2001 benefits to policyholders included pre-tax charges related to the terrorist events of September 11, 2001 of $4.3 million for Employee Benefits and $0.7 million for Individual Insurance. These charges were excluded from the calculation of the benefit ratio.
2000 Individual Insurance benefit ratio is not comparable to subsequent years due to $70.0 million of premiums from Individual life products; this product line was sold to Protective Life effective January 1, 2001.
We have made in this Form 10-K, and from time to time may make in our public filings, news releases and oral presentations and discussions, certain statements which are not based on historical facts. These statements are “forward-looking” and, accordingly, involve risks and uncertainties that could cause actual results to differ materially from those discussed. Although such forward-looking statements have been made in good faith and are based on reasonable assumptions, there is no assurance that the expected results will be achieved. See “Forward-looking Statements.”
Our financial results for 2004 were strong despite challenging economic conditions, including slow job growth and low interest rates. Net income for the full year 2004 was $6.90 per diluted share, a 29.5% increase compared to $5.33 per diluted share for the full year 2003. Net income for the full year 2004 was $199.4 million, a 27.6% increase compared to $156.3 million for 2003. These results represent growth in all of our business segments fueled by strong sales and favorable business retention. Other factors contributing to the solid results included favorable claims experience, the resolution of certain income tax matters, and a continued high level of commercial mortgage loan prepayment fees.
Net income for 2004 included reductions in income taxes from resolutions of certain income tax matters. We do not expect these items to recur in 2005.
Commercial mortgage loan prepayment fees are expected to continue to decrease in 2005 as we expect interest rates to rise.
The following table sets forth premium growth as a percentage by segment for the years ended December 31:
Group employee benefits insurance (our Employee Benefits segment) is our largest business and represented 92.7%, 93.2% and 92.8% of total premiums for 2004, 2003 and 2002, respectively. As a result, premium growth from the Employee Benefits segment is the most significant driver of consolidated premium growth. We exceeded our long-term objective of 10% to 12% premium growth for 2003 and 2002 primarily due to strong premium growth in the Employee Benefits segment. In 2003, consolidated premium growth was also benefited by the assumption of the TIAA block of business. For 2004, consolidated premium growth was below our long-term objective primarily due to slower premium growth from the Employee Benefits segment, which was due largely to slower growth in our in force block of business as a result of slower employment and wage growth, commensurate with overall economic conditions, and correspondingly slower sales growth for this same segment for 2003 and the first half of 2004. See “Business Segments.”
Net investment income increased $10.8 million, or 2.4%, for 2004 compared to 2003. The net increase resulted from a combination of higher invested assets, offset in part by a decrease in yield on invested assets. Average invested assets increased 9.2% for 2004, compared to 2003. Due to new investments, including normal portfolio turnover, at the comparably lower interest rates available during 2004, the portfolio yield for fixed maturity securities decreased to 5.81% at the end of 2004, from 5.94% at the end of 2003. Similarly, the portfolio yield for commercial mortgage loans decreased to 6.71% at the end of 2004, from 7.28% at the end of 2003.
Net investment income increased $56.7 million, or 14.7%, for 2003 compared to 2002. This increase included continuing investment of proceeds from the assumption of the TIAA block of business and approximately $200 million of the related proceeds from the issuance of long-term debt (see “Business Segments-Employee Benefits Segment”) and higher commercial mortgage loan prepayment fees. The portfolio yield for fixed maturity securities decreased to 5.94% at the end of 2003 from 6.22% at the end of 2002. Due to new investments, including normal portfolio turnover, at the comparable lower interest rates available during 2003, the portfolio yield for commercial mortgage loans decreased to 7.28% at the end of 2003, from 7.94% at the end of 2002.
Commercial mortgage loan prepayment fees were $14.9 million, $17.0 million, and $9.0 million for 2004, 2003 and 2002, respectively. The level of commercial mortgage loan prepayment fees will vary depending on the overall interest rate environment. If interest rates rise, we could see a decrease in prepayment fees. Currently, 72% of our commercial mortgage loan portfolio has a provision that requires the borrower to pay a prepayment fee that assures that the Company’s expected cash flow from commercial mortgage loan investments will be fully protected in the event of prepayment. Since 2001, all new commercial mortgage loans contain the new prepayment provision. The remainder of our commercial mortgage loans contain fixed prepayment fees such that total cash flows may be more than or less than those originally expected at the time the loans were made.
Net capital gains and losses occur as a result of sale or impairment of the Company’s invested assets, neither of which is likely to occur in regular patterns. While impairments are generally not controllable, management has significant discretion over the timing of sales of invested assets. Net capital gains and losses are reported in “Other.” Net capital gains were $11.5 million and $9.3 million for 2004 and 2003, respectively, while 2002 had net capital losses of $19.7 million. Net capital gains for both 2004 and 2003 included gains on bond sales. Net capital losses for 2002 were primarily related to impairments of our holdings of WorldCom, Lukens, Sprint, and AT&T bonds. For 2003 and 2004, there were no significant impairments.
Three primary factors drive benefits to policyholders: premium growth (reserves are established in part based on premium levels), claims experience, and the assumptions used to establish related reserves. The predominant factors affecting claims experience are incidence (number of claims) and duration (length of time a disability claim is paid). The assumptions used to establish the related reserves consider incidence and duration, as well as new investment interest rates, which affect the discount rate used to establish reserves. See “Critical Accounting Policies and Estimates-Reserves.”
