The Company leases five floors, or approximately 67,000 square feet, in a 41-story office building in Chicago for its corporate headquarters and Property & Casualty Insurance segment’s headquarters. The lease expires in September 2023. Kemper’s Property & Casualty Insurance segment leases facilities with an aggregate square footage of approximately 452,000 at 14 locations in nine states. The latest expiration date of the existing leases is in June 2025. Kemper’s Life & Health Insurance segment leases facilities with aggregate square footage of approximately 470,000 at 127 locations in 28 states. The latest expiration date of the existing leases is in January 2025. Kemper’s corporate data processing operation leases facilities with aggregate square footage of approximately 36,000 square feet at three locations in three states. The latest expiration date of the existing leases is in June 2021.
Selected financial information as of and for the years ended December 31, 2017, 2016, 2015, 2014 and 2013 is presented below.
results. See MD&A, “Expenses,” beginning on page 57 for additional information related to the internal use software write-off. In the Life & Health Insurance segment, segment net operating income decreased by $41.4 million due primarily to a $50.5 million after-tax charge to recognize the impact of using death verification databases in the Company’s operations, including to determine its IBNR liability for unpaid claims and claims adjustment expenses for life insurance products, partially offset by the impact of an adjustment recorded in 2015 to correct deferred premium reserves on certain limited pay life insurance policies and lower insurance expenses. See MD&A, “Life & Health Insurance,” beginning on page 46 for additional discussion of the segment’s results. The Company’s results were also significantly and negatively impacted in 2016, compared to 2015, by lower net realized gains on sales of investments and positively impacted in 2016, compared to 2015, from a loss from early extinguishment of debt in 2015. See MD&A, “Investment Results,” beginning on page 51, MD&A, “Expenses” beginning on page 57, and MD&A, “Liquidity and Capital Resources,” beginning on page 59 for additional discussion.
Net Investment Income decreased by $4.3 million in 2016 due primarily to lower investment returns from Alternative Investments, lower levels and lower returns on investments in equity securities excluding Alternative Investments, and higher level of investments in fixed income securities, partially offset by lower yields on fixed income securities. Net Investment Income from Alternative Investments decreased by $9.2 million. Alternative investment income from Equity Method Limited Liability Investments and Fair Value Option Investments decreased by $11.5 million and $2.1 million, respectively, in 2016, compared to 2015, while alternative investment income from other limited liability investments included in Equity Securities increased by $4.4 million. See MD&A, “Investment Results,” under the sub-caption “Net Investment Income” beginning on page 51 for additional discussion.
The number of ISO-classified catastrophic events and catastrophe losses and LAE, net of reinsurance recoveries, (excluding loss and LAE reserve development) by range of loss and business segment for the years ended December 31, 2017, 2016 and 2015 are presented below.
See MD&A, “Property & Casualty Insurance,” MD&A, “Life & Health Insurance,” and Note 6, “Property and Casualty Insurance Reserves,” to the Consolidated Financial Statements for additional information on the Company’s reserve development. See MD&A, “Critical Accounting Estimates,” of this 2017 Annual Report for additional information pertaining to the Company’s process of estimating property and casualty insurance reserves for losses and LAE, and the estimated variability thereof, development of property and casualty insurance losses and LAE, and a discussion of some of the variables that may impact them.
Selected financial information for the Property & Casualty Insurance segment is presented below.
As discussed in Note 3, “Acquisition of Business,” to the Consolidated Financial Statements, the Company completed its acquisition of Alliance United on April 30, 2015. Alliance United is a provider of nonstandard personal automobile insurance in California and has added significant scale to the Property & Casualty Insurance segment’s premium base. The results of Alliance United’s operations have been included in the Company’s consolidated results since the date of its acquisition, which can obscure certain comparisons of year-over-year results, particularly when analyzing overall segment results as well as the nonstandard personal automobile insurance line of business.
Net Investment Income in the Property & Casualty Insurance segment increased by $21.9 million in 2017, compared to 2016, due primarily to higher investment income from Alternative Investments, and to a lesser extent, higher levels of non-alternative investments. The Property & Casualty Insurance segment reported Net Investment Income from Alternative Investments of $37.4 million in 2017, compared to $20.2 million in 2016.
