The Company occupies approximately 3.1 million square feet of space at four principal operating centers in Chattanooga, Tennessee; Portland, Maine; Worcester, Massachusetts; and Columbia, South Carolina.
The Company occupies two connected buildings totaling approximately 901,000 square feet in Chattanooga, Tennessee. The office buildings and substantially all of the surrounding 23 acres of land used for employee parking are owned by the Company, including an employee parking garage and a 27-unit apartment building for corporate use and residential leasing to the general public. In addition, approximately 171,000 square feet of office space is leased and occupied in a nearby office building.
The Company owns and occupies five facilities in Portland, Maine, with approximately 838,000 square feet of office space and 250 acres of land, a portion of which has been developed for employee parking. In addition, approximately 115,000 square feet of office space is leased and occupied.
The Company owns and occupies facilities totaling approximately 385,000 square feet in Worcester, Massachusetts, with approximately 5.6 acres of surrounding property used primarily for parking.
The Company owns and occupies approximately 523,000 square feet of office space in Columbia, South Carolina. The buildings are located on approximately 47 acres with a portion developed for employee parking.
The Company also occupies office buildings in the United Kingdom which serve as the home offices of Unum Limited. The Company owns and occupies property located in Dorking, with approximately 63,000 square feet of office space located on approximately 60 acres with a portion developed for employee parking. In addition, approximately 65,000 square feet of office space is leased and occupied in two office buildings located in Bristol and Basingstoke and another 11,000 square feet of leased office space serves five major city locations in England and Scotland.
(3) The Company adopted the provisions of Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets effective January 1, 2002. Prior to January 1, 2002, goodwill was amortized on a straight-line basis over a period not to exceed 40 years. Had amortization of goodwill been excluded from expenses for the year ended December 31, 2001, net income would have been $561.5 million and net income per common share assuming dilution would have been $2.30.
Combined statutory capital and surplus for the Company’s U.S. insurance subsidiaries was approximately $4.270 billion at December 31, 2005, compared to $4.105 billion at December 31, 2004, maintaining the desired capital strength and dividend capacity.
Continued profitability improvement in the U.S. Brokerage segment lines of business, particularly in the group income protection line of business;
Successful implementation of the changes required by the multistate market conduct regulatory settlement agreements and restoration of greater consistency in the timing of claim decisions and better claim management performance;
Maintaining solid performance and profitable growth in the Company’s Unum Limited and Colonial segments;
Managing the investment portfolio to match the effective asset and liability cash flows and durations while seeking to maximize investment income and total return and actively manage credit risk;
Responding to the industry-wide focus on broker compensation and related matters and resolving the California market conduct examination;
For the U.S. Brokerage segment, 2005 operating performance with respect to sales and pricing continued to exhibit evidence of long-term improvement. The Company began to restore sales momentum in its core markets while maintaining its commitment to a disciplined pricing approach for new business and believes that this strategy of focusing on the more profitable market segments will result in increased future profitability. While total sales in 2005 for fully insured products in the U.S. Brokerage group income protection line of business were down slightly relative to 2004, sales in the group income protection core small and mid-employer markets increased in 2005 compared to the prior year, as did sales for the supplemental and voluntary product lines, reflecting achievement of the Company’s strategy of developing a more balanced business mix through diversification. Persistency in the group long-term income protection line of business was consistent with the level of 2004 and was higher than the Company’s expectations.
The continued low level of new money rates and the limited supply of longer duration quality investments currently available in the marketplace continued to pressure the Company’s investment results in 2005. The Company believes its portfolios are well positioned from an asset-liability management perspective and that an increase in interest rates, even slightly, will improve the Company’s ability to grow the profitability of its businesses. Despite this continued low interest rate environment and flat yield curve, all of the reserve interest margins in the Company’s primary business lines remained above the Company’s target range at year-end 2005, and in the current interest rate environment, the Company believes its margins will remain adequate.
The Company continues to focus on operating effectiveness through short-term actions, continual improvement, and operational transformations such as integrated customer administration technology, web-enabled self service solutions, centralized account management technology, and local enrollment technology. The consolidated ratio of operating expenses to premium income was 21.4 percent for both 2005 and 2004. Excluding the fines and the charges for incremental direct operating expenses of $22.3 million resulting from the California Department of Insurance (DOI) settlement agreement in 2005 and $42.5 million resulting from the multistate settlement agreements in 2004, as discussed herein, the operating expense ratio increased slightly to 21.1 percent for 2005 compared to 20.8 percent for 2004. Premium income has been negatively impacted by the Company’s targeted rate increases in its group lines of business. The Company is aggressively managing its expenses against this expected decline in premium income while at the same time continuing to provide innovative and high quality service to its customers.
In October 2005, the Company entered into a settlement agreement with the California DOI, which did not join the 2004 multistate settlement agreements, and also continues to cooperate and provide information in response to other regulatory investigations, as discussed more fully herein and in Note 15 of the “Notes to Consolidated Financial Statements” contained herein in Item 8.
Following the announcement of the settlement agreement with the California DOI, and again subsequent to the issuance of the senior notes in November 2005, all four rating agencies reaffirmed the Company’s existing senior debt ratings, as more fully discussed in “Ratings” contained herein.
The Company repaid $227.0 million of maturing debt in 2005. During the fourth quarter of 2005, the Company repatriated $454.8 million in unremitted foreign earnings from its U.K. subsidiaries, and as part of its repatriation plan, issued $400.0 million of ten-year senior notes. In order to maintain its current debt leverage ratio, the Company reduced its outstanding debt $400.0 million during the first quarter of 2006 by participating in the remarketing of the senior note element of the Company’s adjustable conversion-rate equity security units in February 2006.
Improvement of the perception of the Company with regulators and the media; and
On October 3, 2005, certain of the Company’s insurance subsidiaries entered into a settlement agreement with the California DOI, concluding a market conduct examination and investigation of the subsidiaries’ disability claims handling practices. The California DOI had chosen not to join the fourth quarter of 2004 multistate settlement agreements the Company’s insurance subsidiaries entered into with state insurance regulators of 48 states upon conclusion of a multistate market conduct examination. See “Settlement of Multistate Market Conduct Examination” contained herein for further discussion of the multistate settlement agreements.
Under the terms of the settlement, the Company will change certain provisions specific to California disability policies. Additionally as part of the settlement, the Company received approval from the California DOI for the use of new individual and group disability policy forms, which became available for sale on November 1, 2005.
The California settlement also incorporates the claim reassessment process contained in the 2004 multistate settlement agreements. California claimants were included in the 2004 multistate settlement agreements and could choose to participate in that claim reassessment process even though California did not join the multistate settlement agreements. Under the California agreement, reassessment notices are being mailed to approximately 26,000 individuals whose claims were denied or terminated between January 1, 1997, and September 30, 2005. Many of these individuals had already received reassessment notices under the multistate settlement agreements. Additionally, as part of the California agreement, an individual whose claim denial or termination is upheld by the Company’s reassessment unit may request an independent review by a member of a panel established for that purpose. Following such review, the final decision on the claim is that of the Company’s reassessment unit; however, if there is information that the reviewer believes is appropriate relating to the handling of the claim, the reviewer may add a report to the claim file.
Separately, the Company is offering to reassess private label, acquired, and reinsured block claims, as well as claims administered on behalf of certain employers from January 1, 1997, through January 18, 2005 (and through September 30, 2005 for California residents). These approximately 24,000 claims were not included in the 2004 multistate settlement agreements, but the offer being made generally follows the reassessment procedures contained in those agreements.
Based on the settlement agreement and related matters, in the third quarter of 2005 the Company recorded a charge of $75.0 million before tax, or $51.6 million after tax, comprised of four elements: $14.3 million of incremental direct operating expenses to conduct the reassessment process; $37.3 million for benefit costs and reserves from claims reopened from the reassessment; $15.4 million for additional benefit costs and reserves for claims already incurred and currently in inventory that are anticipated as a result of the claim process changes being implemented; and the $8.0 million civil penalty. The charge decreased before-tax operating results for the U.S. Brokerage segment group income protection line of business and supplemental and voluntary lines of business $37.4 million and $3.3 million, respectively, and the Individual Income Protection - Closed Block segment $34.3 million. The ongoing costs of changes in the claims handling process and governance improvements will be included in the Company’s operating expenses as incurred going forward. These ongoing costs are not anticipated to materially affect the Company’s results of operations.
Beginning in 2004, several of the Company’s insurance subsidiaries’ insurance regulators requested information relating to the subsidiaries’ policies and practices on one or more aspects of broker compensation, quoting insurance business, and related matters. Additionally, the Company has responded to investigations about certain of these same matters by state attorneys general and the U.S. Department of Labor. Following highly publicized litigation involving the alleged practices of a major insurance broker, the National Association of Insurance Commissioners (NAIC) has undertaken to provide a uniform Compensation Disclosure Amendment to the Producer Licensing Model Act that can be adopted by states in an effort to provide uniform guidance to insurers, brokers, and customers relating to disclosure of broker compensation. The Company expects there to be continued uncertainty surrounding this matter until clearer regulatory guidelines are established.
In June 2004, the Company received a subpoena from the NYAG requesting documents and information relating to compensation arrangements between insurance brokers or intermediaries and the Company and its subsidiaries. The Company has received additional subpoenas or requests for additional information from the NYAG concerning its relations with insurance brokers. The NYAG has filed several lawsuits against brokers arising out of its investigation. Several insurers were cited in the complaints but not named as defendants - one such complaint cited the Company but did not name it as a defendant. The Company is cooperating with the NYAG’s investigations and inquiries.
Beginning in March 2005, several of the Company’s insurance subsidiaries received requests from various regulatory agencies seeking information relating to finite reinsurance and whether there are any ancillary or verbal side agreements that affect the potential loss under the terms of the reinsurance agreement. Additionally, the requests seek information on such matters as the Company’s use of finite reinsurance, controls relating to proper accounting treatment, and maintenance of underwriting files on the reinsurance agreements. The Company has responded to the earlier requests and is in the process of responding to the more recent requests.
In April 2005, the Internal Revenue Service (IRS) completed its examination of tax years 1999 through 2001 and issued its revenue agent’s report (RAR). Income tax liabilities of approximately $32.0 million that related primarily to interest on the timing of expense deductions were released in the first quarter of 2005, all of which was reflected as a reduction to income tax expense. In the fourth quarter of 2005, the Company paid the IRS proposed adjustments for its 1999 through 2001 tax years and will file claims for refund on disputed issues.
In the third quarter of 2005, the Company recognized an income tax benefit of approximately $10.8 million related to the finalization of income tax reviews of the Company’s U.K. subsidiaries.
During 2005, the Company repaid $227.0 million of maturing debt. In conjunction with the repatriation, in November 2005, the Company completed a long-term debt offering, issuing $400.0 million of 6.85% senior notes due November 15, 2015.
During 2005, the Company recaptured its closed block individual income protection business originally ceded to Centre Life Reinsurance Ltd. in 1996. The recaptured business includes approximately $1.6 billion in invested assets and $185.0 million of annual premium. The effective date of the recapture was August 8, 2005.
The underlying operating results of the reinsurance contract, prior to recapture, were reflected in other income. The recapture therefore did not have a material impact on operating income for the Individual Income Protection - Closed Block segment.
The impact on the Company’s financial position and results of operations as a result of these storms is expected to be immaterial.
During 2004, certain of the Company’s insurance subsidiaries entered into settlement agreements with state insurance regulators upon conclusion of a multistate market conduct examination led by Maine, Massachusetts, and Tennessee relating to disability claims handling practices. A total of 48 states and the District of Columbia are parties to the settlement agreements. In addition, the U.S. Department of Labor (DOL), which had been conducting an inquiry relating to certain ERISA plans, is a party to the settlement agreements, and the Office of the NYAG, which had engaged in its own investigation of the Company’s claims handling practices, notified the Company that it was in support of the settlement and was, therefore, closing its investigation on this issue. The examination report did not make any findings of violations of law or market conduct regulations. However, the examination report did identify areas of concern. These became the focus of specific changes and enhancements to the Company’s disability claims handling operations which are designed to assure each claim decision is made in a consistently high quality manner.
payment of a fine in the amount of $15.0 million that was allocated among the states and jurisdictions that joined the agreements and a potential fine of $145.0 million in the future if certain standards are not met in examinations at the end of approximately two years.
In the fourth quarter of 2004, the Company recorded a charge of $127.0 million before tax, or $87.8 million after tax, comprised of four elements: $27.5 million of incremental direct operating expenses to conduct the two-year reassessment process; $44.0 million for benefit costs and reserves from claims reopened from the reassessment; $40.5 million for additional benefit costs and reserves for claims already incurred and currently in inventory that are
anticipated as a result of the claim process changes being implemented; and the $15.0 million fine. The charge decreased before-tax operating results for the U.S. Brokerage segment group income protection and individual income protection - recently issued lines of business $116.7 million and $1.7 million, respectively, and the Individual Income Protection - Closed Block segment $8.6 million. The ongoing costs of changes in the claims handling process and governance improvements will be included in the Company’s operating expenses as incurred going forward. These ongoing costs are not anticipated to materially affect the Company’s results of operations.
The final principal part of the settlement agreements addressed aspects of corporate governance which are intended to reflect today’s greater emphasis in this area and to help establish best practices for the industry. A regulatory compliance unit, reporting directly to a newly formed regulatory compliance committee of the board of directors, was created to monitor the reassessment process, compliance with market conduct regulations and ERISA
In the first quarter of 2004, the Company restructured its individual income protection - closed block business wherein three of its insurance subsidiaries entered into reinsurance agreements to reinsure approximately 66.7 percent of potential future losses that occur above a specified retention limit. The individual income protection - closed block reserves in these three subsidiaries comprise approximately 90 percent of the Company’s overall retained risk in the closed block of individual income protection. The reinsurance agreements effectively provide approximately 60 percent reinsurance coverage for the Company’s overall consolidated risk above the retention limit, which equaled approximately $8.0 billion in existing statutory reserves at the date of the transaction. The maximum risk limit for the reinsurer was approximately $783.0 million initially and grows to approximately $2.6 billion over time, after which any further losses will revert to the Company. These reinsurance transactions were effective as of April 1, 2004. The Company transferred cash equal to $521.6 million of reserves ceded in the Individual Income Protection - Closed Block segment plus an additional $185.8 million in cash for a before-tax prepaid cost of insurance which was deferred and is being amortized into earnings over the expected claim payment period covered under the Company’s retention limit. The Company retained the higher yielding investments historically associated with these reserves and redeployed these investments to other lines of business.