While premiums increased 4.3% for 2004 compared to 2003, benefits to policyholders decreased $5.1 million, or 0.4%, for the same comparative periods primarily due to favorable claims experience in the Employee Benefits segment during 2004. In addition, we continued to experience favorable and sustained claims recovery patterns for Employee Benefits group long term disability insurance, and as a result of our on-going assessment of those recovery patterns, we released reserves totaling $12.0 million for 2004, which decreased benefits to policyholders. If the favorable and sustained claims recovery patterns in our group long term disability insurance continue, we may release up to an additional $9 million of reserves in the first three quarters of 2005. Partially offsetting the release of $12 million of reserves for 2004 was a $9 million reserve established as a result of a pricing miscalculation on long term disability contracts with one large Employee Benefits customer.
Operating expenses increased $23.6 million, or 8.4% for 2004 compared to 2003, and $32.3 million, or 13.0% for 2003 compared to 2002. The increases for both comparative periods primarily were to support business growth, as evidenced by premium growth. In addition, operating expenses for 2004 included $9.0 million for enhancements of our customer service and product delivery systems, $3.4 million to support compliance with Sarbanes-Oxley legislation, a $2.7 million increase in employee medical benefit expenses, and a $1.3 million increase in stock-based compensation expense.
In 2003, we began expensing the cost related to stock-based compensation in the determination of net income by adopting fair value recognition provisions for all director and employee grants and awards after January 1, 2003. Total stock-based compensation expense as a result of this adoption was $3.6 million and $2.3 million for 2004 and 2003, respectively. Operating expenses for 2003 also included transitional administrative fees related to the TIAA block of business totaling $8.1 million.
Consolidated operating expenses in 2005 are likely to exceed historical levels to support enhanced investment in customer service systems technology and processes.
Interest expense (recorded in “Other”) was $17.7 million, $17.5 million, and $5.0 million for 2004, 2003, and 2002, respectively. Increases for the comparative periods were primarily due to interest expense on senior notes. Late in the third quarter of 2002, we completed an initial public debt offering of $250.0 million of 6.875%, 10-year senior notes. Prior to that, our debt consisted mainly of periodic short term borrowings. See “Liquidity and Capital Resources-Financing Cash Flows.”
over a period not to exceed the life of the related policy. VOBA primarily represents the discounted future profits of business assumed through reinsurance agreements. See “Critical Accounting Policies and Estimates-Deferred Acquisition Costs and Value of Business Acquired.” The net increase in DAC and VOBA for 2004, 2003, and 2002 was $15.2 million, $12.1 million and $15.8 million, respectively.
Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% because of the net result of permanent differences and the inclusion of state and local income taxes, net of the federal benefit. The combined federal and state effective tax rates were 31.7%, 34.8%, and 35.5% for 2004, 2003, and 2002, respectively. Income taxes for 2004 were reduced approximately $7 million for the favorable resolution of uncertainties related to the Internal Revenue Service examination of the Company’s tax years through 2001, and favorable outcomes on state tax return matters. In addition, income taxes for 2004 were $1.8 million lower than 2003 due to a higher permanent deduction allowed for dividends received by equity investments in separate account assets under management in the Retirement Plans segment (see “Business Segments-Retirement Plans Segment”). At December 31, 2004, years open for audit by the Internal Revenue Service were 2002, 2003 and 2004.
We operate through three segments: Employee Benefits, Individual Insurance, and Retirement Plans.
As measured by premiums, the Employee Benefits segment is our largest segment and substantially influences our consolidated financial results. This segment sells disability, life, AD&D, and dental insurance to employer groups. Income before income taxes for the Employee Benefits segment increased 24.5% to $242.0 million for 2004 compared to 2003, and 22.7% to $194.4 million for 2003 compared to 2002. The increases for the comparative periods were driven primarily by premium growth and decreased benefits to policyholders as a result of favorable claims experience. In addition, the increase for 2003 compared to 2002 was affected by the assumption of the TIAA block of business.
Persistency. Persistency for the Employee Benefits segment has historically exceeded industry averages, which we believe demonstrates our commitment to customer service and pricing discipline for new sales. Our persistency remained relatively stable for 2004, 2003 and 2002.
Premium growth for 2003 included premiums assumed from the TIAA block of business. When assumed, this block of business represented premiums of approximately $180 million.
Premiums for the Employee Benefits segment increased 16.8% for 2003 compared to 2002, while benefits to policyholders (including interest credited) increased $185.8 million, or 18.0% for the same comparative periods. Claims experience, for both incidence and duration across product lines and industry sectors, was slightly less favorable for 2003 compared to 2002. In addition, benefits to policyholders increased for 2003 as a result of our assumption of the TIAA block of business late in 2002.
Benefits to policyholders are also affected by changes in reserves. The establishment of reserves includes discounting expected future benefits to their present value. The discount rate used, which is determined quarterly, is based on our average new money investment rate for a quarter less a margin to allow for reinvestment risk and credit quality exposure. Given the current low interest rate environment, and correspondingly lower reinvestment risk, our targeted margin range for newly incurred claims is approximately 20-30 basis points over a 12-month period. As interest rates increase, we expect to also increase our targeted margin to allow for higher levels of reinvestment risk.
During 2004, we reduced the discount rate used to establish new long term disability reserves in the Employee Benefits segment from 5.20% to 5.00%. We expect the average new money investment rate, including some expansion in the spread earned on those investments, to increase up to 1% in 2005. Given that we discount new reserves established in each quarter using our average new money investment rate less a margin, the expected increase in our average new money investment rate may result in an increase in the discount rate used to establish new reserves in 2005, and therefore, also may reduce the expense of benefits to policyholders. Based on our current size, a 0.25% change in the discount rate would result in a quarterly change of approximately $2 million in the expense of benefits to policyholders and pre-tax earnings, until related adjustments are made to premium rates (generally group long term disability policies offer rate guarantees for periods from one to three years). An increase in the discount rate will result in recording lower benefits to policyholders while a decrease in the rate will result in recording higher benefits to policyholders.
