Exchange Commission) that have or are reasonably likely to have a material current or future effect on its financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
Future Policy Benefits and Unpaid Claims and Claim Expenses. The Company establishes reserves that are intended to be sufficient to fund the future policy benefits and unpaid claims and claim expenses relating to its insurance products. These reserves, which totaled $2,574.1 million at December 31, 2008, represent management’s best estimate of future policy benefits and unpaid claims and claim expenses. The reserves are calculated using various generally recognized actuarial methodologies and are based upon assumptions and estimates that management believes are appropriate and which vary by type of product. Annually, external actuarial experts also review the Company’s property and casualty reserve methodologies, assumptions and the resulting reserves. The Company’s projected ultimate insurance liabilities and associated reserves are estimates, which are subject to variability. This variability arises because the factors and events affecting the ultimate liability for claims have not all taken place, and thus cannot be evaluated with certainty. As a result, actual future ultimate losses will not develop exactly as projected and may vary significantly from the projections. The estimation process is complex and involves information obtained from company-specific and industry-wide data, as well as general economic information. The Company’s insurance reserves are based upon management’s informed estimates and judgments using currently available data. As additional experience emerges and other data become available, these estimates and judgments are reviewed and may be revised. The methods and assumptions used to establish the Company’s insurance reserves are continually reviewed and updated based on current circumstances, and any resulting adjustments may result in reserve increases or decreases that would be reflected in the Company’s results of operations for the periods in which such revisions are made. As discussed above, the Company assumptions with regard to the claims payment pattern for its excess workers’ compensation insurance products were modified in 2008; otherwise, no material changes in the current year in the actuarial methods and/or assumptions from those used in the previous periods were made. See “Property and Casualty Insurance Reserves” in Part I, Item 1 - Business.
The following table summarizes the composition of the Company’s total reserves for disability, accident and property and casualty claims and claim expenses, split between case and IBNR reserves, as of December 31, 2008 (dollars in millions):
The most significant assumptions made in the estimation process for unpaid claims and claim expenses for the Company’s property and casualty insurance products are the trend in loss costs, the expected frequency and severity of claims, the expected timing of claims payments, changes in the timing of the reporting of losses from the loss date to the notification date, and expected costs to settle unpaid claims. Other assumptions include that the coverages under these insurance products will not be expanded by future legislative action or judicial interpretation and that extraordinary classes of losses not previously in existence will not arise in the future. The assumptions vary based on the year in which the claim is incurred. At December 31, 2008, disability and primary and excess workers’ compensation reserves for unpaid claims and claim expenses with a carrying value of $1,312.0 million have been discounted at a weighted average rate of 5.4%, with the rates ranging from 3.7% to 7.5%. Disability reserves for unpaid claims and claim expenses are discounted using interest rate assumptions based upon projected portfolio yield rates for the assets supporting the liabilities. The assets selected to support these liabilities produce cash flows that are intended to match the timing and amount of anticipated claim and claim expense payments. Excess and primary workers’ compensation claim reserves are discounted using interest rate assumptions based on the risk-free rate of return for U.S. Government securities with a duration comparable to the expected duration and payment pattern of the claims. The rates used to discount reserves are determined annually. The level of the rate utilized to discount reserves in a particular period directly impacts the level of the reserves established for such period. For example, a 25 basis point increase in the discount rates the Company applied to disability and primary and excess workers’ compensation claims incurred in 2008 would have decreased the amount of the reserves it established with respect to such claims by approximately $5.1 million, and a 25 basis point decrease in such rates would have increased the amount of such reserves by the same amount. In both cases, discount rate changes of this type and magnitude would be intended to reasonably reflect corresponding changes in market interest rates. These levels of change to the Company’s discount rate would have increased, in the first case, or decreased, in the second, its 2008 net income by $3.3 million.
For the Company’s property and casualty insurance products, a review of the ten most recent years’ historical loss development variation reflects an annual range of -3.4% to + 6.6%. The average annual increase reflected in such review was +3.7% and the average decrease was -1.7%. If the Company were to assume subsequent loss development of +3.7% or -1.7%, each of which are within historical variation, the estimated unpaid claims and claims expense reserves, net of reinsurance, established for such products as of December 31, 2008 would be increased by $35.5 million in the first case, which would have decreased its 2008 net income by $23.0 million, or decreased by $16.0 million in the second, which would have increased its 2008 net income by $10.4 million. Management believes that while fluctuations of this magnitude could have a material impact on the Company’s results of operations, they would not be likely to materially affect its financial condition or liquidity. However, it is possible that, using other assumptions or variables that are outside of the range of historical variation, the level of the Company’s unpaid claims and claim expenses could be changed by an amount that could be material to the Company’s results of operations, financial condition and liquidity.
Deferred Acquisition Costs. Costs related to the acquisition of new insurance business, such as commissions, certain costs associated with policy issuance and underwriting, and certain sales support expenses, are deferred when incurred. The unamortized balance of these deferred acquisition costs is included in cost of business acquired on the consolidated balance sheet. Effective January 1, 2007, the Company adopted the American Institute of Certified Public Accountants Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts”. SOP 05-1 provides accounting guidance for deferred policy acquisition costs associated with internal replacements of insurance and investment contracts not addressed by previous guidance, including group insurance contracts. It defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of a feature or coverage within a contract. The Company made an after-tax reduction to its retained earnings at January 1, 2007, the date of adoption of SOP 05-1, in the amount of $82.6 million, which represents the net reduction in the deferred policy acquisition cost from internal replacements included in cost of business acquired on the consolidated balance sheet. See Note A to the Consolidated Financial Statements.