The separation of the closed block business into a separate reporting segment required the Company to perform, separately for the individual income protection - closed block business and individual income protection - recently issued business, impairment testing for goodwill and loss recognition testing for the recoverability of deferred policy acquisition costs and value of business acquired. As required under GAAP, prior to the change in reporting segments, these tests were performed for the individual income protection line of business on a combined basis. The testing indicated impairment of the individual income protection - closed block deferred policy acquisition costs, value of business acquired, and goodwill balances of $282.2 million, $367.1 million, and $207.1 million, respectively. These impairment charges, $856.4 million before tax and $629.1 million after tax, were recorded in the first quarter of 2004.
Also as part of the restructuring, the Company analyzed the reserve assumptions related to its individual income protection - closed block reserves as a stand-alone segment. Previously these reserves were analyzed for the individual income protection line of business on a combined basis. Included in the analysis was a review of morbidity assumptions, primarily claim resolution rates, and claim reserve discount rate assumptions. Based upon this analysis, the Company lowered the claim reserve discount rate to reflect the segmentation of assets between the individual income protection - recently issued business and the individual income protection - closed block business, the change in the Company’s investment portfolio yield rates during the first quarter of 2004, the Company’s expectation of future investment portfolio yield rates, and the Company’s desire to maintain the relationship between the claim reserve discount rate and the investment portfolio yield rate for the individual income protection - closed block at the Company’s long-term objective. The segmentation of the investment portfolio was necessary to ensure appropriate matching of the duration of the assets and the related policy liabilities. Based on this analysis, in the first quarter of 2004 the Company increased its individual income protection - closed block claim reserves by $110.6 million before tax, or $71.9 million after tax, to reflect its current estimate of future benefit obligations. The first quarter 2004 change represented a 1.2 percent increase in total net Individual Income Protection - Closed Block segment reserves as of March 31, 2004, which equaled $9.530 billion prior to this increase.
In the first quarter of 2004, Unum Limited became responsible for the ongoing administration and management of the United Kingdom portion of the group income protection claims portfolio of Swiss Life (UK) plc (Swiss Life), and Swiss Life reinsured this portfolio to Unum Limited. Unum Limited also became a multi-national pooling partner for Swiss Life Insurance & Pension Company with respect to business written in the United Kingdom.
With the goal of focusing on its core operations, in 2004 the Company sold its Japanese operation, Unum Japan Accident Insurance Co., Ltd. The Company also entered into an agreement with the buyer to reinsure certain existing income protection business and intends to have a continuing presence in these operations for at least one year. The Company wrote down the book value of the Japan operations to the estimated fair value less cost to sell during 2003 and at that time recognized an impairment loss of $1.2 million before tax and $0.8 million after tax. The Company also recognized a tax benefit of $6.8 million, for a net after-tax gain of $6.0 million in 2003.
During the second quarter of 2004, the Company completed the sale of its Canadian branch and reported a loss of $70.9 million after tax on the sale. On a statutory basis of reporting, the Company’s U.S. insurance subsidiaries reported a 2004 gain of $250.6 million after tax on the sale of the branch. Additionally, the transaction resulted in an approximate 29 point improvement in the Company’s RBC ratio for its U.S. insurance subsidiaries, calculated on a weighted average basis.
In 2004, GENEX acquired Integrated Benefits Management, a provider of case management services, to further broaden GENEX’s relationship and distribution partnerships. The purchase price was $0.7 million.
In conjunction with the restructuring of its Argentinean operation, the Company reduced its ownership position in this operation to 40 percent during 2004 and reported a before-tax loss of $4.7 million. The Company also recognized from this transaction a tax benefit of $7.4 million, for a net after-tax gain of $2.7 million on the 2004 transaction. The Company wrote down the book value of the Argentinean operation to the estimated fair value less cost to sell during 2003 and at that time recognized an impairment loss of $13.5 million before tax and $11.3 million after tax.
Furthering its goal of divesting its non-core operations, during 2003, the Company reinsured on a 100 percent indemnity coinsurance basis for non-New York policies and a 90 percent indemnity coinsurance basis for New York policies certain of its insurance policies sold through trade associations and ceded approximately $121.0 million of reserves to the reinsurer. The annual premium on the block reinsured was approximately $40.0 million and related primarily to individual income protection - closed block policies. The transaction had an effective date of April 1, 2003.
In order to strengthen its capital position, during 2003, the Company issued 52.9 million shares of common stock, par value $0.10 per share, in a public offering and received approximately $547.7 million in proceeds from the sale of the shares after deducting underwriting discounts. Also in 2003, the Company issued 23.0 million 8.25% adjustable conversion-rate equity security units (units) in a $575.0 million public offering. Proceeds from the offerings were used primarily to increase the capitalization of the Company’s insurance subsidiaries and to repay amounts loaned to the Company from its insurance subsidiaries.
The Company has various stock-based employee compensation plans. Prior to 2003, the Company accounted for those plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. Effective January 1, 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, and selected the prospective method of adoption allowed under the provisions of Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure. The adoption increased before tax operating expenses for 2003 approximately $0.9 million. See Item 8, Note 1 of the “Notes to Consolidated Financial Statements” concerning the subsequent issuance of SFAS 123(R).
The two primary categories of liabilities for policy and contract benefits are policy reserves for claims not yet incurred and claim reserves for claims that have been incurred and have future benefits to be paid. Policy reserves equal the present value of the difference between future policy benefits and future premiums, allowing a margin for expenses and profit. These reserves are applicable for the majority of the Company’s business, which is traditional non interest-sensitive in nature. The claim payments are estimated using assumptions established when the policy was issued. Throughout the life of the policy, the reserve is based on the original assumptions used for the policy’s issue year. Ordinarily, generally accepted accounting principles require that these assumptions not be subsequently modified unless the policy reserves are determined to be inadequate.
Claim reserves, in general, are an estimate of the current value of future, otherwise unfunded, benefit commitments or liabilities. The calculation of claim reserves involves numerous assumptions. In setting these assumptions, the Company depends upon industry information and experience, Company experience and analysis, and reasoned judgment. There can be no guarantee that these assumptions individually, or collectively, will be duplicated by actual experience over time. The primary assumptions related to claim reserves are the discount rate, the claim resolution rate, and the incidence rate for incurred but not reported (IBNR) claims.
The discount rate is the interest rate at which future benefit cash flows are discounted to determine the present value of those cash flows. It is important since higher discount rates produce lower reserves. If the discount rate is higher than future investment returns, the Company’s assets will not earn sufficient investment income to support future liabilities. In this case, the reserves may eventually be insufficient. Alternatively, if a discount rate is chosen that is too low relative to future investment results, the reserve, and thus the claim cost in the current period, will be overstated and profits will be accumulated in the reserves rather than released through earnings. The Company sets its discount rate assumptions in conjunction with the current and expected future investment income rate of the assets supporting the reserves. If the investment yield at which new investments are purchased is below or above the investment yield of the existing investment portfolio, it is likely that the discount rate on new claims will be established below or above the discount rate on existing claims. It is the Company’s intent to use a discount rate that provides some margin for adverse movement in the investment portfolio yield rate.
The claim resolution rate is the rate of probability that a disability claim will close or change due to maximum benefits being paid under the policy, the recovery or death of the insured, or a change in status in any given period. It is important because it is used to estimate how long benefits will be paid for a claim. Estimated resolution rates that are set too high will result in reserves that are lower than they need to be to pay the claim benefits over time. A claim closes due to maximum benefits being paid if all of the contractual benefits under the policy have been paid. A claim also closes if the policyholder recovers from his or her disability and is no longer receiving disability benefit payments or if the policyholder dies in the period. A claim may change status during the period. For example, a policyholder receiving disability benefits may return to part time work, and the claim benefit may be reduced to reflect the change to partial disability. Establishing claim resolution assumptions is complex and involves many factors, including the cause of disability, the policyholder’s age, the type of contractual benefits provided, etc. Claim resolution assumptions also vary by duration of disability and time since initially becoming disabled. The Company uses its extensive claim experience and analysis to develop its claim resolution assumptions. Claim resolution experience is studied over a number of years with more weight placed on the more recent experience. Claim resolution assumptions are established to represent the Company’s future resolution rate expectations. Due to the individual nature of each claim, it is unlikely that the claim resolution rate will be accurate for any particular claim. The Company establishes its claim resolution assumptions to apply as an average to its large base of active claims. In this manner, the assumed rates are much more accurate over the broad base of claims. Actual claim reserves incurred in the calendar quarter are sensitive to the choice of resolution rate. For example, a
The increase in IBNR reserves from December 31, 2004 is due primarily to the Individual Income Protection - Closed Block segment, which includes a reclassification of reserves from All Other to IBNR reflecting additional IBNR reserves associated with the recapture of the reinsurance treaty in 2005, and the Unum Limited segment, which is due to growth in insured lives and the average premium size per policy. Partially offsetting these increases is a decrease in the IBNR reserves for the U.S. Brokerage segment due primarily to decreases in insured lives in the group income protection and group life and accidental death and dismemberment lines of business. The increase in All Other reserves from December 31, 2004 is driven by growth in the active life reserves for the U. S. Brokerage long-term care and individual income protection - recently issued lines of business and growth in the disabled life reserves in the U.S. Brokerage group income protection line of business.
The Company defers certain costs incurred in acquiring new business and amortizes (expenses) these costs over the life of the related policies. Deferred costs include certain commissions, other agency compensation, selection and policy issue expenses, and field expenses. Acquisition costs that do not vary with the production of new business, such as commissions on group products which are generally level throughout the life of the policy, are excluded from deferral.
Deferred costs related to U.S. Brokerage group and individual income protection products are generally amortized over a twenty-year period, with approximately 75 percent and 90 percent of the original deferred costs related to group income protection products expected to be amortized by years ten and fifteen, respectively. For individual income protection policies, approximately 35 percent and 65 percent of the original deferred costs are expected to be amortized by years ten and fifteen, respectively. Deferred costs for U.S. Brokerage group and individual long-term care products are amortized over a twenty-year period, with approximately 45 percent and 70 percent of the original deferred costs expected to be amortized by years ten and fifteen, respectively. Deferred costs for U.S. Brokerage group life and accidental death and dismemberment products are amortized over a fifteen-year period, with approximately 85 percent of the cost expected to be amortized by year ten. Deferred costs for U.S. Brokerage voluntary products are amortized over a fifteen-year period, with approximately 90 percent of the cost expected to be amortized by year ten.
Increasing the 30 basis points added to the risk free rate for lack of liquidity by 1.5 basis points, increasing the five basis points added to the risk free rates for foreign investments by one basis point, and increasing the additional basis points added to each industry considered to be of greater risk by one basis point would have decreased the December 31, 2005 net unrealized gain in the fixed maturity securities portfolio by approximately $1.7 million. Historically, the Company’s realized gains or losses on dispositions of its private placement fixed maturity securities have not varied significantly from amounts estimated under the valuation methodology described above.
factors or the business environment, an adverse action by a regulator or rating agency, or unanticipated competition would cause the Company to review goodwill for impairment more frequently than annually.
The goodwill reported as an asset in the Company’s consolidated statements of financial condition at December 31, 2005 is attributable primarily to the acquisition of The Paul Revere Life Insurance Company (individual income protection - recently issued business) and GENEX Services, Inc. (disability management services business). The impairment testing for goodwill involves estimating the fair value of the individual income protection block of recently issued business and the fair value of the disability management services business based upon the present value of future cash flows using assumptions such as future sales, morbidity experience, portfolio yield rate, and the rate of return at which the Company believes the market would price the businesses for purchase. Adverse changes in any of these factors could result in an impairment of goodwill for either or both of the blocks of business.
The Company’s volatility in net realized investment gains and losses is due in part to changes in the fair value of the embedded derivatives in certain reinsurance contracts. These fair value changes resulted in a net realized loss of $7.9 million in 2005 compared to net realized gains of $88.6 million for 2004 and $0.8 million for 2003. The Company also experienced improvements in net realized investment gains and losses from sales and write-downs, with a net realized gain of $1.2 million in 2005 compared to net realized losses of $59.4 million and $174.6 million in 2004 and 2003, respectively. The Company believes that its active management of credit risk has resulted in this improving trend and expects the level of realized investment gains or losses during 2006 from sales and write-downs to be relatively consistent with the level of 2005. See “Investments” contained herein in Item 7 for further discussion.
The reported ratio of benefits and change in reserves for future benefits to premium income was 90.6 percent for 2005 compared to 92.5 percent for 2004 and 103.3 percent for 2003. As previously noted, benefits and change in reserves for future benefits for 2005 include charges of $52.7 million related to the settlement agreement with the California DOI and related matters and for 2004 include charges of $84.5 million related to the multistate market conduct examination settlement agreements and $110.6 million related to the restructuring of the individual income protection - closed block business. In 2003, benefits and change in reserves for future benefits include charges of $894.0 million related to the U.S. Brokerage group income protection reserve strengthening. Excluding these items, the ratio of benefits and change in reserves for future benefits to premium income was 90.0 percent for 2005 compared to 90.0 percent for 2004 and 91.6 percent for 2003. See operating results by segment contained herein for discussions of line of business risk results.
Commissions decreased in 2005 relative to 2004 and 2003 due primarily to the decline in sales and also to the restructuring of the Colonial agency field sales force. The Company is aggressively managing its operating expenses, particularly in those lines of business with declining revenue. The Company reported a consolidated operating expense ratio in 2005 consistent with the level of 2004 and lower than 2003. Excluding the 2005 charges of $22.3 million resulting from the California DOI settlement agreement and related matters and the 2004 charges of $42.5 million resulting from the multistate market conduct examination settlement agreements, as discussed herein, the operating expense ratios were 21.1 percent in 2005 compared to 20.8 percent and 22.3 percent for 2004 and 2003, respectively.
As previously discussed, the Company’s income tax for 2005 includes tax benefits of $42.8 million related to the reduction of income tax liabilities in the first and third quarters of 2005 and a net tax benefit of $3.3 million recorded in connection with the repatriation of unremitted foreign earnings from its U.K. subsidiaries under the Homeland Investment Act of 2004.
Sales results shown in the preceding chart generally represent the annualized premium or annualized fee income on new sales expected to be received and reported as premium income or fee income during the next twelve months following or commencing in the initial quarter in which the sale is reported, depending on the effective date of the new sale. Sales do not correspond to premium income or fee income reported as revenue under GAAP because new
annualized premiums measure current sales performance, while premium income and fee income are recognized when earned and reflect renewals and persistency of in force policies written in prior years as well as current new sales. Prior year sales results by segment have been reclassified to conform to the current reporting segments, the change of which is discussed herein.