Operating expenses as a percentage of premiums were 14.8%, 14.2%, and 14.5% for 2004, 2003 and 2002, respectively. See “Consolidated Results of Operations-Benefits and Expenses-Operating Expenses.”
The Individual Insurance segment sells disability insurance and fixed-rate annuities, including life contingent annuities, to individuals. Most of the deposits on our annuity business are not recorded as premiums. Annuity premiums consist of premiums on life contingent annuities, which are a small portion of sales. Annuity deposits are recorded as a liability and therefore not reflected as premiums. Annuity deposits earn investment income, a portion of which is credited to policyholders.
sets forth key indicators that management uses to manage and assess the performance of the Individual Insurance segment at or for the years ended December 31:
Premium growth in our Individual Insurance segment is driven largely by sales of individual disability insurance. Premiums increased $9.5 million, or 11.1%, for 2004 compared to 2003, and $5.4 million, or 6.8%, for 2003 compared to 2002. Sales of individual disability products reached record highs in 2004, growing 18.1% compared to 2003. Sales growth for 2003 was 39.1% compared to 2002. Increases in sales, and therefore premiums, for both comparative periods resulted from an expansion of distribution channels in recent years and the continuation of a national marketing agreement with Minnesota Life for individual disability products. Increased persistency in our individual disability insurance products also contributed to premium growth for this segment.
Individual fixed-rate annuity deposits increased $44.6 million, or 32.0% for 2004, compared to 2003, and $30.3 million, or 27.8% for 2003 compared to 2002. Fixed-rate annuity sales have been strong for 2004 due to growth in our independent brokerage and financial institution distribution channels. Individual annuity assets under management reached a record $1.09 billion as of December 31, 2004.
While premiums for the Individual Insurance segment increased 11.1% for 2004 compared to 2003, benefits to policyholders increased 10.7% for the same comparative periods. For 2003 compared to 2002, premiums increased 6.8%, yet benefits to policyholders decreased 6.0% for the same comparative periods, due to favorable claims incidence and duration during 2003.
In many states, we are required to credit a minimum rate of interest to annuity contract holders. In the low interest rate environment of 2003, we were unable to achieve sufficient margin over minimum interest crediting rates on certain annuity products and therefore ceased offering those products. We resumed sales of these products in 2004. Recent changes in regulation have allowed us to begin to offer new products with lower interest rate guarantees. Factors affecting the level of sales of annuity deposits include movement in interest rates and the equity markets, which make alternative investments more or less attractive.
The primary sources of revenue for the Retirement Plans segment include plan administration fees, fees on separate account assets (equity investments) under management, and investment margin on general account assets under management, which is a fixed-income investment option. In
Income before income taxes for the Retirement Plans segment was $7.9 million, $5.3 million and zero for 2004, 2003 and 2002, respectively. During 2003, we surpassed $2.5 billion of assets under management, our expected level at which we estimated we could maintain consistent profitability. Following are key indicators that management uses to manage and assess the performance of the Retirement Plans segment:
Premiums for the Retirement Plans segment are generated from three sources: plan administration fees, fees on separate account assets that are primarily based on average daily market values of assets under management, and life contingent annuities sold, which can vary significantly from year to year. Premium growth in our Retirement Plans segment was $4.0 million, or 17.2% for 2004 compared to 2003, and $4.3 million, or 22.6% for 2003 compared to 2002. The increases for both comparative periods were primarily from fees on separate account assets. At December 31, 2004, assets under management for this segment reached a record $3.37 billion, a 30.6% increase compared to $2.58 billion at December 31, 2003. The growth in assets under management was primarily from strong underlying business fundamentals including continuing deposits, strong customer retention, new sales growth, and an increase in the market value of equity investments in the separate account.
Premiums for life contingent annuities were $2.6 million, $3.0 million, and $2.5 million for 2004, 2003, and 2002, respectively.
Other businesses include StanCorp Mortgage Investors, which originates and services small fixed-rate commercial mortgage loans for investment portfolios of our insurance subsidiaries and generates additional fee income from the origination and servicing of commercial mortgage loans sold to institutional investors. StanCorp Mortgage Investors contributed income before income taxes of $12.1 million, $11.2 million, and $7.7 million for 2004, 2003, and 2002, respectively, before intercompany eliminations. Supporting both internal and external investor demand, StanCorp Mortgage Investors originated a record $1.17 billion of commercial mortgage loans for 2004, a 25.8% increase over 2003. The increase in commercial mortgage loan originations also was driven by originations for Standard to allocate more invested assets to commercial mortgage loans. See “Liquidity and Capital Resources-Investing Cash Flows.”
It is management’s objective to align generally the cash flow characteristics of assets and liabilities to ensure that the Company’s financial obligations can be met under a wide variety of economic conditions. From time to time, management may choose to liquidate certain investments and reinvest in alternate investments to better match the cash flow characteristics of assets to liabilities. See “-Investing Cash Flows.”