Insurance expenses were $382.8 million, or 22.1% of earned premiums, in 2017, an improvement of 1.8 percentage points compared to 2016, driven primarily by a mix shift in business written in the segment toward nonstandard personal automobile insurance, which runs at a lower expense ratio, improvement in the Alliance United expense ratio, an increase in the percentage of software development costs eligible for capitalization, cost reduction initiatives and premium growth outpacing growth in fixed costs.
Earned Premiums in the Property & Casualty Insurance segment increased by $199.6 million in 2016, compared to 2015. Excluding the $235.9 million impact from Alliance United, earned premiums decreased by $36.3 million, as lower volume accounted for a decrease of $55.6 million, while higher average earned premium accounted for an increase of $19.3 million. Excluding Alliance United, the lower volume was driven primarily by preferred personal automobile insurance, homeowners insurance and nonstandard personal automobile insurance, which had volume decreases of $28.3 million, $11.9 million and $9.0 million, respectively. Excluding Alliance United, the increase in average earned premium was driven primarily by nonstandard personal automobile insurance, which had an increase of $15.3 million.
Earned premiums in preferred personal automobile insurance decreased by $1.8 million in 2017, compared to 2016, as lower volume accounted for a decrease of $16.6 million, while higher average earned premium accounted for an increase of $14.8 million. The run-off of the direct-to-consumer business accounted for approximately 60% of the decrease in earned premiums attributed to lower volume. Incurred losses and LAE were $339.6 million, or 80.3% of earned premiums, in 2017, compared to $324.2 million, or 76.4% of earned premiums, in 2016. Incurred losses and LAE as a percentage of earned premiums increased due primarily to a higher level of adverse loss and LAE reserve development and higher underlying losses and LAE as a percentage of related earned premiums. Underlying losses and LAE as a percentage of related earned premiums were 73.0% in 2017, compared to 72.6% in 2016, which was a deterioration of 0.4 percentage points due primarily to higher severity of losses, particularly on bodily injury coverages, partially offset by lower frequency of claims on most coverages, particularly bodily injury. Catastrophe losses and LAE (excluding reserve development) were $11.3 million in 2017, compared to $11.6 million in 2016, both periods experiencing higher losses than average due primarily to Hurricane Harvey in 2017, and hailstorms in Texas in both 2017 and 2016. Adverse loss and LAE reserve development was $19.3 million in 2017, compared to $4.6 million in 2016.
Earned premiums in preferred personal automobile insurance decreased by $25.3 million in 2016, compared to 2015, as lower volume accounted for a decrease of $28.3 million, while higher average earned premium accounted for an increase of $3.0 million. The run-off of the direct-to-consumer business accounted for approximately 60% of the decrease in earned premiums attributed to lower volume. Incurred losses and LAE were $324.2 million, or 76.4% of earned premiums, in 2016, compared to $307.3 million, or 68.3% of earned premiums, in 2015. Incurred losses and LAE as a percentage of earned premiums increased due to an unfavorable change in loss and LAE reserve development, higher incurred catastrophe losses and LAE (excluding reserve development) and higher underlying losses and LAE as a percentage of earned premiums. Underlying losses and LAE as a percentage of related earned premiums were 72.6% in 2016, compared to 70.9% in 2015, which was an deterioration of 1.7 percentage points due primarily to slightly higher severity of losses on most coverages.