Premiums for fully insured products are reported as premium income while the fees for administrative services only (ASO) products, wherein the risk and responsibility for funding claim payments remains with the customer, are included in other income. Sales, together with persistency of the existing block of business and the Company’s renewal program, are an indicator of growth in the Company’s premium and fee income. Trends in new sales, as well as existing market share, are also indicators of the Company’s potential for growth in its respective markets and the level of market acceptance of price changes and new product offerings. Sales may fluctuate significantly due to case size and timing of sales submissions. Negative media attention or downgrades in the financial strength ratings of the Company’s insurance subsidiaries may adversely affect the Company’s ability to grow sales and renew its existing business. The Company intends to continue with its disciplined approach to pricing and also with the strategy of developing a more balanced business mix of large, small, and mid-employer markets.
The Company has field sales personnel who specialize in (1) employer-provided plans for employees and (2) supplemental benefit plans that include multi-life income protection and long-term care product offerings and products sold to groups of employees through payroll deduction at the workplace. These field sales personnel partner with Company representatives from claims, customer service, and underwriting who work in conjunction with independent brokers and consultants to present coverage solutions to potential customers and to manage existing customer accounts. The Company utilizes a distribution model for the sale of individual income protection and individual long-term care insurance products whereby independent brokers and consultants are provided direct access to a sales support center centrally located in the Company’s corporate offices. The Company intends to maintain its focus on workplace customers and increased integration between supplemental benefit plans and group offerings by continuing to provide highly focused field support. The Company also utilizes an agency field sales force to market the products offered by its Colonial segment.
Effective July 1, 2005, the Company modified its reporting segments to separate its United States business from that of its United Kingdom subsidiary, Unum Limited, due to the continued growth in that subsidiary and to recent organizational changes within the Company which established a separate management team to focus solely on the U.S. Brokerage lines of business. The Company’s new reporting segments are comprised of the following: U.S. Brokerage, Unum Limited (U.K. business), Colonial, Individual Income Protection - Closed Block, Other, and Corporate.
The U.S. Brokerage segment includes the results of the Company’s U.S. group income protection insurance, group life and accidental death and dismemberment products, and supplemental and voluntary lines of business, including individual income protection - recently issued, group and individual long-term care, and brokerage voluntary workplace benefits products. The Unum Limited segment includes group long-term income protection, group life, and individual income protection products. The products now reported in the U.S. Brokerage segment and the Unum Limited segment were previously combined and reported in the Income Protection and Life and Accident segments. The modification of the Company’s reporting segments had no impact on the level at which the Company performs impairment testing for goodwill or loss recognition testing for the recoverability of deferred policy acquisition costs and value of business acquired.
In the following segment financial data and discussions of segment operating results, “operating revenue” excludes net realized investment gains and losses. “Operating income” or “operating loss” excludes net realized investment gains and losses, income tax, and results of discontinued operations. These are considered non-GAAP financial measures. A non-GAAP financial measure is a numerical measure of a company’s performance, financial position, or cash flows that excludes or includes amounts that are not normally excluded or included in the most directly comparable measure calculated and presented in accordance with U.S. generally accepted accounting principles (GAAP).
A reconciliation of total operating revenue by segment to total consolidated revenue and total operating income (loss) by segment to consolidated net income (loss) is as follows.
Sales in 2005 for fully insured group long-term and short-term income protection and group life in the small and mid-employer core markets increased approximately 11.6 percent in these three product lines, offset by a decline in sales in the more competitive large case market.
Individual income protection - recently issued sales attributable to multi-life business were approximately 85 percent of this product line’s new sales in 2005 compared to 81 percent in 2004.
Group long-term and short-term income protection sales, on a fully insured basis, decreased during 2004 compared to 2003 due to a decline in sales as a result of the Company’s aforementioned approach to pricing and continued shift to focus on the small and mid-employer core markets. Sales for group life decreased in 2004 relative to 2003 due to a more competitive market, which resulted in sales declines in all market sizes, and also due to a decrease in large-employer market sales. The Company anticipated weaker sales for 2004 as compared to 2003 for its group products due primarily to its balanced business mix strategy and the competitive pricing environment.
Persistency during 2005 for the overall block of fully-insured group long-term income protection, on average, was level with 2004, but was higher than expected. Persistency for fully insured group short-term income protection, on average, declined marginally during 2005 compared to the prior year and was slightly less than expected. Included in the 2005 policy terminations was a group policyholder who did not terminate the relationship with the Company, but transferred from fully insured short-term income protection to ASO. Adjusting persistency for this policyholder’s transfer, persistency for fully insured group short-term income protection was slightly higher than expected for 2005. It was anticipated that persistency in the group income protection business would decline in 2005 due to the Company’s more disciplined approach to pricing, renewals, and risk selection. Since the group life and accidental death and dismemberment products are primarily sold in conjunction with group income protection, the more focused renewal effort in group income protection has reduced persistency in these lines, though the reduction in persistency is less than anticipated. The persistency for the supplemental and voluntary product lines generally continues to be within expected levels.
During 2005, the Company completed its annual comprehensive scenario testing with respect to the amortization and recoverability of its group income protection and group life deferred policy acquisition costs. The deferred policy acquisition costs were fully recoverable. The assessment is performed primarily to test both recoverability and the limits of recoverability. Sustained adverse persistency at the levels tested would result in lower emerging future profits due to lower overall premium levels and additional acceleration, on a prospective basis, of the amortization of deferred policy acquisition costs relative to the “scheduled” or expected amortization, but the Company does not anticipate prolonged persistency rates at the stress levels tested.
The Company’s previous renewal programs have generally been successful in retaining business that is relatively more profitable than business that terminated. While it is expected that the additional premium and related profits associated with renewal activity will continue to emerge, the Company intends to balance the renewal program with the need to maximize persistency and retain producer relationships.
In January of 2006, the Company began a process of filing a request with various state insurance departments for rate adjustments on one older series of individual long-term care policies. The rate adjustment will bring the rates for this policy series closer to today’s market, better reflecting current interest rates, higher expected future claims, persistency, experience, and other factors related to pricing individual long-term care coverage. Overall, the average increase will be in the 30 percent range and will affect approximately 130,000 policyholders, less than 16 percent of the Company’s total long-term care block of business. Increases are subject to state review and approval and will be effective on the policy anniversary following the state approval and only after the proper state-specific notification requirements have been satisfied. In states for which a rate increase is submitted and approved, customers will also be given options for coverage changes or other approaches that might fit their current financial and insurance needs.
Persistency during 2004 for group long-term income protection, on average, declined from that experienced in 2003. Terminations were more heavily concentrated in the large-employer market, while persistency in the small and mid-employer markets improved slightly in 2004 compared to 2003. Persistency for fully insured short-term income protection also declined during 2004, on average, over the prior year. These declines in persistency were expected due to the Company’s disciplined approach to pricing, renewals, and risk selection. Persistency in 2004 in group life and the supplemental and voluntary lines of business within this segment was consistent with the levels of 2003.
Shown below are financial results and key performance indicators for U.S. Brokerage group income protection.
(1) Included in these ratios are the 2005 before-tax reserve charge of $27.3 million related to the settlement agreement with the California Department of Insurance and related matters; the 2004 before-tax reserve charge of $80.2 million related to the settlement of the multistate market conduct examination; and the 2003 before-tax reserve strengthening of $894.0 million. Excluding these charges, the benefit ratios for 2005, 2004, and 2003 would have been 93.8%, 92.7%, and 94.6%, respectively.
Excluding the charges noted in (3) above and discussed more fully in the preceding significant transactions and events discussions for each applicable year, group income protection would have reported operating income of $68.4 million in 2005, $58.7 million in 2004, and $24.0 million in 2003.
Commissions and the deferral of policy acquisition costs were below the prior year due primarily to lower sales. Operating expenses for 2005 include charges of $10.1 million related to the settlement agreement with the California DOI and related matters and for 2004 includes charges of $36.5 million related to the settlement of the multistate market conduct examination. Excluding those charges, expenses are lower than the prior year, and while the adjusted operating expense ratio has increased slightly relative to the prior year, the Company is aggressively managing its expenses against the expected decline in premium income.
As discussed under “Cautionary Statement Regarding Forward-Looking Statements,” and in “Risk Factors” contained herein in Item 1A, certain risks and uncertainties are inherent in the Company’s group income protection business. Components of claims experience, including, but not limited to, incidence and recovery rates, may be worse than expected. Both economic and societal factors can affect claim incidence. Adjustments to reserve amounts may be required in the event of changes from assumptions regarding the incidence of claims or the rate of recovery, as well as persistency, mortality, and interest rates used in calculating the reserve amounts.
The settlement of the multistate market conduct examination resulted in a 2004 charge of $80.2 million for benefit costs and reserves. Excluding this reserve charge as well as the 2003 reserve strengthening previously discussed, the benefit ratio for 2004 declined compared to 2003. Contributing to the decline in the 2004 benefit ratio relative to 2003 was a decrease in the submitted claim incidence rate for group long-term income protection and an increase in premium per insured life, primarily due to rate increases placed on poorer performing business through the 2004 renewal program. Partially offsetting the factors contributing to the decline in the benefit ratio was a lower claim discount rate used for new claims occurring in 2004 relative to the rate used in 2003. For group short-term income protection, the benefit ratio was lower primarily due to a decline in paid claim incidence in 2004 compared to 2003.
Costs capitalized during 2004 for group income protection were lower than in the prior year due to an updated analysis of costs associated with the acquisition of new business and due to the decrease in sales. Operating expenses for 2004 include a charge of $36.5 million related to the settlement of the multistate market conduct examination.
Shown below are financial results and key performance indicators for U.S. Brokerage group life and accidental death and dismemberment.
Premium income decreased in 2005 relative to the prior year due to decreased sales growth and lower persistency levels. The increase in net investment income relative to the prior year is due to an increase in the yield on floating rate investments that support certain products within the group life line of business offset somewhat by a decline in the level of assets supporting this business.
The increase in premium income for 2005 relative to the prior year for the individual income protection - recently issued business and individual long-term care is due to sales growth in prior periods and stable persistency. The increase in premium income in the group long-term care and voluntary workplace benefits lines of business is attributable to current year sales growth as well as sales growth in previous periods and stable persistency.
The benefit ratio for the individual income protection - recently issued business decreased slightly in 2005 relative to the prior year, excluding the 2005 reserve charge related to the California DOI settlement agreement and related matters and the 2004 reserve charge related to the multistate market conduct examination as discussed above, driven primarily by lower incidence and a release of active life reserves on two large multi-life cases which terminated during 2005. Multi-life business, which constitutes approximately 60 percent of the individual income protection - recently issued block of business, has consistently had lower claim incidence rates than the non multi-life business. The benefit ratio for long-term care was higher in 2005 than in the prior year due primarily to the aging of the block of business and a lower net claim resolution rate. The benefit ratio for the voluntary workplace benefits products was lower in comparison to the prior year due primarily to a lower rate of insureds in claim payout status in the voluntary income protection line of business and improved mortality experience in the voluntary life line of business.
The deferral of policy acquisition costs decreased during 2005 relative to the prior year due primarily to the lower level of sales in the individual income protection - recently issued and long-term care lines of business, offset somewhat by higher levels of deferral for the voluntary workplace benefits product lines due to increased sales. Amortization of deferred policy acquisition costs was higher for 2005 due to the termination during 2005 of two large multi-life cases which resulted in the write-off of associated unamortized acquisition costs. This increased amortization was offset by the release of active life reserves, as previously mentioned. Operating expenses increased in comparison to the prior year due to growth in these lines of business; however, the operating expense ratio remained consistent with that of the prior year.
Net investment income for 2004 increased slightly from 2003 due to the continued growth in invested assets supporting these lines of business offset by a decline in the yield on the portfolio as well as internal redistributions of invested assets in conjunction with the Company’s management of asset and liability cash flows.
The increase in the benefit ratio for individual income protection - recently issued for 2004 relative to 2003 was primarily due to a decline in the net claim resolution rate, partially offset by a decrease in submitted claim incidence due to the growth in the multi-life portion of this line of business, which has consistently had lower claim incidence rates than the non multi-life business. The increase in the benefit ratio for the long-term care lines of business is due to higher submitted claim incidence in 2004 in comparison to 2003 and a higher net claim resolution rate.
Acquisition costs capitalized during 2004 were lower than in 2003 due primarily to the reduction in sales of individual income protection - recently issued and long-term care business.
Because of anticipated long-term improvements in the claim management results for the group long-term income protection business, the Company expects its overall benefit ratio for group income protection to gradually improve relative to 2005 while the benefit ratios in the other lines of business are expected to remain relatively stable year over year.
The Unum Limited segment includes insurance for group long-term income protection, group life, and individual income protection products sold primarily in the United Kingdom through field sales personnel and independent brokers and consultants. Shown below are financial results and key performance indicators for the Unum Limited segment.
Group long-term income protection sales increased in 2004 compared to 2003 due to the exit of a major insurer in the group long-term income protection market and the favorable movement in the foreign currency exchange rate in 2004 relative to 2003. When measured in its local currency, the sales growth rate in the group long-term income protection line was approximately 13.2 percent year over year. Group life sales increased in 2004 compared to 2003 due to the acquisition of the Sun Life block of business in 2003 as well as the favorable foreign exchange rate in 2004 compared to 2003.
Premium income increased in comparison to the prior year due primarily to growth in the group long-term income protection line of business resulting from block acquisitions, the related growth in prior year sales, and favorable persistency. The premium income increase in the group life line of business was due to prior period sales growth and favorable persistency. Net investment income increased in 2005 relative to 2004 due to continued growth in the business and the assets supporting it, offset partially by a slight decrease in portfolio yields relative to the prior year. Other income for 2005 includes $5.7 million related to the disposal of Unum Limited’s Netherlands branch during 2005, as previously discussed.
Operating expenses have increased in 2005 compared to 2004 due to growth of the lines of business, but the operating expense ratios decreased due to an increase in premium income, economies of scale, and the Company’s focus on expense management.
The growth in the group long-term income protection premium income was primarily attributable to continued strong sales growth and the favorable foreign currency exchange rate in 2004 relative to 2003. When measured in its local currency, the growth rate in premium income in the group long-term income protection line was approximately 20.8 percent year over year. The growth in group life premium income for 2004 relative to 2003 was attributable primarily to the acquisition of Sun Life, as previously discussed, and the favorable exchange rate. The increase in net investment income was due primarily to the growth in assets supporting the lines of business and the favorable movement in the exchange rate.
The benefit ratio for the Unum Limited lines of business decreased in 2004 relative to 2003 due primarily to the extremely favorable claim resolution experience on an acquired block of group long-term income protection business.