Deferred acquisition costs are charged to current earnings to the extent that it is determined that future premiums or estimated gross profits will not be adequate to cover the amounts deferred. The amortization of deferred acquisition costs totaled $79.9 million, $80.7 million and $78.7 million in 2008, 2007 and 2006, respectively. These amounts represented 49%, 59% and 33% of the total amounts of the deferred acquisition cost balances outstanding at the beginning of the respective periods.
Investments. Investments are primarily carried at fair value with unrealized appreciation and depreciation included as a component of other comprehensive income or loss in shareholders’ equity, net of the related income tax benefit or expense and the related adjustment to cost of business acquired. Eighty-nine percent of the Company’s fixed maturity and equity securities portfolio are actively traded in a liquid market or have other liquidity mechanisms. Investments acquired through private placements which are not actively traded in a liquid market and do not have other mechanisms for their liquidation totaled $114.1 million at December 31, 2008. The Company estimates the fair value for these securities primarily by comparison to similar securities with quoted market prices. If quotes are not available on similar securities, the Company estimates fair value based on recent purchases or sales of similar securities or other internally prepared valuations. Key assumptions used in this process include the level of risk-free interest rates, risk premiums, and performance of underlying collateral, if applicable. In certain cases, estimates of the fair value of investments managed by third party investment managers are based on values provided to the Company by such managers. In addition, due to the market conditions described above (see Part I, Item 1A - Risk Factors and “Introduction”), market trading activity relating to securities of the type contained within certain portions of the Company’s mortgage-backed securities and collateralized loan obligation portfolios has substantially declined or ceased or exist. Accordingly, fair values for these investments have been determined based on internal assumptions for expected cash flows and appropriately risk-adjusted discount rates. See Note C to the Consolidated Financial Statements included in this Form 10-K. The total amount of these investments was $295.3 million at December 31, 2008. All of these investments, as well as the Company’s private placement investments, are classified as available for sale. The Company’s ability to liquidate these investments in a timely manner, if necessary, may be limited by the lack of an actively traded market. The Company believes that its estimates reasonably reflect the fair value of these securities; however, had there been an active market for these securities during the applicable reporting period, the market prices may have been materially different from the amounts reported.
Effective January 1, 2008, the Company adopted Statement of Financial Accounting Standard (“SFAS”) No. 157, “Fair Value Measurements”, which addresses the manner in which fair value should be measured under GAAP. SFAS No. 157 provides a common definition of fair value and establishes a framework that fair value measures should follow under GAAP, but this statement does not supersede existing guidance on when fair value measures should be used. This standard also requires companies to disclose the extent to which they measure assets and liabilities at fair value, the methods and assumptions they use to measure fair value, and the effect of fair value measures on their earnings. See Notes A and C to the Consolidated Financial Statements included in this Form 10-K.
rating agency to determine if and when a decline in the fair value of an investment below amortized cost is other than temporary. The length of time and extent to which the fair value of the investment is lower than its amortized cost and the Company’s ability and intent to retain the investment to allow for any anticipated recovery in the investment’s fair value are also considered. In 2008, 2007 and 2006, the Company recognized losses totaling $78.6 million, $4.1 million and $4.2 million, respectively, for the other than temporary decline in the value of various fixed maturity and other securities. These losses were recognized as a result of events that occurred in the respective periods, such as downgrades in an issuer’s credit ratings, deteriorating financial results of issuers, adverse changes in the estimated amount and timing of future cash flows from securities and the impact of adverse economic conditions on issuers’ financial positions. Investment grade and non-investment grade fixed maturity securities comprised 76% and 5%, respectively, of the Company’s total investment portfolio at December 31, 2008. Gross unrealized appreciation and gross unrealized depreciation, before the related income tax expense or benefit and the related adjustment to cost of business acquired, attributable to investment grade fixed maturity securities totaled $77.3 million and $535.2 million, respectively, at December 31, 2008. Gross unrealized appreciation and gross unrealized depreciation, before the related income tax expense or benefit and the related adjustment to cost of business acquired, attributable to non-investment grade fixed maturity securities totaled $1.2 million and $91.9 million, respectively, at December 31, 2008. Unrealized appreciation and depreciation, net of the related income tax expense or benefit and the related adjustment to cost of business acquired, has been reflected on the Company’s balance sheet as a component of accumulated other comprehensive income or loss. The Company may recognize additional losses due to other than temporary declines in security market values in the future, particularly if the adverse market conditions described above (see Part I, Item 1A - Risk Factors and “Introduction”) were to persist or worsen. The extent of any such losses will depend on, among other things, future developments in the global economy, financial and credit markets, credit spreads, interest rates, the outlook for the performance by the issuers of their obligations under such securities and changes in security values. The Company continuously monitors its investments in securities whose fair values are below the Company’s amortized cost pursuant to its procedures for evaluation for other than temporary impairment in valuation. While it is not possible to predict the extent of any future changes in value or the results of the future application of these procedures with respect to these securities, current market conditions have substantially increased the likelihood of additional future losses due to impairments of this type and such losses may be significant. There can be no assurance that the Company will realize investment gains in the future that would ameliorate the effect of any such losses.
The information required by Item 8 is included in this Form 10-K beginning on page 54 of this Form 10-K.