Earned Premiums on nonstandard personal automobile insurance increased by $242.2 million in 2016, compared to 2015. Excluding the impact from Alliance United, Earned Premiums increased by $6.3 million as higher average earned premium accounted for an increase of $15.3 million, while lower volume accounted for a decrease of $9.0 million. Incurred losses and LAE were $726.7 million, or 88.6% of earned premiums, in 2016, compared to $518.0 million, or 89.7% of earned premiums, in 2015. Excluding Alliance United, incurred losses and LAE were $243.3 million, or 78.2% of related earned premiums, in
2016, compared to $257.0 million, or 84.3% of related earned premiums, in 2015. Excluding the impact of Alliance United, incurred losses and LAE as a percentage of earned premiums decreased due to lower underlying losses and LAE as a percentage of earned premiums and a lower level of adverse loss and LAE reserve development, partially offset by higher incurred catastrophe losses and LAE (excluding reserve development). Excluding Alliance United, underlying losses and LAE as a percentage of related earned premiums were 75.9% in 2016, compared to 81.2% in 2015, which was an improvement of 5.3 percentage points due primarily to higher average earned premium, lower frequency of claims across all coverages on non-California policies and lower severity of property losses on California policies, partially offset by higher frequency of claims on most coverages on California policies and higher severity of bodily injury losses on non-California policies. For Alliance United, underlying losses and LAE as a percentage of related earned premiums were 94.0% in 2016, compared to 92.8% in 2015, which was a deterioration of 1.2 percentage points due primarily to higher frequency of claims on all coverages and, to a lesser extent, higher severity of losses on most coverages. Catastrophe losses and LAE (excluding reserve development) were $5.7 million in 2016, compared to $3.7 million in 2015. Adverse loss and LAE reserve development was $6.7 million in 2016, compared to $13.4 million in 2015.
Earned premiums in homeowners insurance decreased by $7.1 million in 2017, compared to 2016, as lower volume accounted for a decrease of $13.2 million, while higher average earned premium accounted for an increase of $6.1 million. Incurred losses and LAE were $287.8 million, or 108.7% of earned premiums, in 2017, compared to $204.5 million, or 75.2% of earned premiums, in 2016. Incurred losses and LAE as a percentage of earned premiums increased due to higher incurred catastrophe losses and LAE (excluding reserve development) and an unfavorable change in loss and LAE reserve development, partially offset by lower underlying losses and LAE as a percentage of earned premiums. Underlying losses and LAE as a percentage of earned premiums were 48.9% in 2017, compared to 49.9% in 2016, which was an improvement of 1.0 percentage points due primarily to lower frequency of claims, partially offset by higher severity of losses. Catastrophe losses and LAE (excluding reserve development) were $157.3 million in 2017, compared to $89.0 million in 2016. This increase was driven primarily by California wildfires, with estimated losses and LAE of $53.3 million, and higher average severity on catastrophic events in 2017 with losses and LAE (excluding reserve development) of less than $15 million, compared to 2016, partially offset by the impact of the aggregate losses and LAE from the two aforementioned Texas hailstorms that occurred in 2016 exceeding the losses and LAE from the aforementioned Texas hailstorm that occurred in March of 2017. Loss and LAE reserve development was adverse by $1.0 million in 2017, compared to favorable development of $20.0 million in 2016.
Selected financial information for the commercial automobile insurance product line follows.
Earned premiums in commercial automobile insurance decreased by $1.9 million in 2017, compared to 2016, as lower volume accounted for a decrease of $6.1 million, while higher average earned premium accounted for an increase of $4.2 million. Incurred losses and LAE were $42.4 million, or 82.5% of earned premiums, in 2017, compared to $47.2 million, or 88.6% of earned premiums, in 2016. Incurred losses and LAE as a percentage of earned premiums decreased due primarily to lower underlying losses and LAE as a percentage of earned premiums and a lower level of adverse loss and LAE reserve development Underlying losses and LAE as a percentage of earned premiums were 79.4% in 2017, compared to 82.6% in 2016, which was an improvement of 3.2 percentage points due primarily to higher average earned premium and lower frequency of claims, partially offset by higher severity of losses. Adverse loss and LAE reserve development was $0.9 million in 2017, compared to $2.4 million in 2016.
Selected financial information for the Life & Health Insurance segment is presented below.
Earned Premiums in the Life & Health Insurance segment increased by $8.8 million for the year ended December 31, 2017, compared to 2016 due primarily to higher volume from accident and health insurance products offered by Reserve National, partially offset by lower earned premiums on property insurance products offered by Kemper Home Service Companies (“KHSC”).
Policyholders’ Benefits and Incurred Losses and LAE decreased by $74.2 million in 2017, compared to 2016. Excluding the initial impact of using death verification databases described above, Policyholders’ Benefits and Incurred Losses and LAE increased by $3.6 million due primarily to growth in the Company’s accident and health insurance business, partially offset by lower policyholders’ benefits on life insurance. Insurance Expenses in the Life & Health Insurance segment decreased by $1.7 million due primarily to a higher portion of agent compensation for KHSC being deferrable as well as lower legal and agent incentive conference expenses for KHSC, partially offset by higher commission and amortization expense for Reserve National. Segment Net Operating Income in the Life & Health Insurance segment was $90.8 million for the year ended December 31, 2017, compared to $30.3 million in 2016.