The amortization of value of business acquired increased during 2004 due to the previously discussed transaction with Swiss Life.
During 2006, the Company intends to focus on maintaining its strong leadership position in the U.K and to continue to identify new sources of business to drive future growth in both the group and individual markets.
Total sales for 2006 are expected to be level with that of 2005, with increases in individual income protection sales offsetting declines in the sale of group income protection products. Sales growth is expected to gain momentum throughout the year, with quarter over prior year comparable quarter increases in the latter half of the year. It is expected that persistency will remain at its current levels, although pricing competition may negatively impact sales and/or persistency.
Although claims experience is favorable for the group long-term income protection line of business, it is expected that the benefit ratio may increase during 2006, relative to the current level, as positive claim resolution trends on recent block acquisitions become less pronounced.
The sales decrease in 2004 relative to 2003 was attributable to a decline in sales of income protection products, partially offset by an increase in sales for the cancer and life products. The decline in sales for income protection results from the discontinuance by the Company of new sales of group long-term income protection as well as from lower sales of individual short-term income protection to employee groups of 2,000 or more lives.
Commissions in 2005 declined relative to the prior year, and operating expenses increased. These changes were due primarily to the restructuring of the agency field sales force wherein the Company is moving certain functions from a commissioned sales agency status to salaried employees of the Company.
The Individual Income Protection - Closed Block segment generally consists of those individual income protection policies in force prior to the Company’s substantial changes in product offerings, pricing, distribution, and underwriting. These changes generally occurred during the period 1994 through 1998. A minimal amount of new business continued to be sold subsequent to these changes, but the Company ceased selling new policies in this segment at the beginning of 2004 other than update features contractually allowable on existing policies.
(1) Included in these ratios are the 2005 before-tax reserve charge of $2.3 million related to the settlement agreement with the California Department of Insurance and related matters and the 2004 before-tax reserve charge of $0.6 million related to the settlement of the multistate market conduct examination. Excluding these charges, the benefit ratios for 2005 and 2004 would have been 57.0% and 57.6%, respectively.
The benefit ratio for 2005 was stable in comparison to the prior year, excluding the reserve charge in 2005 related to the settlement agreement with the California DOI and the reserve charges in 2004 related to the restructuring of this block and the settlement of the multistate market conduct examination, as noted in the preceding financial metrics. Claim recovery rates were lower in 2005 relative to 2004, while claim incidence rates improved.
Excluding the charges noted in (2) above, operating expenses were lower than the prior year due primarily to the Company’s overall expense management initiatives.
Premium income decreased relative to the prior year due to the expected decline in this closed block of business. Net investment income declined in 2004 relative to the prior year due to a decline in the portfolio yield rate and due to lower prepayments on mortgage-backed securities, offset somewhat by a retrospective adjustment of the amortization of the purchase discount on mortgage-backed securities. Net investment income was also negatively impacted due to the lower yield on cash equivalent investments held during the first half of 2004 in conjunction with the pending transfer of cash for the reinsurance agreements entered into as part of the restructuring of this block. Other income includes the underlying results of certain blocks of reinsured business.
The operating expense ratio decreased relative to 2003 due primarily to a reduction in selling and underwriting expenses. A minimal amount of new business was still being sold during 2003, primarily related to update features on existing policies.
Due to the impairment of intangible assets as of January 1, 2004, no “scheduled” amortization of deferred policy acquisition costs or value of business acquired was included in operating results for this segment during 2004, compared to $74.0 million in 2003.
The Company believes that the 2004 restructuring of this closed block of business has strengthened the balance sheet for this segment and minimized the Company’s exposure to potential future adverse morbidity. As part of the 2004 restructuring, the Company entered into reinsurance agreements which effectively provide approximately 60 percent reinsurance coverage for the Company’s overall consolidated risk above a specified retention limit, which at December 31, 2005, equaled approximately $8.0 billion. The maximum risk limit for the reinsurer grows to approximately $2.6 billion over time, after which any further losses will revert to the Company. The Company has not yet reached the retention limit and does not currently anticipate that once reached, the Company’s experience would be such that its losses would exceed the maximum risk limit for the reinsurer and therefore revert back to the Company. The reinsurance receivable for this contract, as reported in the Company’s consolidated statements of financial condition, was approximately $570.0 million at December 31, 2005.
The Company’s reinsurance operations include the reinsurance management operations of Duncanson & Holt, Inc. (D&H) and the risk assumption, which includes reinsurance pool participation; direct reinsurance which includes accident and health (A&H), long-term care (LTC), and long-term disability coverages; and Lloyd’s of London (Lloyd’s) syndicate participations. During the years 1999 through 2001, the Company exited its reinsurance pools and management operations through a combination of a sale, reinsurance, and/or placement of certain components in run-off. Total operating revenue for the reinsurance pools and management operations was $7.7 million, $5.2 million, and $15.5 million in 2005, 2004, and 2003, respectively. During 2005, this line of business reported an
operating loss of $11.0 million, compared to operating losses of $7.5 million and $7.1 million in 2004 and 2003, respectively.
The Corporate segment includes investment income on corporate assets not specifically allocated to a line of business, corporate interest expense, and certain other corporate income and expense not allocated to a line of business.
The Corporate segment reported operating losses of $152.8 million, $153.7 million, and $193.5 million in 2005, 2004, and 2003, respectively. Interest and debt expense increased from $187.2 million in 2003 and $207.1 million in 2004 to $208.0 million in 2005 due to the impact of the debt offerings, as discussed under “Liquidity and Capital Resources” included herein.
Included in operating expenses for 2003 is approximately $15.0 million in severance and pension benefit payouts related to the change of the Company’s president and chief executive officer.
During 2003, the Company entered into an agreement to sell its Canadian branch. The transaction closed April 30, 2004, and the Company reported a second quarter of 2004 loss of $113.0 million before tax and $70.9 million after tax on the sale of the branch. The Company also recognized a first quarter of 2004 loss of $0.6 million before tax and $0.4 million after tax to write down the value of bonds in the Canadian branch investment portfolio to market value.
The maximum investment per issuer group is limited based on internal limits established by the Company’s board of directors and is more restrictive than the 5 percent limit generally allowed by the state insurance departments which regulate the type of investments the Company’s insurance subsidiaries are allowed to own. These internal limits are as follows:
Asset mix guidelines and limits are established by the Company and approved by the board of directors.
Net investment income was $2,188.3 million in 2005, up 1.4 percent relative to the prior year. Included in net investment income for 2005 is approximately $35.0 million related to the $1.6 billion of bonds transferred to the Company in conjunction with the 2005 recapture of a ceded closed block of individual income protection business. Excluding that, net investment income was fairly consistent with the prior year, with the increase from the growth in invested assets and higher bond call premiums offset by a lower portfolio yield due to the low interest rate environment and the investment of new cash at lower rates as well as a decline in the level of prepayments on mortgage-backed securities. The overall yield in the portfolio was 6.85 percent as of December 31, 2005, and the weighted average credit rating was A2. This compares to an overall yield in the portfolio of 6.93 percent as of December 31, 2004 and a weighted average credit rating of A3. In the current low interest rate market, the Company expects that the portfolio yield will continue to gradually decline until the market rates on new purchases increase above the level of the overall yield.
The Company reported before-tax realized investment gains and losses during the last three years as shown in the following chart. Impairment losses were recognized as a result of management’s determination, based on the factors discussed herein in “Critical Accounting Policies,” that the value of certain fixed maturity and equity securities had
The Company also reports changes in the fair values of certain embedded derivatives as realized investment gains and losses, as required under the provisions of Statement of Financial Accounting Standards No. 133 Implementation Issue B36 (DIG Issue B36), Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposure That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor Under Those Instruments. During 2005, the change in fair values of the embedded derivatives was minimal, reflecting interest rate levels on mid-term and longer-term maturities that were, on average, fairly consistent at the end of 2005 with the level of rates existing at the end of 2004. The realized loss on these embedded derivatives for 2005 also includes recognition of a $9.4 million before tax loss related to the time value component of the embedded derivative in the reinsurance contract that was recaptured in the third quarter of 2005. Interest rates generally decreased during 2004, resulting in an increase in the fair value of these embedded derivatives during that time period.
Approximately 81 percent of the 2005 other than temporary impairment losses occurred in the transportation and financial institutions industries. Circumstances surrounding larger other than temporary impairment losses are as follows:
$10.3 million loss on certificates issued by a trust backed by leases to a U.S. based airline. Although the airline had filed for bankruptcy in the third quarter of 2004, the bonds are secured by aircraft owned by the trust and have remained current on all interest payments to date. However, due to the lack of clarity regarding the value of aircraft collateralizing these securities and the length of time these securities have been in an unrealized loss position, the Company determined that an other than temporary impairment had occurred. These securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the first quarter of 2000. At the time of the impairment, these securities had been continuously in an unrealized loss position for a period of greater than three years. The circumstances of this impaired investment have no impact on other investments.
$9.0 million loss on structured securities issued by a trust and collateralized by a pool of high yield bonds. The Company performs a periodic review of the estimated cash flows associated with all of its securitized high yield securities. During each of the 2004 quarterly reviews, it was determined that an adverse change in estimated cash flows had occurred for these securities. The investment was originally purchased as part of the Company’s below-investment-grade strategy. At the time of the initial impairment loss, these securities had been in an unrealized loss position for a period of greater than two years but less than three years. The circumstances of this impaired investment have no impact on other investments.
$5.2 million loss on securities issued by a U.S. based heavy construction company. The company has been struggling with a number of problem projects and is below plan in attaining new business. This continued financial stress culminated in the company’s failure to make its monthly interest payment for June 2004. These bonds are secured by a number of real estate properties. These securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the third quarter of 2002. At the time of the write-down, these securities had been continuously in an unrealized loss position for a period of greater than two years but less than three years. The circumstances of this impaired investment have no impact on other investments.
$18.1 million loss on securities issued by a Norwegian based energy services company engaged in offshore seismic surveying and floating production. The impairment loss was taken after further analysis of available information indicated the company’s lack of near term liquidity and that overall industry conditions in the energy sector had negatively affected the operations more than previous analysis had indicated. The securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the third quarter of 2002. At the time of the impairment loss, these securities had been continuously in an unrealized loss position for a period of greater than three years. The circumstances of this impaired investment have no impact on other investments.
$14.4 million loss on securities issued by a United Kingdom electrical generation subsidiary of a U.S. based company. Although this industry’s operating environment in the U.K. weakened over the past few years due to competitive pricing pressures, the company had benefited from a favorable, long-term power sales agreement with a large, investment-grade U.K. power customer. Depressed electricity prices in the merchant power market and operating problems at the company, as well as financial difficulties experienced by the company’s U.K. power customer, contributed to a weakened financial profile. In October 2002, the financial problems associated with the major U.K. customer resulted in the termination of the favorable power contract. The company made its December 2002 interest payments as scheduled. However, due to discussions that were initiated between the issuer and senior lenders in the first quarter of 2003 and the continued weakness in the U.K. power market, it was determined that this investment was other than temporarily impaired. The securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the fourth quarter of 2001. Prior to its impairment loss, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The Company also owns securities in the previously mentioned U.K. power customer of this issuer and previously recorded an impairment loss on those securities in the fourth quarter of 2002.
$11.3 million loss on securities issued by a regulated natural gas pipeline company located in Argentina. The impairment loss was taken following continued delays by the Argentine government in implementing tariff reform and the company’s default on its interest payment due during the second quarter. These securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the second quarter of 2001. At the time of the impairment loss, these securities had been continuously in an unrealized loss position for a period of greater than two years but less than three years. The circumstances of this impaired investment have no impact on other investments.
$11.1 million loss on securities issued by a leading producer of performance products for the automotive industry and nylon fibers for the carpet industry. The securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the first quarter of 2002. The issuer was current on its interest payments as of September 30, 2003, but filed for bankruptcy in December 2003, despite having implemented several successful measures which improved liquidity and reduced potential legal liabilities. At the time of the impairment loss, these securities had been continuously in an unrealized loss position for a period of greater than 1 year but less than two years. The circumstances of this impaired investment have no impact on other investments.
For the year ended December 31, 2005, the Company realized a loss of $76.6 million on the sale of fixed maturity securities. The securities sold during the year had a book value of $919.4 million and a fair value of $842.8 million at the time of sale and represented 85 different issuers. Circumstances surrounding larger realized investment losses from sale of securities are as follows:
$9.8 million loss on securities linked to the credit of two major U.S. based airlines. These securities were trust certificates secured by leases on aircraft that were subleased to the two airlines, one of which is currently in bankruptcy. The risk of a potential restructuring of the securities had increased following the continued delay in the bankrupt airline’s plans to emerge from bankruptcy. These securities had an investment-grade rating until downgraded to below-investment-grade in the first quarter of 2003. At the time of sale, these securities had been continuously in an unrealized loss position for a period of greater than 2 years but less than 3 years. The circumstances of this investment have no impact on other investments.
For the year ended December 31, 2004, the Company realized a loss of $53.0 million on the sale of fixed maturity securities in its continuing operations. The securities sold during the year had a book value of $604.6 million and a fair value of $551.6 million at the time of sale and represented 67 different issuers. Circumstances surrounding larger realized investment losses from sale of securities are as follows:
$5.3 million loss on securities issued by an international reinsurance provider. The company was negatively impacted after it was determined it had failed to adequately reserve for projected claims. The company’s financial strength ratings were subsequently downgraded by Standard & Poor’s Corporation and A.M. Best Company. These securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the third quarter of 2004. At the time of sale, these securities had been continuously in an unrealized loss position for a period of less than ninety days. The circumstances of this investment have no impact on other investments.
Realized Investment Losses during 2003 from Sale of Fixed Maturity Securities
$28.1 million loss on securities issued by a leading producer of performance products for the automotive industry and nylon fibers for the carpet industry. The company’s operations had been severely impacted by the increased price of raw materials and energy as well as a weakening demand for its products. In addition, the company was involved in an environmental pollution lawsuit with a potentially large negative impact. These securities had an investment-grade rating until downgraded to below-investment-grade in the first quarter of 2002. At the time of sale, the investment had been continuously in an unrealized loss position for a period of greater than three years. The circumstances of this investment have no impact on other investments.
$15.2 million loss on securities issued by a major domestic airline. The Company has systematically sold the securities during the first nine months of 2003 to substantially reduce its exposure to the airline. These securities had an investment-grade rating until the various issues were downgraded to below-investment-grade in the third quarter of 2001 and the first quarter of 2002. At the time of sale, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The Company also took an other than temporary impairment charge of $0.3 million on the value of certain private, secured debt obligations of this issuer as part of a consensual restructuring proposal.