The Company manages interest rate risk, in part, through asset/liability duration analyses. As part of this strategy, detailed actuarial models of the cash flows associated with each type of insurance liability and the financial assets related to the liability are generated under various interest rate scenarios. Both interest rate risk and investment strategies are
Net cash used in investing activities was $594.7 million, $743.6 million, and $637.9 million for 2004, 2003, and 2002, respectively. Net cash used in investing activities for 2004 and 2003 helped us to achieve our target investment portfolio allocation and included commercial mortgage loan originations of $1.17 billion and $930.6 million, respectively. Our target investment portfolio allocation is approximately 60% fixed maturity securities and 40% commercial mortgage loans. At December 31, 2004, our portfolio consisted of 59.3% fixed maturity securities and 39.6% commercial mortgage loans, with the remainder in real estate. We anticipate that commercial mortgage loans will continue to
Commercial mortgage loans in our investment portfolio totaled $2.95 billion at December 31, 2004. We currently have a portfolio of over 3,500 commercial mortgage loans. The average loan to value ratio in the overall portfolio was 59% at December 31, 2004, and the average loan size was approximately $0.8 million. The Company receives personal recourse on almost all loans.
At December 31, 2004, our commercial mortgage loan portfolio was collateralized by properties with the following characteristics:
In the normal course of business, we commit to fund commercial mortgage loans generally up to 90 days in advance. At December 31, 2004, the Company had outstanding commitments to fund commercial mortgage loans with fixed interest rates ranging from 4.875% to 7.0%, totaling $186.0 million. These commitments generally have fixed expiration dates. A small percentage of commitments expire due to the borrower’s failure to deliver the requirements of the commitment by the expiration date. In these cases, we will retain the commitment fee and good faith deposit. Alternatively, if we terminate a commitment due to our disapproval, the commitment fee and deposit will be refunded to the borrower, less an administrative fee.
Financing cash flows consist primarily of policyholder fund deposits and withdrawals, borrowings and repayments on the line of credit, borrowings and repayments on long-term debt, repurchase of common stock, and dividends paid on common stock. Net cash provided by financing activities was $200.7 million, $233.9 million, and $252.0 million for 2004, 2003, and 2002, respectively. The increase in policyholder fund deposits net of withdrawals for 2004 and 2003 primarily reflected higher individual annuity sales in the Individual Insurance segment and higher deposits into the Retirement Plans segment general account assets, both of which reflected distribution system growth during those time periods. Net cash provided by financing activities in 2002 included our initial public debt offering and repayment of our line of credit.
We currently have two unsecured credit agreements for $75 million each, with credit availability totaling $150 million. The agreements expire on June 27, 2005. Under the credit agreements, we are subject to customary covenants that take into consideration the impact of material transactions, changes to the business, compliance with legal requirements and financial performance. The financial covenants include limitations on indebtedness, financial liquidity and RBC. We are not required to maintain compensating balances, but pay commitment fees. Interest charged for use of the facilities is based on the federal funds rate, the bank’s prime rate, or the London Interbank Offered Rate at the time of borrowing plus an incremental basis point charge that varies by agreement, type of borrowing, and the amount outstanding on the lines. At December 31, 2004, we were in compliance with all covenants under the credit agreements and had no outstanding balance on the lines of credit. We currently have no commitments for standby letters of credit, standby repurchase obligations, or other related commercial commitments under the credit agreements.
We had a debt to total capitalization ratio of 17.0% and 19.3% at December 31, 2004 and 2003, respectively. Our ratio of earnings to fixed charges for the years ended December 31, 2004 and 2003 was 3.9x and 3.4x, respectively.
At December 31, 2004, our total capital in excess of targeted RBC and holding company requirements was approximately $110 million. We will continue to maintain our three priorities, in the following order, for excess capital:
StanCorp’s ability to pay dividends to its shareholders, repurchase its shares, and meet its obligations substantially depends upon the receipt of distributions from its subsidiaries, including Standard. Standard’s ability to pay dividends to StanCorp is affected by factors deemed relevant by Standard’s board of directors, including the ability to maintain adequate capital (RBC) according to Oregon law. Under Oregon law, Standard may pay dividends only from the earned surplus arising from its business. It also must receive the prior approval of the Director of the Oregon Department of Consumer and Business Services - Insurance Division (the “Oregon Insurance Division”) to pay a dividend if such dividend exceeds certain statutory limitations. The current statutory limitations are the greater of (a) 10% of Standard’s combined capital and surplus as of December 31st of the preceding year, or (b) the net gain from operations after dividends to policyholders and federal income taxes and before realized capital gains or losses for the 12-month period ended on the December 31st last preceding. In each case, the limitation must be determined under statutory accounting practices. Oregon law gives the Oregon Insurance Division broad discretion to disapprove requests for dividends in excess of these limits.
In August 2003, Standard made an extraordinary distribution to StanCorp of $200 million from its paid-in capital and contributed surplus. Concurrently, Standard borrowed the distributed amount from StanCorp and issued a $200 million subordinated surplus note. These transactions have no net financial statement impact as they eliminate in consolidation. The extraordinary distribution is a reduction of the paid-in capital that was recorded in connection with StanCorp’s contribution to Standard in 2002 to fund the reinsurance agreement with TIAA to assume TIAA’s group disability and group life insurance business. The surplus note matures in August 2018 and bears an interest rate of 6.44% per annum. The form of the surplus note complies with the requirements of the NAIC with respect to surplus notes, including provisions requiring the approval of the Oregon Insurance Division for any repayments of principal or for any payments of interest and subordinating any payments with respect to the surplus note to Standard’s other obligations to policyholders, lenders and trade creditors.