Earned premiums on life insurance decreased by $1.9 million in 2017, compared to 2016, due primarily to the termination of the relationship between Reserve National and one of its brokers. Policyholders’ benefits on life insurance were $274.1 million in 2017, compared to $356.3 million in 2016, a decrease of $82.2 million. Excluding the initial impact of using death verification databases described above, Policyholders’ Benefits and Incurred Losses and LAE decreased by $4.4 million due primarily to lower policyholder benefits on Reserve National’s life insurance products. Insurance Expenses decreased by $3.4 million in 2017, compared to 2016, due primarily to a higher portion of agent compensation for KHSC being deferrable as well as lower legal and agent incentive conference expenses for KHSC, partially offset by higher commission and other general expenses for Reserve National.
Net Investment Income for the years ended December 31, 2017, 2016 and 2015 was:
Net Investment Income increased by $28.9 million for the year ended December 31, 2017, compared to 2016, due primarily to higher investment returns from Alternative Investments and higher levels of investments in fixed income securities, partially offset by lower yields on fixed income securities and lower levels of investments in equity securities, excluding alternative investments.
The components of Net Realized Gains on Sales of Investments for the years ended December 31, 2017, 2016 and 2015 were:
Net Realized Gains on Sales of Equity Securities for the year ended December 31, 2017 includes $35.2 million recognized on the sale of exchange traded fund shares due to tax planning initiatives and portfolio allocation adjustments.
Other sales activity in 2017, 2016 and 2015 was due to normal portfolio management.
The following table summarizes the credit quality of the fixed maturity investment portfolio at December 31, 2017 and 2016:
The following table summarizes the fair value of the Company’s ten largest exposures, excluding investments in U.S. Government and Government Agencies and Authorities and Short-term Investments, at December 31, 2017.
The Company engages in limited hedging activities to optimize exposure to foreign currencies and changes in interest rates. In 2017 the Company entered into a cross-currency interest rate swap to hedge the foreign denominated cash flows of one fixed maturity investment. In 2016, in anticipation of a debt offering in 2017, the Company entered into a cash flow hedge to optimize exposure to changes in interest rates. The Company does not directly participate, as either a lender or borrower of securities, in any securities lending program, nor does the Company participate directly in credit default swaps. The Company has limited exposure to such programs and activities by virtue of its investments in the limited liability investment companies and limited partnerships noted above. See Note 7 “Debt,” to the Consolidated Financial Statements for additional discussion of the cash flow hedge entered into by the Company in 2016 in anticipation of a debt offering in 2017.
Insurance Expenses decreased by $3.0 million for the year ended December 31, 2017, compared to 2016, due primarily to a lower premium deficiency in the Alliance United nonstandard personal automobile book of business, which allows for a higher percentage of acquisition costs to be deferred, an increase in the percentage of software development costs eligible for capitalization as projects moved from the preliminary project stage to the application development stage, and cost reduction initiatives, partially offset by growth in business. Insurance Expenses increased by $2.2 million for the year ended December 31, 2016, compared to 2015, due primarily to growth in business, partially offset by lower amortization of insurance in force.
2017 resulting from the full-year effect of freezing benefit accruals under the Company’s defined benefit pension plans and a longer amortization period to amortize actuarial losses, as discussed in Note 16 “Pension Benefits” to the Consolidated Financial Statements, partially offset by net curtailment gains recognized in 2016, higher employee compensation and a charge to earnings in 2017 to record the ineffective portion of a hedging relationship related to an anticipated debt issuance. Other Expenses decreased by $15.2 million for the year ended December 31, 2016, compared to 2015, due primarily to lower pension expense from the effect of freezing benefit accruals under the Company’s defined benefit pension plans.