$11.1 million loss on unsecured debt and private, secured debt obligations issued by a major domestic airline. The Company sold the securities to reduce its exposure to the airline. These securities had an investment-grade rating until downgraded in the third quarter of 2001. At the time of sale, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The circumstances of this investment have no impact on other investments.
$9.2 million loss on securities issued by a provider of phone, cable, and internet services. This company’s operations were severely impacted by the decline in the telecommunications market and thus, the decision was made to reduce the exposure to this company. These securities were originally purchased as part of the Company’s below-investment-grade strategy. At the time of sale, this security had been continuously in an unrealized loss position for a period of greater than three years. The circumstances of this investment have no impact on other investments.
The following table provides the distribution of invested assets for the periods indicated. Ceded policy loans of $3.0 billion as of December 31, 2005 and $2.9 billion as of December 31, 2004, which are reported on a gross basis in the consolidated statements of financial condition contained herein in Item 8, are excluded from the table below. The investment income on these ceded policy loans is not included in income.
Fixed maturity securities at December 31, 2005, included $34.7 billion, or 99.6 percent, of bonds and derivative instruments and $155.4 million, or 0.4 percent, of redeemable preferred stocks. The following table shows the fair value composition by internal industry classification of the fixed maturity bond portfolio and the associated unrealized gains and losses.
Of the $431.3 million in gross unrealized losses at December 31, 2005, $343.5 million, or 79.6 percent, are related to investment-grade fixed maturity bonds. The following table shows the length of time the Company’s investment-grade fixed maturity bonds had been in a gross unrealized loss position as of December 31, 2005.
For those fixed maturity securities with an unrealized loss and on which the Company has not recorded an impairment loss, the Company believes that the decline in fair value below amortized cost is temporary. The Company has the ability to hold its securities to the earlier of recovery or maturity and intends to hold all of its fixed maturity investments until maturity to meet its liability obligations. If information becomes available that changes the Company’s assessment as to whether the Company will receive contractual payments related to a fixed maturity security and the security is also not projected to recover in value, the related security is generally sold. The Company may also in certain circumstances sell a security in an unrealized loss position because of changes in tax laws, when a merger or the disposition of a segment or product line results in position levels outside of the Company’s investment guidelines, due to changes in regulatory or capital requirements, due to unexpected changes in liquidity needs, to better match portfolio cash flows, or to take advantage of tender offers that recover up to or beyond the cost of the investment.
The fixed maturity bonds of the U.S. based automobile manufacturer are securities issued by the manufacturer and its captive finance subsidiary. The reduction in market value of these securities was primarily due to a decline in profitability and cash flow due to the competitive environment, loss of market share, high cost of raw materials, and rising employee healthcare and pension costs. The company recently announced several expense management initiatives that include plant closings, staffing reductions, and restructuring of employee healthcare and retiree benefits. The automotive company and the finance subsidiary both have substantial liquidity. The automotive company has approximately $25 billion in cash and equivalents compared to $18 billion of debt with an average maturity of 25 years. The finance subsidiary has approximately $18 billion in cash and equivalents. These securities have been in an unrealized loss position for greater than 270 days but less than one year, and the Company believes that the decline in fair value of these securities is temporary. The Company has the ability to hold these securities to the earlier of recovery or maturity.
The Company’s investment in mortgage-backed and asset-backed securities was approximately $4.2 billion and $3.8 billion on an amortized cost basis at December 31, 2005 and, 2004, respectively. At December 31, 2005, the mortgage-backed securities had an average life of 7.9 years and effective duration of 4.5 years. The mortgage-backed and asset-backed securities are valued on a monthly basis using valuations supplied by the brokerage firms that are dealers in these securities. The primary risk involved in investing in mortgage-backed securities is the uncertainty of the timing of cash flows from the underlying loans due to prepayment of principal with the possibility of reinvesting the funds in a lower interest rate environment. The Company uses models which incorporate economic variables and possible future interest rate scenarios to predict future prepayment rates. The Company has not invested in mortgage-backed derivatives, such as interest-only, principal-only or residuals, where market values can be highly volatile relative to changes in interest rates.
The Company’s mortgage loan portfolio was $739.4 million and $498.2 million on an amortized cost basis at December 31, 2005 and 2004, respectively. The Company believes its mortgage loan portfolio is well diversified geographically and among property types. The incidence of problem mortgage loans and foreclosure activity remains low, and management expects the level of delinquencies and problem loans to remain low in the future. The Company had no restructured or delinquent mortgage loans at December 31, 2005 or 2004.
The Company invested in commercial mortgage loans during 2005 and expects that during 2006 it will continue to add investments in this category either through the secondary market or through loan originations.
The Company uses a comprehensive rating system to evaluate the investment and credit risk of each mortgage loan and to identify specific properties for inspection and reevaluation. The Company establishes an investment valuation allowance for mortgage loans based on a review of individual loans and the overall loan portfolio, considering the value of the underlying collateral. Investment valuation allowances for real estate held for sale are established based on a review of specific assets. If a decline in value of a mortgage loan or real estate investment is considered to be other than temporary or if the asset is deemed permanently impaired, the investment is reduced to estimated net realizable value, and the reduction is recognized as a realized investment loss. Management monitors the risk associated with these invested asset portfolios and regularly reviews and adjusts the investment valuation allowance. At December 31, 2005, the balance in the valuation allowances for real estate was $7.6 million. No valuation allowance was held for mortgage loans at December 31, 2005.
Almost all hedging transactions involving product portfolios are associated with the individual and group long-term care and the individual and group income protection products. All other product portfolios are periodically reviewed to determine if hedging strategies would be appropriate for risk management purposes.
The Company’s current credit exposure on derivatives, which is limited to the value of those contracts in a net gain position, was $63.4 million at December 31, 2005. Additions and terminations, in notional amounts, to the Company’s hedging programs during 2005 were $1,269.4 million and $1,458.8 million, respectively. Additions and terminations in 2004 were $1,706.6 million and $911.9 million, respectively. Additions and terminations include roll activity, which is the closing out of an old contract and initiation of a new one when a contract is about to
The Company’s exposure to non-current investments totaled $29.5 million at December 31, 2005, or 0.1 percent of invested assets excluding ceded policy loans, compared to $91.5 million at December 31, 2004. Non-current investments are those investments for which principal and/or interest payments are more than thirty days past due. At December 31, 2005 these investments, which are subject to the same review and monitoring procedures in place for other investments in determining when a decline in fair value is other than temporary, consisted of fixed maturity securities for which before-tax impairment losses of approximately $107.6 million had been recorded life-to-date. The amortized cost of these investments was $5.7 million. Approximately $28.8 million of the fixed maturity securities, on a fair value basis, had principal and/or interest payments past due for a period greater than one year.
The Company has an investment program wherein it simultaneously enters into repurchase agreement transactions and reverse repurchase agreement transactions with the same party. The Company nets the related receivables and payables in the consolidated statements of financial condition as these transactions meet the requirements for the right of offset. As of December 31, 2005, the Company had $729.7 million face value of these agreements in an open position that were offset. The Company also uses the repurchase agreement market as a source of short-term financing. The Company had no contracts for this purpose outstanding at December 31, 2005.
Cash flow could also be negatively impacted by a deterioration in the credit market whereby the Company’s ability to liquidate its positions in certain of its fixed maturity securities would be impacted such that the Company might not be able to dispose of these investments in a timely manner. The Company believes its cash resources are sufficient to meet its liquidity requirements for the next twelve months.
Operating cash flows are primarily attributable to the receipt of premium and investment income, offset by payments of claims, commissions, expenses, and income taxes. Premium income growth is dependent not only on new sales, but on renewals of existing business, renewal price increases, and stable persistency. Investment income growth is dependent on the growth in the underlying assets supporting the Company’s insurance reserves and on the level of portfolio yield rates. Increases in commissions and operating expenses are attributable primarily to new sales growth and the first year acquisition expenses associated with new business. The level of paid claims is due partially to the growth and aging of the block of business and also to the general economy, as previously discussed in the operating results by segment.
Investing cash inflows consist primarily of the proceeds from the sales and maturities of investments. Investing cash outflows consist primarily of payments for purchases of investments. Net cash used in investing activities was $1,633.3 million for the year ended December 31, 2005 compared to $919.7 million and $2,107.9 million for the comparable periods of 2004 and 2003, respectively. The Company generated $575.1 million less in proceeds from maturities of available-for-sale securities in 2005 than in 2004, primarily due to a decrease in principal prepayments on mortgage-backed securities and bond calls. The Company utilized short-term investments during 2004 in anticipation of the cash to be transferred in conjunction with the reinsurance transaction related to the individual income protection - closed block restructuring. The Company generated less in proceeds from maturities of available-for-sale securities in 2004 than in 2003, primarily due to a decrease in principal prepayments on mortgage-backed securities and bond calls during 2004. The Company received less in proceeds from sales of available-for-sale securities during 2004 compared to 2003 due to the Company’s sales and subsequent purchases during 2003 related to the reduction and restructuring of its below-investment-grade portfolio.
During 2005, the Company had cash inflows of $8.8 million related to the sale of Unum Limited’s Netherlands branch and cash outflows of $3.5 million related to the GENEX acquisition of Independent Review Services, Inc.
Financing cash flows consist primarily of borrowings and repayments of debt, issuance or repurchase of common stock, and dividends paid to stockholders. Net cash provided by financing activities was $71.0 million for 2005 compared to $181.9 million and $734.8 million provided in 2004 and 2003, respectively.
The Company’s combined offering in May 2003 provided $575.0 million in proceeds from the issuance of long-term debt, less underwriting discounts of $17.2 million, and $547.7 million in net proceeds from the issuance of common stock. These proceeds were used primarily to increase the capitalization of the Company’s insurance subsidiaries and to repay amounts loaned to the Company from its insurance subsidiaries. During 2003, the Company reduced short-term debt $235.0 million by repayment of reverse repurchase agreements and $20.0 million by repayment of the current portion of the medium-term notes.
See “Debt” as follows for further information on the Company’s debt offerings.
The payment of ordinary dividends to the Company from its insurance subsidiaries is further limited to the amount of statutory surplus as it relates to policyholders. Based on the restrictions under current law, during 2006, $621.4 million is available for the payment of ordinary dividends to the Company from its U.S. insurance subsidiaries.
The ability of the Company to continue to receive dividends from its insurance subsidiaries without regulatory approval will be dependent upon the level of earnings of its insurance subsidiaries as calculated under law. In addition to regulatory restrictions, the amount of dividends that will be paid by insurance subsidiaries will depend on additional factors, such as risk-based capital ratios, funding growth objectives at an affiliate level, and maintaining appropriate capital adequacy ratios to support the ratings desired by the Company. Insurance regulatory restrictions do not limit the amount of dividends available for distribution to the Company from its non-insurance subsidiaries except where the non-insurance subsidiaries are held directly or indirectly by an insurance subsidiary and only indirectly by the Company. The Company’s risk-based capital (RBC) ratio for its U.S. insurance subsidiaries, calculated on a weighted average basis using the NAIC Company Action Level formula, was 308 percent and 298 percent at the end of 2005 and 2004, respectively. The individual RBC ratios for the Company’s principal operating subsidiaries ranged from 234 percent to 447 percent at December 31, 2005. The individual RBC ratio for each insurance subsidiary is above the range that would require state regulatory action.
At December 31, 2005, the Company had long-term debt, including the adjustable conversion-rate equity security units and the junior subordinated debt securities, totaling $3,261.6 million. At December 31, 2005, the debt to total capital ratio was 35.0 percent compared to 35.2 percent at December 31, 2004. The debt to total capital ratio, when calculated allowing no equity credit for the Company’s junior subordinated debt securities and 50 percent equity credit for the Company’s adjustable conversion-rate equity security units, was 30.3 percent at December 31, 2005, compared to 30.2 percent at December 31, 2004.
In May 2004, the Company issued 12.0 million 8.25% adjustable conversion-rate equity security units (units) in a private offering for $300.0 million. The Company subsequently registered the privately placed securities for resale by the private investors. Each unit has a stated amount of $25 and will initially consist of (a) a contract pursuant to which the holder agrees to purchase, for $25, shares of the Company’s common stock on May 15, 2007 and which entitles the holder to contract adjustment payments at the annual rate of 3.165 percent, payable quarterly, and (b) a 1/40 or 2.5 percent ownership interest in a senior note issued by the Company due May 15, 2009 with a principal amount of $1,000, on which the Company will pay interest at the initial annual rate of 5.085 percent, payable quarterly. Upon settlement of the common stock purchase contract and successful remarketing of the senior note element of the units, the Company will receive proceeds of approximately $300.0 million and will issue between 17.7 million and 20.4 million shares of common stock.
In May 2003, the Company issued 23.0 million 8.25% adjustable conversion-rate equity security units (units) in a public offering for $575.0 million. Each unit has a stated amount of $25 and will initially consist of (a) a contract pursuant to which the holder agrees to purchase, for $25, shares of the Company’s common stock on May 15, 2006 and which entitles the holder to contract adjustment payments at the annual rate of 2.25 percent, payable quarterly, and (b) a 1/40, or 2.5 percent, ownership interest in a senior note issued by the Company due May 15, 2008 with a principal amount of $1,000, on which the Company will pay interest at the initial annual rate of 6.00 percent, payable quarterly. Upon settlement of the common stock purchase contract and successful remarketing of the senior note element of the units, the Company will receive proceeds of approximately $575.0 million and will issue between 43.3 million and 52.9 million shares of common stock. The scheduled remarketing of the senior note element of these units occurred in February 2006, as stipulated by the terms of the original offering, and the
In 2001, the Company issued $575.0 million of 7.625% senior notes due March 1, 2011. In 2002, the Company completed two long-term offerings, issuing $250.0 million of 7.375% senior debentures due June 15, 2032 and $150.0 million of 7.250% public income notes due June 15, 2032. The public income notes are redeemable at the Company’s option, in whole or in part, on or after June 25, 2007. In 1998, the Company completed public offerings of $200.0 million of 7.25% senior notes due March 15, 2028, $200.0 million of 7.0% senior notes due July 15, 2018, and $250.0 million of 6.75% senior notes due December 15, 2028.
Contractual debt, junior subordinated debt securities, adjustable conversion-rate equity security units, estimated policyholder liability maturities, and estimated lease commitments are as follows (in millions of dollars):
The Company’s policyholder liability maturities, which are presented net of reinsurance ceded, represent the projected payout of the current inforce policyholder liabilities and therefore incorporate uncertainties as to the timing and amount of claim payments. The Company utilizes extensive liability modeling to project future cash flows from the inforce business. The primary assumptions used to project future cash flows are claim incidence rates for mortality and morbidity, claim resolution rates, persistency rates, and interest rates. These cash flows are discounted to determine the current value of the projected claim payments. The timing and amount of payments on policyholder liabilities may vary significantly from the projections above. See previous discussion of asset/liability management under “Investments - Overview” contained here.