On November 8, 2004, the board of directors of StanCorp declared an annual cash dividend of $1.00 per share of common stock. The dividend was paid on December 3, 2004
to shareholders of record at the close of business on November 19, 2004. The dividend represented a 43% increase over the annual dividend of $0.70 paid per share of common stock for 2003. On November 3, 2003, the board of directors of StanCorp declared an annual dividend of $0.70 per share of common stock. The dividend was paid on December 5, 2003, to shareholders of record at the close of business on November 14, 2003. The dividend represented a 75% increase over the annual dividend of $0.40 paid per share of common stock in 2002. The declaration and payment of dividends in the future is subject to the discretion of StanCorp’s board of directors and it is anticipated that annual dividends will be paid in December of each year depending on StanCorp’s financial condition, results of operations, cash requirements, future prospects, regulatory restrictions on distributions from the insurance subsidiaries, the ability of the insurance subsidiaries to maintain adequate capital, and other factors deemed relevant by StanCorp’s board of directors.
During 2003, we repurchased 185,700 shares of common stock at a total cost of $9.3 million for a volume weighted-average price of $50.35 per common share. Also during 2003, the Company acquired 22,986 shares of common stock from executive officers to cover tax liabilities resulting from the release of performance-based shares at a total cost of $1.1 million for a volume weighted-average price of $47.76 per common share. See Item 5, “Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.”
The Company’s long-term debt obligations consisted primarily of the $250.0 million 6.875%, 10-year senior notes. Interest payable related to the total long-term obligations totals $144.8 million for the periods shown in the table. The operating lease obligations include leases on certain buildings and equipment under non-cancelable operating leases, software maintenance, licensing, and telecommunication commitments, all expiring in various years through 2011 with renewal options ranging from one to five years.
Other long-term liabilities reflected in the Company’s balance sheet at December 31, 2004 consisted of a $13.5 million tax reimbursement liability related to the block of life insurance business sold to Protective Life Insurance Company in 2001, $10.3 million in capital commitments related to our low income housing investments, $19.9 million in unfunded liabilities for non-qualified deferred compensation and supplemental retirement plans, an accrued liability of $12.8 million for postretirement benefits, and $0.9 million of accrued guarantee association payments. In addition to long-term liabilities recorded on the balance sheet, a $5.5 million required minimum contribution to the defined benefit pension plan in 2005 is included in this category.
In November 2003, the Financial Accounting Standards Board (“FASB”) reached a partial consensus under Emerging Issue Task Force (“EITF”) 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-1 required certain quantitative and qualitative disclosures for securities accounted for under Statement of Financial Accounting Standards (“SFAS”) No.115, Accounting for Certain Investments in Debt and Equity Securities, that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The portions of EITF 03-1 on which consensus was reached were effective for financial statements for fiscal years ending after December 15, 2003. Effective December 31, 2003, the required disclosures were included in the notes to consolidated financial statements. The portions of EITF 03-1 on which consensus was not reached are not yet final. EITF 03-1 provides more specific guidelines related to SFAS No.115 regarding when impairments need to be recognized through the income statement, as well as on the balance sheet. EITF 03-1 addresses whether a change in the interpretation of temporary impairments due to interest rate and credit spread moves is appropriate. Under EITF 03-1, companies that do not have the ability and intent to hold an asset with unrealized losses until recovery of fair value would be required to impair the asset. Impaired losses would flow through net income and accretion on the impaired assets would be recognized in investment income in later periods. Currently, the FASB is considering whether a materiality threshold for recognizing impairment may be appropriate. The effective date for EITF 03-1 has been delayed until this determination is made. The Company is evaluating the potential financial statement effect of EITF 03-1.
Our consolidated financial statements and certain disclosures made in this Form 10-K have been prepared in accordance with GAAP and require us to make estimates and assumptions that affect reported amounts of assets and liabilities and contingent assets and contingent liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The estimates most susceptible to material changes due to significant judgment (identified as the “critical accounting policies”) are those used in determining investment impairments, the reserves for future policy benefits and claims, DAC and VOBA, and the provision for income taxes. The results of these estimates are critical because they affect our profitability and may affect key indicators used to measure the Company’s performance.
These estimates have a material effect on our results of operations and financial condition.
For most of our product lines, we establish and carry as a liability actuarially determined reserves that are calculated to meet our obligations for future policy benefits and claims. These reserves do not represent an exact calculation of our future benefit liabilities, but are instead estimates based on assumptions and considerations concerning a number of factors, including:
In particular, our group and individual long term disability reserves are sensitive to assumptions and considerations regarding the following factors:
Quarterly, we evaluate the appropriateness of the discount rate used to establish new long term disability claim reserves. We determine the discount rate based on the average rate of return on invested assets we acquire during the quarter less a margin to allow for reinvestment risk and credit quality deterioration. If assets are subsequently reinvested at rates less than the established discount rate on the reserves or credit quality deterioration is worse than provided for in the margin, we could be required to increase our reserves.
The provision for income taxes includes amounts currently payable and deferred amounts that result from temporary differences between financial reporting and tax bases of assets and liabilities as measured by current tax rates. Income taxes for 2004 were reduced approximately $7 million related to the favorable resolution of uncertainties related to the Internal Revenue Service examination of the Company’s tax years through 2001, and favorable outcomes on state tax return matters. At December 31, 2004, years open for audit by the Internal Revenue Service were 2002, 2003 and 2004.
Our actual results and financial condition may differ, perhaps materially, from the anticipated results and financial condition in any such forward-looking statements and, accordingly, readers are cautioned not to place undue reliance on such statements. We undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.
changes in the regulatory environment at the state or federal level, including developments of industry investigations regarding insurance broker compensation and insolvency assessments and guaranty association assessments;
Given these uncertainties or circumstances, readers are cautioned not to place undue reliance on these forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
We have audited the accompanying consolidated balance sheets of StanCorp Financial Group, Inc. and subsidiaries (the “Company”) as of December 31, 2004 and 2003, and the related consolidated statements of income and comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits.