The Company’s effective income tax rate from continuing operations differs from the Federal statutory income tax rate due primarily to the effects of tax-exempt investment income and dividends received deductions, the Tax Act, interest related to unrecognized tax benefits, estimated indemnification recoveries recognized in earnings pursuant to the Alliance United purchase agreement, a permanent difference between the amount of long-term equity-based compensation expense recognized under GAAP and the amount deductible in the computation of Federal taxable income, and the net effects of state income taxes.
During 2017, Kemper did not repurchase any shares of its common stock. During 2016, Kemper repurchased approximately 0.1 million shares of its common stock at an aggregate cost of $3.8 million in open market transactions under the 2014 Repurchase Program. During 2015, Kemper repurchased approximately 1.2 million shares of its common stock at an aggregate cost of $43.5 million in open market transactions under the 2014 Repurchase Program. The Company had $243.7 million of remaining capacity under the 2014 Repurchase Program at December 31, 2017.
Kemper paid a quarterly dividend to shareholders of $0.24 per common share in each quarter of 2017. Dividends paid were $49.5 million for the year ended December 31, 2017.
Kemper directly held cash and investments totaling $197.3 million at December 31, 2017, compared to $298.7 million at December 31, 2016. Sources available for the repayment of indebtedness, repurchases of common stock, future shareholder dividend payments, additional capitalization of its direct insurance subsidiaries, and the payment of interest on Kemper’s senior notes and subordinated debentures include cash and investments directly held by Kemper, receipt of dividends from Kemper’s subsidiaries and borrowings under the credit agreement.
During periods of growth, insurance companies typically experience positive operating cash flows and are able to invest a portion of their operating cash flows to fund future policyholder benefits and claims. During periods in which premium revenues decline, insurance companies may experience negative cash flows from operations and may need to sell investments to fund payments to policyholders and claimants. In addition, if the Company’s property and casualty insurance subsidiaries experience several significant catastrophic events over a relatively short period of time, investments may have to be sold in
advance of their maturity dates to fund payments, which could result in either investment gains or losses. Management believes that its property and casualty insurance subsidiaries maintain adequate levels of liquidity in the event that they were to experience several future catastrophic events over a relatively short period of time.
The Company has no material obligations under guarantee contracts. The Company has no material retained or contingent interests in assets transferred to an unconsolidated entity. The Company has no material obligations, including contingent obligations, under contracts that would be accounted for as derivative instruments. The Company has no obligations, including contingent obligations, arising out of a variable interest in an unconsolidated entity held by, and material to, the Company,
where such entity provides financing, liquidity, market risk or credit risk support to, or engages in leasing, hedging or research and development services with the Company. Accordingly, the Company has no material off-balance sheet arrangements.
Estimated cash disbursements pertaining to the Company’s contractual obligations at December 31, 2017 are presented below.
In addition to the purchase obligations included above, the Company had certain investment commitments totaling $255.1 million at December 31, 2017. The funding of such investment commitments is dependent on a number of factors, the timing of which is indeterminate. The contractual obligations reported above also exclude the Company’s liability of $8.1 million for unrecognized tax benefits. The Company cannot make a reasonably reliable estimate of the amount and period of related future payments, if any, for such liability. Other Contractual Obligations Reflected in Long Term Liabilities on the Consolidated Balance Sheet under GAAP primarily consist of interest obligations related to Long Term Debt Obligations.
Kemper’s subsidiaries conduct their businesses in two industries: property and casualty insurance and life and health insurance. Accordingly, the Company is subject to several industry-specific accounting principles under GAAP. The preparation of financial statements in accordance with GAAP requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The process of estimation is inherently uncertain. Accordingly, actual results could ultimately differ materially from the estimated amounts reported in a company’s financial statements. Different assumptions are likely to result in different estimates of reported amounts. The Company’s critical accounting policies most sensitive to estimates include the valuation of investments, the valuation of property and casualty insurance reserves for losses and LAE, the assessment of recoverability of goodwill and the valuation of pension benefit obligations.
reasonably possible that changes in the fair values of the Company’s investments reported at fair value will occur in the near term and such changes could materially affect the amounts reported in the financial statements. Also, it is reasonably possible that changes in the carrying values of the Company’s Equity Method Limited Liability Investments will occur in the near term and such changes could materially affect the amounts reported in the financial statements because these issuers follow specialized industry accounting rules which require that they report all of their investments at fair value (See Item 1A., “Risk Factors” under the title “The Company’s investment portfolio is exposed to a variety of risks that may negatively impact net investment income and cause realized and unrealized losses”).