During 2005, the Company recorded an expense of $9.1 million to recognize a termination fee, payable in the first quarter of 2006, to exit an existing contract with an information technology provider. The Company has entered into an agreement with a new provider which is expected to result in a significantly less costly infrastructure.
A.M. Best Company (AM Best), Fitch Ratings (Fitch), Moody’s Investors Service (Moody’s), and Standard & Poor’s Corporation (S&P) are among the third parties that rate the Company’s senior debt and the financial strength of the Company’s principal U.S. insurance subsidiaries. Financial strength ratings are based primarily on U.S. statutory financial information for the individual U.S. domiciled insurance companies and reflect the rating agency’s view of the overall financial strength (capital levels, earnings, growth, investments, business mix, operating performance, and market position) of that insuring entity and its ability to meet its obligations to policyholders. Debt ratings represent the opinions of the rating agencies regarding an issuer’s ability to repay its debt and are based primarily on consolidated financial information prepared using generally accepted accounting principles. Both financial strength ratings and debt ratings incorporate qualitative analyses by rating agencies on an ongoing basis.
The Company competes based in part on the financial strength ratings provided by rating agencies. A downgrade of the Company’s financial strength ratings can be expected to adversely affect the Company. A downgrade of the financial strength ratings could, among other things, adversely affect the Company’s relationships with distributors of its products and services and retention of its sales force, negatively impact persistency and new sales, particularly large case group sales and individual sales, and generally adversely affect the Company’s ability to compete. Downgrades in the Company’s debt ratings can be expected to adversely affect the Company’s ability to raise capital or its cost of capital.
In November 2004, AM Best reaffirmed the Company’s ratings and commented that it would be closely monitoring the Company’s operations as to the impact of the multistate market conduct regulatory settlement. In this regard it noted that California conducted a separate examination and that there could be fines or remediation costs in addition to the charge announced by the Company in connection with the multistate settlement. AM Best stated that the maintenance of the Company’s current ratings reflected the agency’s expectation that several key financial and operational measures would be maintained.
After-tax operating earnings in 2005 (excluding special charges) of $500 million on a GAAP basis and at least $375 million on a statutory basis.
The BCAR is maintained by AM Best and has not yet been provided to the Company; however, the Company believes that its BCAR will be at least 150 percent for the year ended 2005.
The Company’s RBC for its U.S. insurance subsidiaries, calculated on a weighted average basis, was 308 percent at the end of 2005.
At December 31, 2005, cash at the holding company was approximately $610.0 million, of which $402.7 million was used to participate in the remarketing of the units. The remainder is adequate to cover the required interest and dividend obligations.
For 2005, persistency in group long-term income protection was 84.8 percent, consistent with the prior year. The profitability of the business terminated was generally lower than the profitability of the retained business. It is expected that the additional premium and related profits associated with renewal activity will continue to emerge.
AM Best reaffirmed the Company’s ratings subsequent to the Company’s 2005 settlement agreement with the California DOI.
negative outlook. This rating action concluded the review for possible downgrade that began in November 2004. In October 2005, Moody’s reaffirmed the ratings of the Company following the announcement of the settlement agreement with the California DOI. In November 2005, Moody’s assigned a Ba1 rating to the $400.0 million 6.85% senior debentures and reaffirmed the financial strength ratings of the Company’s insurance subsidiaries.
See “Ratings” in Part 1, Item 1 and “Risk Factors - Debt and Financial Strength Ratings” in Part 1, Item 1A, contained herein for further discussion.
The Company sponsors several defined benefit pension and postretirement plans for its employees, including non-qualified pension plans. The U.S. pension plans comprise the majority of the total benefit obligation and pension expense for the Company. The value of the benefit obligations is determined based on a set of economic and demographic assumptions that represent the Company’s best estimate of future expected experience. These assumptions are reviewed annually. Two of the economic assumptions, the discount rate and the long-term rate of return, are adjusted accordingly based on key external indices. The Company follows Statements of Financial Accounting Standards No. 87 (SFAS 87), Employers’ Accounting for Pensions, No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions, and No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits in its financial reporting and accounting for its pension and post-retirement benefit plans.
The assumptions chosen for U.S. pension plans and the U.S. postretirement plan use consistent methodology but reflect the differences in the plan obligations. The Company uses a December 31 measurement date for each plan.
The Company holds an unrecognized net loss representing the cumulative liability and asset gains and losses that have not been recognized in pension expense. As of December 31, 2005, there was an estimated unrecognized loss of approximately $363.9 million in the U.S. pension plans, compared to $318.2 million at December 31, 2004. The unrecognized loss has increased due to the decline in the year end discount rate from 6.05 percent at 2004 to 5.80 percent at 2005 and because the rate of return on assets was 4.90 percent in 2005 compared to an assumed rate of return of 8.50 percent. The unrecognized net loss is amortized as a component of pension expense. Only amounts outside of a corridor (equal to 10 percent of the greater of the projected benefit obligation or market related value of assets) are amortized. The 2006 pension expense is expected to include a loss amortization of approximately $22.4 million. This loss amortization was $19.2 million, $16.0 million, and $18.0 million in 2005, 2004, and 2003, respectively.
The fair value of plan assets in the U.S. qualified defined benefit pension plan was $515.4 million at December 31, 2005, compared to $478.1 million at year end 2004. In recent years, the moderate increase in assets, coupled with the liability increase due to declining discount rates, has reduced the year end funding level in the plan such that it has a deficit of $246.1 million as of December 31, 2005, compared to $176.5 million as of December 31, 2004. The Company had no regulatory contribution requirements for 2005 and 2004; however, the Company elected to make voluntary contributions of $23.0 million and $20.0 million, respectively, to its U.S. qualified defined benefit pension plan. The Company expects to make a voluntary contribution of approximately $42.0 million to its U.S. qualified defined benefit pension plan in 2006, based on current tax law.
The long-term rate of return on asset assumption used in the net periodic pension costs for 2006 and 2005 was 6.70 percent and 7.10 percent, respectively.
The Company previously maintained separate defined benefit plans for the employees of its Canadian branch operation. As a result of the sale of the Canadian branch, the Company froze the Canadian defined benefit pension plans during 2004 and recorded a curtailment loss of $0.7 million. The Company is currently in the process of terminating the Canadian plans.
REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM, ON INTERNAL CONTROL OVER FINANCIAL REPORTING
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that UnumProvident Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). UnumProvident Corporation and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We have audited the accompanying consolidated statements of financial condition of UnumProvident Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
During 2004, the Company completed the sale of its Canadian branch. Financial results for the Canadian branch are reported as discontinued operations in the consolidated financial statements, and, except where noted, the information presented in the notes to consolidated financial statements excludes the Canadian branch. See Note 2 for further discussion of the Company’s discontinued operations.
Description of Business: The Company is the largest provider of group and individual income protection products in the United States and the United Kingdom. It also provides a complementary portfolio of other insurance products, including long-term care insurance, life insurance, employer- and employee-paid group benefits, and related services. It markets its products primarily to employers interested in providing benefits to their employees. The Company has three major business segments: U.S. Brokerage, Unum Limited, and Colonial, as well as the Individual Income Protection - Closed Block segment, Other segment, and Corporate segment. See Note 14 for further discussion of the operating segments.
Real Estate classified as investment real estate is carried at cost less accumulated depreciation. Real estate acquired through foreclosure is valued at fair value at the date of foreclosure. If investment real estate is determined to be other than temporarily impaired, the carrying amount of the asset is reduced to fair value. Occasionally, investment real estate is reclassified to real estate held for sale when it no longer meets the Company’s investment criteria. Real estate held for sale is valued net of a valuation allowance that reduces the carrying value to the lower of cost less accumulated depreciation or fair value less estimated cost to sell. Accumulated depreciation on real estate was $9.3 million and $14.1 million as of December 31, 2005 and 2004, respectively.
Other Long-term Investments are carried at cost plus the Company’s share of changes in the investee’s ownership equity since acquisition.
Derivative Financial Instruments: The Company recognizes all of its derivative instruments (including certain derivative instruments embedded in other contracts) as either assets or liabilities in the consolidated statements of financial condition and measures those instruments at fair value.
Gains or losses on the termination of ineffective hedges are reported in current earnings. In the event a hedged item is disposed of or the anticipated transaction being hedged is no longer likely to occur, the Company will terminate the related derivative and recognize the gain or loss on termination in current earnings.
Loss recognition is generally performed on an annual basis. Insurance contracts are grouped on a basis consistent with the Company’s manner of acquiring, servicing, and measuring profitability of the contracts. If loss recognition testing indicates that deferred policy acquisition costs are not recoverable, the deficiency is charged to expense. The assumptions used in loss recognition testing represent management’s best estimates of future experience.
The following table provides the changes in deferred policy acquisition costs:
Value of Business Acquired: Value of business acquired represents the present value of future profits recorded in connection with the acquisition of a block of insurance policies. The asset is amortized based upon expected future premium income for traditional insurance policies and estimated future gross profits for interest-sensitive insurance policies, with the accrual of interest added to the unamortized balance at interest rates principally ranging from 5.05 percent to 6.00 percent. The accumulated amortization for value of business acquired was $83.8 million and $75.6 million as of December 31, 2005 and 2004, respectively. The Company periodically reviews the carrying amount of value of business acquired using the same methods used to evaluate deferred policy acquisition costs.
Property and Equipment: Property and equipment is reported at cost less accumulated depreciation, which is calculated on the straight-line method over the estimated useful life. The accumulated depreciation for property and equipment was $477.3 million and $468.6 million as of December 31, 2005 and 2004, respectively.
Disabled lives reserves for future policy and contract benefits on disability policies are calculated based upon assumptions as to interest and claim resolution rates that are currently appropriate. Claim resolution rate assumptions are based on Company experience. The interest rate assumptions used for discounting claim reserves are based on projected portfolio yield rates, after consideration for defaults and investment expenses, for the assets supporting the liabilities for the various product lines. The assets for each product line are selected according to the specific investment strategy for that product line to produce asset cash flows that follow similar timing and amount patterns to those of the anticipated liability payments.
Effective January 1, 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation, and selected the prospective method of adoption allowed under the provisions of Statement of Financial Accounting Standards No. 148 (SFAS 148), Accounting for Stock-Based Compensation - Transition and Disclosure. The recognition provisions were applied to all employee awards granted, modified, or settled after January 1, 2003. Prior to 2003, the Company accounted for various stock-based employee compensation plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25 (Opinion 25), Accounting for Stock Issued to Employees, and related Interpretations.
Had the Company applied the fair value recognition provisions of SFAS 123 as of its original effective date, pro forma net income (loss) and net income (loss) per share would be as follows:
Effective October 1, 2003, the Company adopted the provisions of Statement of Financial Accounting Standards No. 133 Implementation Issue B36 (DIG Issue B36), Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposure That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor Under Those Instruments. DIG Issue B36 addresses financial accounting and reporting for embedded derivatives in modified coinsurance contracts that incorporate credit risk exposure unrelated to the credit risk of the counterparty to the reinsurance contract and requires the bifurcation of any such derivative from the host reinsurance contract. The Company had two reinsurance contracts for which DIG Issue B36 was applicable, one of which was recaptured in 2005.
Statement of Financial Accounting Standards No. 123 (revised 2004) (SFAS 123(R)), Share-Based Payment, requires all stock-based employee compensation, including grants of employee stock options, to be recognized in the financial statements using the fair value based method. SFAS 123(R) is a revision of SFAS 123 and supersedes Opinion 25. The Company will adopt the provisions of SFAS 123(R) effective January 1, 2006. Because the Company adopted the fair value recognition provision of SFAS 123 effective January 1, 2003, the adoption of this pronouncement will have an immaterial effect on the Company’s financial position and results of operations.
Compensation costs for awards subject to accelerated vesting upon retirement are currently recognized over the explicit service period (subject to acceleration upon an employee’s actual retirement). The Company will continue to apply this accounting policy to share-based awards issued prior to January 1, 2006 and will apply SFAS 123(R) to awards issued after that date. The effect on the Company’s financial position and results of operations, had these costs had been recognized over the period to the date the employee first became eligible to retire, is immaterial.
Financial Accounting Standards Board Staff Position No. FAS 115-1 (FSP 115-1), The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, addresses the determination of when an investment is considered impaired, whether the impairment is other than temporary, and the measurement of an impairment loss. FSP 115-1 also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses. The Company will adopt the provisions of FSP 115-1 effective January 1, 2006. The adoption of this pronouncement will not have a material effect on the Company’s financial position or results of operations.
During 2003, the Company entered into an agreement to sell its Canadian branch. In conjunction with the classification of the Canadian branch as an asset held for sale, the Company tested the goodwill related to the Canadian branch for impairment and determined that the balance of $190.9 million was impaired. The Company also recognized a loss of $9.3 million before tax and $6.0 million after tax to write down the value of bonds in the Canadian branch investment portfolio to market value. These two charges, which total $196.9 million after tax, were included in the 2003 loss from discontinued operations. The Company recognized an additional loss of $0.6 million before tax and $0.4 million after tax in the first quarter of 2004 to further write down the value of bonds in the Canadian branch investment portfolio to market value. The transaction closed April 30, 2004, and in the second quarter of 2004, the Company recognized a loss of $113.0 million before tax and $70.9 million after tax on the sale of the branch.
Fair values for insurance contracts other than investment contracts are not required to be disclosed. However, the fair values of liabilities under all insurance contracts are taken into consideration in the Company’s overall management of interest rate risk, which minimizes exposure to changing interest rates through the matching of investment maturities with amounts due under insurance contracts.
The carrying amounts and fair values of the Company’s financial instruments are presented as follows.
The gross unrealized loss on below-investment-grade fixed maturity bonds (securities rated below Baa3 by Moody’s Investors Service or an equivalent internal rating) was $87.8 million at December 31, 2005, or 20.4 percent, of the total gross unrealized loss on fixed maturity bonds. Generally, below-investment-grade fixed maturity securities are more likely to develop credit concerns.