Our largest subsidiary, Standard, underwrites group and individual disability insurance and annuity products, group life, accidental death and dismemberment (“AD&D”), and dental insurance. Founded in 1906, Standard is domiciled in Oregon and licensed in 49 states, the District of Columbia and the U.S. Territories of Guam and the Virgin Islands.
StanCorp Investment Advisers is a Securities and Exchange Commission (“SEC”) registered investment adviser providing performance analysis, fund selection support, and model portfolios to our retirement plan clients and other third parties. It also provides investment management service to third parties and subsidiaries of StanCorp.
StanCorp Mortgage Investors originates and services small fixed-rate commercial mortgage loans for investment portfolios of our insurance subsidiaries. It also generates additional fee income from the origination and servicing of commercial mortgage loans sold to institutional investors.
Our consolidated financial statements and certain disclosures made in this Form 10-K have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and require us to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The estimates most susceptible to material changes due to significant judgment (the “critical accounting policies”) are those used in determining investment impairments, the reserves for future policy benefits and claims, deferred acquisition costs (“DAC”) and value of business acquired (“VOBA”), and the provision for income taxes. The results of these estimates are critical because they affect our profitability and may affect key indicators used to measure the Company’s performance. These estimates have a material effect on our results of operations and financial condition.
For all investments, capital gains and losses are recognized using the specific identification method. Net investment income and capital gains and losses related to separate account assets and liabilities are included in the separate account assets and liabilities. For all investments, we record impairments when it is determined that the decline in fair value of an investment below its amortized cost basis is other than temporary. We reflect impairment charges in net capital gains or losses and permanently adjust the cost basis of the investment to reflect the impairment. In our quarterly impairment analysis, we evaluate whether a decline in value of fixed maturity securities is other than temporary. Factors considered in this analysis include the length of time and the extent to which the fair value has been below amortized cost, the financial condition and near-term prospects of the issuer, our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in market value, and the value of any security interest we may have collateralized in the investment. See “Note 5, Investment Securities.” For securities expected to be sold, an other than temporary impairment charge is recorded if we do not expect the realizable market value of a security to recover
Certain costs related to obtaining new business and acquiring business through reinsurance agreements have been deferred to accomplish matching against related future premiums or gross profits, as appropriate. We normally defer certain acquisition-related commissions and incentive payments, certain costs of policy issuance and underwriting, and certain printing costs. Assumptions used in developing DAC and amortization amounts each period include the amount of business in force, expected future persistency, withdrawals, interest rates and profitability. These assumptions are modified to reflect actual experience when appropriate. The amortization of DAC is charged to current earnings to the extent it is determined that future premiums or gross profits are not adequate to cover the remaining amounts deferred. DAC totaled $132.5 million and $100.0 million at December 31, 2004 and 2003, respectively.
The following table sets forth income statement activity for DAC for the years ended December 31:
VOBA primarily represents the discounted future profits of business assumed through reinsurance agreements. VOBA is amortized in proportion to future premiums or expected future profitability as appropriate. If actual premiums or future profitability is inconsistent with our assumptions, we could be required to make adjustments to VOBA and related amortization. For the VOBA associated with the Minnesota Life Insurance Company (“Minnesota Life”) block of business reinsured, the amortization period is up to 30 years. Accompanying the transaction was a national marketing agreement that provides access to Minnesota Life agents, some of whom now market Standard’s individual disability insurance products. The amortization period of the intangible asset for the marketing agreement with Minnesota Life is 23 years. The VOBA associated with the Teachers Insurance and Annuity Association of America (“TIAA”) is comprised of two parts with differing amortization methods. The amortization periods are up to 10 years for VOBA that is amortized in proportion to premiums and up to 20 years for VOBA that is amortized in proportion to expected gross profits, although approximately 75% is expected to be amortized within 5 years, or by the end of 2007.
The estimated net amortization of VOBA and intangible assets for each of the next five years is as follows:
Separate account assets and liabilities represent segregated funds held for the exclusive benefit of contract holders. The activities of the account primarily relate to participant-directed 401(k) contracts. Standard charges the separate account asset management and plan administration fees associated with the contracts. Separate account assets and liabilities are carried at fair value.
the amount of premiums on existing business that we will receive in the future;
the amount of monthly benefit paid to the insured (less reinsurance recoveries and other offsets);
age and gender of the claimant, and for individual policies, occupation class of the claimant;
The provision for income taxes includes amounts currently payable and deferred amounts that result from temporary differences between financial reporting and tax bases of assets and liabilities as measured by current tax rates. Income taxes for 2004 also include approximately $7 million related to the favorable resolution of uncertainties related to the Internal Revenue Service examination of the Company’s tax years through 2001, and favorable outcomes on state tax return matters. At December 31, 2004, years open for audit by the Internal Revenue Service were 2002, 2003 and 2004.
The current year change in unrealized capital gains on securities available-for-sale, net of tax includes $1.1 million, net, for the increase in the unfunded liability of the non-qualified supplemental retirement plan.
The Company has in effect three stock-based employee compensation plans. See “Note 12, Stock-Based Compensation.” Effective January 1, 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No.123, Accounting for Stock-Based Compensation prospectively to all employee awards granted, modified, or settled after January 1, 2003.