The Company has four special purpose entities which support the Company’s investment objectives and which are consolidated under the provisions of Interpretation No. 46 (FIN 46(R)), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51. These entities are securitized asset trusts and contain specific financial instruments that do not include the Company’s common stock or debt. Three of these entities are trusts holding forward contracts to purchase unrelated equity securities. Each of these trusts also holds a defeasance swap contract for highly rated bonds to provide principal protection for the investments. The fair values of the underlying forward and swap contracts equaled $153.1 million as of December 31, 2005, and are reported as fixed maturity securities in the consolidated statements of financial condition. The fourth entity is a trust containing a highly rated bond for principal protection, unrelated equity securities, and several partnership equity investments. The Company contributed the bond and partnership investments into the trust at the time it was established. The purpose of this trust was to allow the Company to maintain its investment in the partnerships while at the same time protecting the principal of the investment. The fair values of the bond, equity securities, and partnerships were $78.0 million, $10.3 million, and $46.1 million, respectively, as of December 31, 2005.
The Company has a significant investment in, but is not the primary beneficiary of, a special purpose entity which is a collateralized bond obligation asset trust (CBO) in which the Company holds interests in several of the tranches and for which the Company acts as investment manager of the underlying securities. This special purpose entity does not meet the consolidation requirements of FIN 46(R). The Company issued the CBO in 1998, and its purpose is to securitize high yield bonds and earn a spread over the cost of the funds from the different tranches issued. The outstanding balance of all tranches was $178.2 million at December 31, 2005, of which third parties hold $126.3 million. These third parties have no recourse against the Company. The total value of the CBO assets is $117.3 million at December 31, 2005. The Company’s maximum exposure to loss for the fixed maturity securities is $21.5 million at December 31, 2005.
Deposit assets in the form of marketable securities held in trust for certain reinsurance contracts are reported in miscellaneous assets in the consolidated statements of financial condition. Under the provisions of DIG Issue B36, the net unrealized gain is attributed to the value of the embedded derivative and is reported as such in fixed maturity securities.
Mortgage loans are impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. The Company had no impaired mortgage loans at December 31, 2005 or 2004.
At December 31, 2005, the Company had capital commitments of approximately $58.0 million for commercial mortgage loan originations. The funds will be due at closing of the mortgage loans.
At December 31, 2005 and 2004 the Company had real estate investment allowances totaling $7.6 million and $9.3 million, respectively. Deductions for allowances released upon disposal or restructuring totaled $1.7 million in 2005 and $10.6 million in 2003. There were no deductions in 2004 and no additions in 2005, 2004, and 2003.
There were no additional investment valuation allowances at December 31, 2005 and 2004.
The following table summarizes the timing of anticipated settlements of interest rate swaps outstanding at December 31, 2005, whereby the Company receives a fixed rate and pays a variable rate. The weighted average interest rates assume current market conditions.
The Company’s freestanding derivatives all qualify as hedges and have been designated as cash flow hedges. The cash flow hedging programs are described as follows.
The Company has entered into an interest rate swap whereby it receives a fixed rate of interest and pays a variable rate of interest. The purpose of this swap is to hedge the variable cash flows associated with a floating rate security owned by the Company. The variable rate the Company pays on the swap is offset by the amount the Company receives on the variable rate security.
During 2005, the Company entered into a forward treasury lock which, by taking a long position, allowed the Company to lock in the interest rate on the future purchase of a specific U.S. Treasury bond. This derivative was identified as a cash flow hedge and was used to minimize the interest rate risk related to the purchase price of a certain fixed maturity security. Because the purchase price of the security was partially determined by the change in the interest rate of a specific twenty year U.S. Treasury bond, the forward treasury lock allowed the Company to hedge the projected cash flows associated with the purchase of the security. The Company terminated the treasury lock, for cash, at the time the security was purchased.
During 2005, the Company entered into a foreign currency forward contract whereby it will receive a fixed amount of U.S. dollars and pay a fixed amount of foreign currency. The purpose of this derivative is to hedge the variability of functional currency cash flows associated with the anticipated receipt of foreign currency proceeds from the settlement of a bankruptcy claim related to a fixed maturity security owned by the Company. The Company intends to terminate this derivative, for cash, at the time the bankruptcy claim proceeds are received.
During 2004 and 2003, the Company entered into certain foreign currency forward contracts whereby the Company agreed to pay its counterparty a specific Canadian dollar denominated notional amount in exchange for a specific U.S. dollar denominated notional amount. These derivatives were identified as cash flow hedges and were used to
As discussed in Note 1, effective October 1, 2003, the Company adopted the provisions of DIG Issue B36. The Company had two reinsurance contracts for which DIG Issue B36 was applicable, one of which was recaptured during 2005. Prior to recapture, the Company included in miscellaneous assets a deposit asset for the applicable reinsurance contract. At the time of recapture, the receivable in the deposit asset was settled, the derivative was terminated, and the assets were recorded using the market value of $1,621.7 million that existed on that date. The difference in the book value transferred out of the deposit asset account, which was $1,472.7 million, and the market value recorded equaled the embedded derivative market value component of $149.0 million. The time value component of $9.4 million was recognized as a realized investment loss. The fair value of the embedded derivative related to the remaining applicable reinsurance contract was $(6.2) million as of December 31, 2005. The change in fair value of DIG Issue B36 derivatives is reported as a realized investment gain or loss during the period of change.
During the years ended December 31, 2005, 2004, and 2003, the Company recognized net gains of $120.7 million, $29.1 million, and $79.6 million, respectively, on the termination of cash flow hedges and reported $121.0 million, $29.2 million, and $79.1 million, respectively, in other comprehensive income and $(0.3) million, $(0.1) million, and $0.5 million, respectively, as a component of realized investment gains and losses. The Company amortized $21.8 million of net deferred gains into net investment income during 2005, $20.7 million during 2004, and $17.3 million during 2003. The estimated amount of net deferred gains to be amortized into operating earnings during 2006 is $23.8 million.
During 2005, the Company acquired Independent Review Services, Inc., a provider of medical diagnostic networks and independent medical examinations, at a price of $3.5 million.
During 2003, the Company acquired the United Kingdom group income protection business of Sun Life Assurance Company of Canada (UK) Ltd, together with the renewal rights to the group life business. The amount attributable to value of business acquired on this block of business was $36.6 million.
During 2005, Unum Limited completed the sale of its Netherlands branch. The gain on the sale was $5.7 million before tax and $4.0 million after tax.
In 2003, the Company entered into an agreement to sell its wholly-owned subsidiary Unum Japan Accident Insurance Co., Ltd. The Company also entered into an agreement with the buyer to reinsure certain existing income protection business and had a continuing presence in the operation throughout 2004. Upon initially entering into the agreement in 2003, the Company recognized a before tax impairment loss of $1.2 million and an after tax gain of $6.0 million. The transaction closed in 2004, at which time the Company received $18.8 million and recorded a receivable of $4.7 million to be paid in 2006, net of indemnification claims, if any. At December 31, 2005, the Company estimated that approximately 75 percent of that amount would be received in 2006. The remainder of the balance of the receivable was expensed.
In 2003, the Company wrote down the book value of its Argentinean operation to the estimated fair value less cost to sell and at that time recognized an impairment loss of $13.5 million before tax and $11.3 million after tax. During 2004, the Company reduced its ownership position in this operation to 40 percent and reported a before-tax loss of $4.7 million and an after-tax gain of $2.7 million. In 2005, the Company disposed of its remaining 40 percent ownership position and recognized an after tax gain of $0.4 million.
During 2005, the Company implemented the procedural and organizational changes outlined in the multistate settlement agreements and resulting from other process improvement initiatives. Implementation of the procedural and organizational changes temporarily reduced the operating effectiveness of the Company’s U.S. Brokerage claims management performance. This resulted in an increase in the change in the provision during 2005 and 2004 for incurred claims and claim adjustment expenses related to prior years. The change in provision for 2005 also includes a portion of the reserve charge recorded in connection with the 2005 California Department of Insurance settlement agreement and related matters. The change in provision for 2004 includes a portion of the reserve charge recorded in conjunction with the 2004 multistate settlement agreements as well as the reserve strengthening for the individual income protection - closed block business. The net increase reported for 2003 includes the $894.0 million for the two reserve strengthenings related to the U.S. Brokerage group income protection business, all of which was related to prior year incurred claims. See further discussion as follows for the reserve strengthenings and Note 15 for further discussion of the settlement agreements.
In April 2003, the Company completed an analysis of its assumptions related to its U.S. Brokerage group long-term income protection claim reserves. Included in the analysis was a review of active claim reserves, incurred but not reported (IBNR) reserves, and claim reopen reserves. An active claim reserve is established for future benefit payments when a claim is incurred and reported to the Company. IBNR reserves are established on claims which are estimated to have been incurred but not yet reported to the Company. Claim reopen reserves are established for those claimants who have previously recovered but who are anticipated to return to disabled status under the same disability and within a specified period of time, as contractually allowed by the disability policy. The analysis was initiated based on lower claim resolution rates observed during the first quarter of 2003. The claim resolution rate is the rate of probability that a disability claimant will recover, die, or reach maximum benefit limits and no longer receive benefit payments from the Company. Generally, claim resolution rates vary by the age of the claimant at the time of disability, duration or length
The amount of the policyholders’ surplus accounts of the Company’s U.S. insurance subsidiaries at December 31, 2004, was approximately $228.8 million. Distributions made during 2005 by these life insurance subsidiaries, including dividend distributions, were deemed to occur first from the policyholders’ surplus accounts. As a result, the Company’s U.S. life insurance subsidiaries distributed as dividends the remaining balance of their policyholders’ surplus account to the holding company during 2005. This resulted in the elimination of a future potential tax of approximately $80.1 million which had not previously been provided for in current or deferred taxes because management considered the conditions under which such a tax would be paid to be remote.
During the first quarter of 2005, the Internal Revenue Service (IRS) completed its examination of tax years 1999 through 2001 and issued its revenue agent’s report (RAR) in April 2005. Income tax liabilities of approximately $32.0 million that related primarily to interest on the timing of expense deductions were released in the first quarter of 2005, all of which was reflected as a reduction to income tax expense. Subsequently, the Company paid the IRS for proposed adjustments for tax years 1999 through 2001 and recorded an income tax benefit of an additional $2.0 million, net of the payment, pertaining to the items paid. The Company will file claims for refund on disputed issues in the IRS report. The Company also recognized $3.0 million of net investment income as a result of refunds received from the IRS during the year. Additionally, in 2005, the Company recognized an income tax benefit of approximately $10.8 million in connection with the finalization of income tax reviews of the Company’s U.K. subsidiaries.
The Company is under continuous examination by the IRS and other tax authorities in areas wherein the Company has significant business operations. The current IRS examination covers the tax years 2002 through 2004. Management believes sufficient provision has been made for potential adjustments and that any future adjustment will not have a material adverse effect on the financial position, liquidity, or results of operations of the Company although the resolution of income tax matters could impact the Company’s effective tax rate for a particular future period.
At December 31, 2005, the Company had no short-term debt. At December 31, 2004, short-term debt consisted of $200.0 million for the 6.375% notes due in 2005 and $27.0 million for the portion of the Company’s medium-term notes due in 2005. The weighted average interest rate for the current portion of the medium-term notes outstanding during 2004 was 7.2 percent.
The 7.25% notes due 2032 are redeemable at the Company’s option on or after June 25, 2007. The remaining callable debt may be redeemed, in whole or in part, at any time. The aggregate contractual principle maturities are $575.0 million in 2008, $300.0 million in 2009, and $2,387.0 million in 2011 and thereafter.
In May 2003, the Company issued 23.0 million 8.25% adjustable conversion-rate equity security units (units) in a public offering for $575.0 million. Each unit has a stated amount of $25 and will initially consist of (a) a contract pursuant to which the holder agrees to purchase, for $25, shares of the Company’s common stock on May 15, 2006 and which entitles the holder to contract adjustment payments at the annual rate of 2.25 percent, payable quarterly, and (b) a 1/40, or 2.5 percent, ownership interest in a senior note issued by the Company due May 15, 2008 with a principal amount of $1,000, on which the Company will pay interest at the initial annual rate of 6.00 percent, payable quarterly. Upon settlement of the common stock purchase contract and successful remarketing of the senior note element of the units, the Company will receive proceeds of approximately $575.0 million and will issue between 43.3 million and 52.9 million shares of common stock. The present value of the quarterly contract adjustment payments, which is included in other liabilities in the consolidated statements of financial condition, and the related purchase contract issuance costs reduced additional paid-in capital by $37.4 million.
In 1998, Provident Financing Trust I (the trust) issued $300.0 million of 7.405% capital securities in a public offering. These capital securities, which mature on March 15, 2038, are fully and unconditionally guaranteed by the Company, have a liquidation value of $1,000 per capital security, and have a mandatory redemption feature under certain circumstances. The Company issued $300.0 million of 7.405% junior subordinated deferrable interest debentures which mature on March 15, 2038, to the trust in connection with the capital securities offering. The sole assets of the trust are the junior subordinated debt securities. In accordance with the provisions of FIN 46(R), the Company reports these securities as long-term debt in the consolidated statements of financial condition.
The Company has a shelf registration, which became effective in 2005, with the Securities and Exchange Commission to issue various types of securities, including common stock, preferred stock, debt securities, depository shares, stock purchase contracts, units and warrants, or preferred securities of wholly-owned finance trusts up to an aggregate of $1.0 billion. If utilized, the shelf registration will enable the Company to raise funds from the offering of any individual security covered by the shelf registration as well as any combination thereof, subject to market conditions and the Company’s capital needs.
The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets were $979.3 million, $843.4 million, and $607.5 million, respectively, as of December 31, 2005, and $857.9 million, $744.9 million, and $558.6 million, respectively, as of December 31, 2004.
A one percent increase or decrease in the assumed health care cost trend rate at December 31, 2005 would have increased (decreased) the service cost and interest cost by $1.2 million and $(1.1) million, respectively, and the postretirement benefit obligation by $8.1 million and $(9.7) million, respectively.
The Company’s funding policy for its U.S. qualified defined benefit plan is to contribute annually an amount at least equal to the minimum annual contribution required under the Employee Retirement Income Security Act and other applicable laws, but generally not greater than the maximum amount that can be deducted for federal income tax purposes. The Company had no regulatory contribution requirements for 2005 and 2004; however, the Company elected to make voluntary contributions of $23.0 million and $20.0 million, respectively. The Company expects to make a voluntary contribution of approximately $42.0 million to its U.S. qualified defined benefit pension plan in 2006, based on current pension funding law. The funding policy for the U.S. non-qualified defined benefit pension plan and postretirement plan is to contribute the amount of the benefit payments made during the year.
The Company also maintains a reserve for life insurance benefits payable to certain former retirees covered under the postretirement welfare plan. The expected return assumption for this reserve was 5.75 percent, which was based on full investment in fixed income securities with an average book yield of 6.56 percent and 6.72 percent for 2005 and 2004, respectively.