Amounts reported as “Other” primarily include net capital gains and losses on investments, return on capital not allocated to the product segments, other financial service businesses, holding company expenses, interest on senior notes and adjustments made in consolidation. Other financial service businesses are generally non-insurance related and include StanCorp Mortgage Investors, our commercial mortgage lending business, and StanCorp Investment Advisers, our registered investment adviser. As of December 31, 2004, StanCorp Mortgage Investors was servicing $2.95 billion in commercial mortgage loans for subsidiaries of StanCorp. Commercial mortgage loans serviced for other institutional investors and associated capitalized mortgage servicing rights totaled $747.9 million and $2.1 million, respectively, at December 31, 2004.
financial instruments, policy loans are an integral component of the insurance contract and have no maturity date.
Securities deposited for the benefit of policyholders in various states, in accordance with state regulations, amounted to $5.5 million and $6.3 million at December 31, 2004 and 2003, respectively.
commercial mortgage loans more than 60 days delinquent or in the process of foreclosure at December 31, 2003.
7. LIABILITY FOR UNPAID CLAIMS, CLAIMS ADJUSTMENT EXPENSES, AND OTHER POLICYHOLDER FUNDS
The liability for unpaid claims, claims adjustment expenses, and other policyholder funds includes liabilities for insurance offered on products such as group long term and short term disability, individual disability, group dental, and group AD&D. The liability for unpaid claims and claim adjustment expenses is included in future policy benefits and claims in the consolidated balance sheets. The following table sets forth the change in the liabilities for unpaid claims and claim adjustment expenses for the years ended December 31:
The Company is carrying forward a net operating loss of $7.0 million that originated in the parent company and The Standard Life Insurance Company of New York. The loss will be used in future years to offset taxable income from those entities to the degree allowed by the Internal Revenue Code. If unutilized, $4.3 million would expire in 2024 and $2.7 million would expire in 2025.
The Company has two non-contributory defined benefit pension plans: the employee pension plan and the agent pension plan. The employee pension plan is for all eligible employees of StanCorp and its subsidiaries. The agent pension plan, which is frozen, is for former field employees and agents. Both plans are sponsored and administered by Standard. The defined benefit pension plans provide benefits based on years of service and final average pay. During 2003, several changes were made to the employee pension plan. These included limiting future participation in the plan and reducing future benefit levels.
The following table sets forth the Company’s target and actual weighted average asset allocations for defined benefit pension plans at December 31:
The investment goal of the employee pension plan is to produce long run portfolio returns that are consistent with reasonable contribution rates and a well-funded plan. To manage the overall risk of the portfolio, the portfolio is rebalanced as necessary to keep the allocation within tolerance levels of the target allocation. The portfolio is diversified across a number of equity asset categories and stable value assets. The investment goal of the agent pension plan is to invest in stable value assets in order to maintain its funded status.
The long run rate of return for the employee pension plan portfolio is derived by calculating the average return for the portfolio monthly, from 1971 to the present, using the average mutual fund manager returns in each asset category, weighted by the target allocation to each category. Because the average equity market value returns over the last 30 years generally have been higher than the long run expected rate of return, the historical average return used to determine the expected return on plan assets was reduced by 20%.
The Company was not obligated to make any contributions to its pension plans for 2004, and expects to make a minimum required contribution of $5.5 million in 2005.
Eligible executive officers are covered by a non-qualified supplemental retirement plan. The accrued benefit cost was $11.7 million and $9.2 million at December 31, 2004 and 2003, respectively. Expenses were $1.4 million, $1.4 million, and $1.5 million for 2004, 2003, and 2002, respectively. For 2004, the accumulated benefit obligation exceeded the unfunded liability and additional liability of $1.7 million was recognized and reported, net of tax, in accumulated other comprehensive income.
Standard sponsors and administers a postretirement benefit plan that includes medical, prescription drug benefits, and group term life insurance. Eligible retirees are required to contribute specified amounts, which are determined periodically, and are based on retirees’ length of service. During 2003, the cost sharing between Standard and its retirees was changed for employees retiring after December 31, 2003, shifting a greater portion towards retirees.
In May 2004, Financial Accounting Standards Board Staff Position (“FSP”) No.106-2, Accounting and Disclosure
Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003 was issued. FSP No. 106-2 addresses the accounting and disclosure requirements resulting from the Medicare Prescription Drug, Improvement and Modernization Act (“the Act”) that was enacted on December 8, 2003. The Act introduces a prescription drug benefit under Medicare (Medicare Part D) as well as a federal subsidy to sponsors of retiree health care plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. FSP No. 106-2 was effective for the first interim or annual period beginning after June 15, 2004, with early adoption allowed. During the second quarter of 2004, the Company elected early adoption As a result, the net periodic benefit cost decreased $0.5 million, and we estimate that the accumulated postretirement benefit obligation will decrease by $3.0 million.
The expected benefit payments for the Company’s postretirement plan for the years indicated are as follows:
The 1999 Omnibus Stock Incentive Plan authorizes the board of directors of StanCorp to grant eligible employees certain incentive or non-statutory stock options, bonuses and performance stock options, restricted and foreign stock awards, and stock appreciation and cash bonus rights related to StanCorp’s common stock. All options are granted at a stock price of not less than the market value at the date of the option grant and may be exercised for a period not exceeding ten years from the date of the grant. The maximum number of shares of common stock that may be issued under this plan is 1.7 million. By the end of 2004, 1.6 million shares, or options for shares, had been issued under this plan.
The weighted-average grant date fair value of option awards for 2004, 2003, and 2002 was $19.95, $18.28, and $21.14, respectively.
Effective October 1, 2004, we maintain reinsurance coverage for catastrophe losses related to group life and AD&D through a catastrophe reinsurance agreement. This agreement excludes nuclear, biological and chemical acts of terrorism.
Effective October 1, 2002, Standard entered into a reinsurance agreement with TIAA to assume TIAA’s group disability and group life insurance business. This business included approximately 1,800 group insurance contracts, representing 650,000 insured individuals. Standard paid a ceding commission of approximately $75 million and received approximately $705 million in assets and corresponding statutory liabilities. If Standard were to become unable to meet its obligations, TIAA would retain the reinsured liabilities. Therefore, in accordance with the agreement with TIAA, Standard established a trust for the benefit of TIAA with the market value of assets in the trust equal to TIAA’s reinsurance receivable from Standard. The market value of assets required to be maintained in the trust is determined quarterly. The market value of assets required to be maintained in the trust at December 31, 2004 was approximately $644.3 million. Approximately $60 million in VOBA was capitalized related to the reinsurance agreement.
Effective January 1, 2001, Standard ceded to Protective Life, through a reinsurance agreement, Standard’s individual life insurance product line. Standard received a ceding commission of approximately $90 million and transferred to Protective Life approximately $790 million in assets and corresponding statutory liabilities. If Protective Life were to become unable to meet its obligations, Standard would retain the reinsured liabilities. Therefore, the liabilities remain on Standard’s books and an equal amount is recorded as a recoverable from reinsurer. In accordance with the agreement, Protective Life established a trust for the benefit of Standard with assets in the trust required to be equal to Standard’s reinsurance receivable from Protective Life. The market value of assets required to be maintained in the trust is determined quarterly.
Statutory accounting practices differ in some respects from GAAP. The principal statutory practices which differ from GAAP are: a) bonds and commercial mortgage loans are reported principally at amortized cost; b) asset valuation and IMR are provided as prescribed by the NAIC; c) certain assets designated as non-admitted, principally deferred tax assets, furniture, equipment, and unsecured receivables, are not recognized as assets, resulting in a charge to statutory surplus; d) annuity considerations with life contingencies, or purchase rate guarantees, are recognized as revenue when received; e) reserves for life and disability policies and contracts are reported net of ceded reinsurance and calculated based on statutory requirements, including required discount rates; f) commissions, including initial commissions and expense allowance paid for reinsurance assumed, and other policy acquisition expenses are expensed as incurred; g) initial commissions and expense allowance received for a block of reinsurance ceded net of taxes are reported as deferred gains in surplus and recognized as income in subsequent periods; h) federal income tax expense includes current income taxes defined as current year estimates of federal income taxes and tax contingencies for current and all prior years and amounts incurred or received during the year relating to prior periods, to the extent not previously provided; i) deferred tax assets, net of deferred tax liabilities, are included in the regulatory financial statements but are limited to those deferred tax assets that will be realized within one year; and j) surplus notes are included in capital and surplus.
Standard and The Standard Life Insurance Company of New York are subject to statutory restrictions that limit the maximum amount of dividends and distributions that they could declare and pay to StanCorp without prior approval of the states in which the subsidiaries are domiciled. In August 2003, Standard made an extraordinary distribution of $200
million to StanCorp from Standard’s paid-in capital and contributed surplus. Concurrently, Standard borrowed the distributed amount from StanCorp and issued a $200 million subordinated surplus note. Both transactions eliminate in consolidation. The extraordinary distribution is a reduction of the paid-in capital that was recorded in connection with StanCorp’s contribution to Standard in 2002 to fund the reinsurance agreement with TIAA to assume TIAA’s group disability and group life insurance business. The surplus note matures in August 2018 and bears an interest rate of 6.44% per annum. The form of the surplus note complies with the requirements of the NAIC with respect to surplus notes, including provisions requiring the approval of the Oregon Insurance Division for any payments of principal or interest and subordinating any payments with respect to the surplus note to Standard’s other obligations to policyholders, lenders, and trade creditors. In addition, as long as the surplus note is outstanding, distributions from Standard will first be applied to repayment of the principal balance and interest on the surplus note.
We currently have two unsecured credit agreements for $75 million each, with credit availability totaling $150 million expiring in June 2005. Under the credit agreements, we are subject to customary covenants that take into consideration the impact of material transactions, changes to the business, compliance with legal requirements and financial performance. The financial covenants include limitations on indebtedness, financial liquidity and RBC. We are not required to maintain compensating balances, but pay commitment fees. Interest charged for use of the facilities is
At December 31, 2004, minimum future rental receivables on non-cancelable leases of retail and office space in the home office properties with initial terms of one year or more were 2005, $11.1 million; 2006, $10.1 million; 2007, $9.6 million; 2008, $9.1 million; 2009, $8.1 million and thereafter, $22.5 million.
The Company’s long-term debt obligations consisted primarily of the $250.0 million 6.875%, 10-year senior notes pursuant to the shelf registration statement. Interest payable related to the total long-term obligations totals $144.8 million for the periods shown in the table. The lease obligations include leases on certain buildings and equipment under non-cancelable operating leases, software maintenance, licensing, and telecommunication commitments, all expiring in various years through 2011 with renewal options ranging from one to five years.
Other long-term liabilities reflected in the Company’s balance sheet at December 31, 2004 consisted of a $13.5 million tax reimbursement liability related to the block of life insurance business sold to Protective Life Insurance Company in 2001, $10.3 million in capital commitments related to our low income housing investments, $19.9 million in unfunded liabilities for non-qualified deferred compensation and supplemental retirement plans, an accrued liability of $12.8 million for postretirement benefits,
and $0.9 million of accrued guarantee association payments. In addition to long-term liabilities recorded on the balance sheet, a $5.5 million required minimum contribution to the defined benefit pension plan in 2005 is included in this category.