The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Medicare Act) was enacted in December 2003 to add a voluntary prescription drug benefit for Medicare-eligible retirees to be effective January 1, 2006. The Medicare Act allows an employer to choose whether to coordinate prescription drug benefits under a retiree medical plan with the Medicare prescription drug benefit or to keep the company plan design as it is and receive a subsidy from the federal government. The Company reviewed the options available as a result of Medicare reform and aligned the options, as appropriate, for each of its designated groups of retirees.
Based on a preliminary analysis conducted in 2004, the Company expected to qualify for the subsidy for retirees covered under prior Company plans and first reflected it in the 2004 net periodic benefit cost. For retiree groups who are covered by the current retiree medical plan design and active employees who meet certain age and service requirements, the Company amended its postretirement medical plan in 2004 to coordinate with the Medicare Act such that Medicare is the primary payer of prescription drug benefits. The Company also amended its postretirement medical plan in 2004 to eliminate the premium subsidy for employees who had not reached a minimum age of 45 and a specified minimum years of service requirement as of December 31, 2003.
During 2005 the Company confirmed, using final regulations issued by the Centers for Medicare & Medicaid Services on January 21, 2005, that all of its retiree medical plans would qualify for a government subsidy under the Medicare Act and chose to defer coordination with the new prescription drug benefit until 2007. For 2006, the Company will maintain its current retiree medical plans and expects to receive the government subsidy for all retirees. This change is reflected in the 2005 net periodic benefit cost.
The Company accounts for the effect on the number of weighted average common shares, assuming dilution, using the treasury stock method. As such, the purchase contract element of the Company’s adjustable conversion-rate equity security units (units), as described in Note 9, and the Company’s outstanding stock options, as described in Note 12, will have a dilutive effect only when the average market price of the Company’s common stock during the period exceeds the threshold appreciation price of the purchase contract element of the units or the exercise price of the stock options. The purchase contract elements of the Company’s units issued in 2004 and 2003 have a threshold appreciation price of $16.95 per share and $13.27 per share, respectively. The Company’s outstanding stock options and other dilutive securities have exercise prices ranging from $9.48 to $58.56.
Under the broad-based stock plan of 2001, the Company has available up to 2,000,000 shares of common stock for stock option awards to its employees, officers, consultants, and producers, excluding certain senior officers and directors. The stock options have a maximum term of ten years after the date of grant and generally vest after three years. At December 31, 2005, 437,500 shares were available for future grants.
In the normal course of business, the Company assumes reinsurance from and cedes reinsurance to other insurance companies. The primary purpose of ceded reinsurance is to limit losses from large exposures. However, if the assuming reinsurer is unable to meet its obligations, the Company remains contingently liable. The Company evaluates the financial condition of reinsurers and monitors concentration of credit risk to minimize this exposure. The Company may also require assets in trust, letters of credit, or other acceptable collateral to support reinsurance receivable balances.
The reinsurance receivable at December 31, 2005 relates to approximately 100 companies. Thirteen major companies account for approximately 91 percent of the reinsurance receivable at December 31, 2005, and are all companies rated A or better by A.M. Best Company or are fully securitized by letters of credit or investment-grade fixed maturity securities held in trust. Virtually all of the remaining nine percent of the reinsurance receivable relates to business reinsured either with companies rated A- or better by A.M. Best Company, with overseas entities with equivalent ratings or backed by letters of credit or trust agreements, or through reinsurance arrangements wherein the Company retains the assets in its general account. Less than one percent of the reinsurance receivable is held by companies either rated below A- by A.M. Best Company or not rated.
During 2004, the Company restructured its individual income protection - closed block business wherein three of its insurance subsidiaries entered into reinsurance agreements to reinsure approximately 66.7 percent of potential future losses that occur above a specified retention limit. The reinsurance agreements effectively provide approximately 60 percent reinsurance coverage for the Company’s overall consolidated risk above a specified retention limit, which equaled approximately $8.0 billion in existing statutory reserves at the date of the transaction. The maximum risk limit for the reinsurer was approximately $783.0 million initially and grows to approximately $2.6 billion over time, after which any further losses will revert to the Company. These reinsurance transactions were effective as of April 1, 2004. The Company transferred cash equal to $521.6 million of ceded reserves plus an additional $185.8 million in cash for a before-tax prepaid cost of insurance which was deferred and is being amortized into earnings over the expected claim payment period covered under the Company’s retention limit.
The Colonial segment includes insurance for income protection products, life products, and cancer and critical illness products issued and marketed primarily to employees at the workplace through an agency field sales force and brokers.
The Other segment, which has been redefined to include the disability management services business, also includes results from U.S. Brokerage insured products not actively marketed (with the exception of the individual income protection products in the Individual Income Protection - Closed Block segment), including individual life and corporate-owned life insurance, reinsurance pools and management operations, group pension, health insurance, and individual annuities.
The products now reported in the U.S. Brokerage segment and the Unum Limited segment were previously combined and reported in the Income Protection and Life and Accident segments. There were no changes to the Colonial, Individual Income Protection - Closed Block or Corporate segments. The modification of the Company’s reporting segments had no impact on the level at which the Company performs impairment testing for goodwill or loss recognition testing for the recoverability of deferred policy acquisition costs and value of business acquired.
detailed separate financial metrics and models were unavailable to appropriately manage this block of business separately from the recently issued individual income protection block of business.
In the following segment financial data, “operating revenue” excludes net realized investment gains and losses. “Operating income” or “operating loss” excludes net realized investment gains and losses, income tax, results of discontinued operations, and cumulative effect of accounting principle change. These are considered non-GAAP financial measures. These non-GAAP financial measures of “operating revenue” and “operating income” or “operating loss” differ from revenue and income (loss) from continuing operations before income tax and cumulative effect of accounting principle change as presented in the Company’s consolidated statements of operations prepared in accordance with GAAP reported herein due to the exclusion of before-tax realized investment gains and losses. The Company measures segment performance for purposes of Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information, excluding realized investment gains and losses because management believes that this performance measure is a better indicator of the ongoing businesses and the underlying trends in the businesses. The Company’s investment focus is on investment income to support its insurance liabilities as opposed to the generation of realized investment gains and losses, and a long-term focus is necessary to maintain profitability over the life of the business. Realized investment gains and losses are dependent on market conditions and not necessarily related to decisions regarding the underlying business of the Company’s segments.
Selected data by segment is presented as follows. Segment results for prior years have been reclassified to conform to current year reporting.
The lawsuits described below are for the most part in very preliminary stages. The outcome of the matters is uncertain, and the Company is unable to estimate a range of reasonably possible losses. Unless indicated otherwise, reserves have not been established for these matters. An adverse outcome in one or more of these actions could, depending on the nature, scope, and amount of the ruling, materially adversely affect the Company’s consolidated results of operations in a period, encourage other litigation, harm the Company’s reputation and goodwill, and limit the Company’s ability to write new business, particularly if the adverse outcomes negatively impact certain of the Company’s debt and financial strength ratings.
On October 17, 2003, the district court consolidated these actions under the caption In re UnumProvident Corporation Derivative Actions. On April 19, 2004, the plaintiffs filed a single consolidated amended complaint. On September 10, 2004, the defendants answered the consolidated amended complaint by denying generally the salient factual allegations in the complaint and by asserting various affirmative defenses.
On March 19, 2004, amended complaints were filed in both the Azzolini and Bernstein actions. The amended complaints assert claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder against UnumProvident and one of its officers. The Azzolini plaintiff seeks to represent a putative class of purchasers of certain CorTs certificates between March 21, 2001 and March 24, 2003. The Bernstein plaintiff seeks to represent a putative class of purchasers of a different series of CorTs certificates between February 8, 2001 and March 10, 2003. On April 19, 2004, the defendants moved to dismiss the complaints in each of these actions. On September 12, 2005, the court issued a Memorandum and Order granting the motion to dismiss filed by the Company. On January 12, 2006, plaintiffs filed a notice of appeal from the court’s decision dismissing this action.
Between November 2002 and November 2003, six additional similar putative class actions were filed in (or later removed to) federal district courts in Illinois, Massachusetts, New York, Pennsylvania, and Tennessee. The complaints alleged that the putative class members’ claims were evaluated improperly and allege that the Company and its insurance subsidiaries breached certain fiduciary duties owed to the class members under the Employee Retirement Income Security Act (ERISA), Racketeer Influenced Corrupt Organizations Act (RICO), and/or various state laws. The complaints sought various forms of equitable relief and money damages, including punitive damages.
On December 14, 2005, the court granted in part the defendants’ motion for summary judgment in Taylor, dismissing plaintiff’s request for equitable relief on her breach of contract claim and dismissing any claim plaintiff may make for punitive damages under the Tennessee Consumer Protection Act. The former claim is the principal claim upon which class certification is sought. The court reserved ruling on the remainder of the pending motion for summary judgment pending further mediation of the Taylor and ERISA Benefits actions.
On February 26, 2004, the defendants filed a motion to dismiss contending that the complaint failed to state a valid claim under ERISA. On January 13, 2005, the court denied that motion. The defendants filed an answer to the complaint denying all material allegations on February 28, 2005.
approximately one year. The Company believes that the changes it has made to its claims operations to enhance its oversight functions will substantially reduce the likelihood that the Company would fail to meet the performance standards in the agreements when these examinations are concluded.
In addition, the U.S. Department of Labor (DOL), which had been conducting an inquiry relating to certain ERISA plans, joined the settlement agreements. The Office of the New York Attorney General (NYAG), which had engaged in its own investigation of the Company’s claim handling practices, notified the Company that it supported the settlement and closed its investigation on this issue.
On October 3, 2005, certain of the Company’s insurance subsidiaries entered into a settlement agreement with the California Department of Insurance (DOI), concluding a market conduct examination and investigation of the subsidiaries’ disability claims handling practices. The California DOI had chosen not to join the 2004 multistate settlement agreements.
In entering the settlement, the Company did not agree with the allegations and characterization of the Company’s past claims handling practices made by the California DOI.
These and other regulatory examinations or investigations could result in, among other things, changes in business practices, including changes in broker compensation and related disclosure practices, changes in the use and oversight of finite reinsurance, changes in governance and other oversight procedures, fines, and other administrative action. Such results, singly or in combination, could injure the Company’s reputation, cause negative publicity, adversely affect the Company’s debt and financial strength ratings, or impair the Company’s ability to sell or retain insurance policies, thereby adversely affecting the Company’s business, and potentially materially adversely affecting the
The Company and its insurance company subsidiaries, as part of their normal operations in managing disability claims, are engaged in claim litigation where disputes arise as a result of a denial or termination of benefits. Most typically those lawsuits are filed on behalf of a single claimant or policyholder, and in some of these individual actions punitive damages are sought, such as claims alleging bad faith in the handling of insurance claims. For its general claim litigation, the Company and its insurance company subsidiaries maintain reserves based on experience to satisfy judgments and settlements in the normal course. Management expects that the ultimate liability, if any, with respect to general claim litigation, after consideration of the reserves maintained, will not be material to the consolidated financial condition of the Company. Nevertheless, given the inherent unpredictability of litigation, it is possible that an adverse outcome in certain claim litigation involving punitive damages could, from time to time, have a material adverse effect on the Company’s consolidated results of operations in a period, depending on the results of operations of the Company for the particular period. The Company is unable to estimate a range of reasonably possible punitive losses.
On December 20, 2004, Weiller v. New York Life Insurance Company, et al., was filed in New York Supreme Court against, among others, UnumProvident and certain subsidiaries on behalf of a putative class of insureds under policies issued by several third-party insurers on behalf of whom UnumProvident administers claims. The complaint alleges that the defendants breached the insurance policies by improperly denying or terminating benefits, and seeks equitable relief on behalf of the class and benefits on behalf of the named plaintiff. On February 18, 2005, the defendants filed a motion to dismiss this action. On June 20, 2005, the plaintiff filed a motion seeking certification of a putative class, which the defendants opposed. These motions remain pending. The Company denies the allegations and will vigorously defend against the allegations raised in the complaint.
Since October 2004, the Company and/or its insurance subsidiaries have received subpoenas or information requests from the Office of the NYAG, a Federal Grand Jury in San Diego, the District Attorney for the County of San Diego, insurance departments, and/or other state regulatory or investigatory agencies of at least eight additional states including California, Connecticut, Florida, Maine, Massachusetts, North Carolina, Oklahoma, and South Carolina.
The Company is a defendant in a case brought by the California Insurance Commissioner, styled California v. Universal Life Resources, et al., pending in California Superior Court. The Complaint purports only to seek injunctive relief under the California Insurance Code based on allegations of undisclosed or inadequately disclosed compensation paid to brokers, steering, bid rigging, and customer allocation similar to the claims asserted in MDL No. 1663. The defendants filed a demurrer to the Second Amended Complaint on July 21, 2005. The demurrer was overruled on December 23, 2005, and the Company filed an answer denying all material allegations on January 18, 2006.
On December 21, 2004, a putative derivative action styled Leonard v. UnumProvident Corporation, et al., was filed in Tennessee Chancery Court against the Company and various members of its board of directors alleging claims on behalf of the Company against the director defendants for breach of duty, mismanagement, and corporate waste, challenging certain compensation paid to insurance brokers and alleging insider trading against certain director defendants. On April 1, 2005, the defendants moved to dismiss the complaint on the grounds that the plaintiff failed to make a pre-suit demand on the Company’s board of directors and that the complaint fails to state a claim upon which relief could be granted. That motion remains pending. The defendants strongly deny the allegations in the complaint and will vigorously defend both the substantive and procedural aspects of the litigation.
The Company denies the allegations in these matters and intends to vigorously contest them.
In certain of the Company’s reinsurance businesses there are disputes among the pool members, reinsurance participants, and/or reinsurers concerning the scope of their obligations and liabilities within the reinsurance contracts, including the reinsurance pools for which subsidiaries of the Company acted either as pool managers or underwriting agents, as pool members, or as reinsurers. The Company or the Company’s subsidiaries either have been or may in the future be brought into disputes, arbitration proceedings, or litigation with other pool members or reinsurers in the process of resolving the various claims.
The Company’s insurance subsidiaries’ statutory combined net income, as reported in conformity with statutory accounting principles as prescribed by the National Association of Insurance Commissioners (NAIC) and adopted by the applicable state laws, for the years ended December 31, 2005, 2004, and 2003, was $641.8 million, $607.6 million, and $22.7 million, respectively. Statutory combined net gain from operations was $650.0 million, $662.1
million, and $214.8 million for the years ended December 31, 2005, 2004, and 2003, respectively. Statutory capital and surplus at December 31, 2005 and 2004, was $4,270.2 million and $4,105.4 million, respectively.