Under GAAP, a company may elect to use the fair value option for some or all of its investments in financial instruments. Under the fair value option, a company is required to recognize changes in the fair values into income for the period reported. Had the Company elected the fair value option for all of its investments in financial instruments, the Company’s reported net income for the year ended December 31, 2017, would have increased by $59.0 million.
Changes in these factors from their December 31, 2017 evaluation date could result in the Company determining that a temporary decline in the fair value of an investment held and evaluated at December 31, 2017 is no longer temporary at a subsequent evaluation date. Such determination would result in an impairment loss recognized in earnings in the period such determination is made.
The Company’s Property and Casualty Insurance Reserves are reported using the Company’s estimate of its ultimate liability for losses and LAE for claims that occurred prior to the end of any given accounting period but have not yet been paid. The Company had $1,016.8 million and $931.4 million of gross loss and LAE reserves at December 31, 2017 and 2016, respectively.
In estimating the Company’s Property and Casualty Insurance Reserves, the Company’s actuaries exercise professional judgment and must consider, and are influenced by, many variables that are difficult to quantify. Accordingly, the process of estimating and establishing the Company’s Property and Casualty Insurance Reserves is inherently uncertain, and the actual ultimate net cost of known and unknown claims may vary materially from the estimated amounts reserved. The reserving process is particularly imprecise for claims involving asbestos, environmental matters, construction defect and other emerging and/or long-tailed exposures which may not be discovered or reported until years after the insurance policy period has ended. Property and Casualty Insurance Reserves related to the Company’s discontinued operations are predominantly long-tailed exposures, $16.3 million of which was related to asbestos, environmental matters and construction defect exposures at December 31, 2017.
The key assumption in these estimation methodologies is that patterns observed in prior periods are indicative of how losses and LAE are expected to develop in the future and that such historical data can be used to predict and estimate ultimate losses and LAE. However, changes in the Company’s business processes, by their very nature, are likely to affect the development patterns, which generally results in the historical development factors becoming less reliable over time in predicting how losses and LAE will ultimately develop. The ultimate impact of a single change in a business process is difficult to quantify and detect, and even more difficult if several changes to business processes occur over several years. Initially after a change is implemented, there are fewer data points, as compared to the historical data, for the Company’s actuaries to analyze. With fewer
data points to analyze, the Company’s actuaries cannot be certain that observed differences from the historical data trends are a
development methodology. However, in some circumstances changes can occur which impact numerous variables, including, but not limited to, those variables identified below that are difficult to quantify and/or impact the predictive value of prior development patterns relied upon in the incurred loss development methodology and paid loss development methodology. In those circumstances, the Company’s actuaries must make adjustments to these loss reserving estimation methodologies or use additional generally accepted actuarial estimation methodologies. In those circumstances, the Company’s actuaries, using their professional judgment, may place more weight on the adjusted loss reserving estimation methodologies or other generally accepted actuarial estimation methodologies until the newer development patterns fully emerge and the Company’s actuaries can fully rely on the unadjusted loss reserving estimation methodologies. In the event of a wide variation among results generated by the different projection methodologies, the Company’s actuaries further analyze the data using additional techniques.
The Company’s goal is to ensure that its total reserves for property and casualty insurance losses and LAE are adequate to cover all costs, while sustaining minimal variation from the time reserves for losses and LAE are initially estimated until losses and LAE are fully developed. Changes in the Company’s estimates of these losses and LAE over time, also referred to as “development,” will occur and may be material. Favorable development is recognized and reported in the Consolidated Financial Statements when the Company decreases its previous estimate of ultimate losses and LAE and results in an increase in net income in the period recognized, whereas adverse development is recognized and reported in the Consolidated Financial Statements when the Company increases its previous estimate of ultimate losses and LAE and results in a decrease in net income.
Development for the years ended December 31, 2017, 2016 and 2015, was:
development, which could result in the actual loss developing closer to, or even below, the lower end of the Company’s estimated reserve variability. Significant unfavorable changes in one or more factors will lead to unfavorable loss reserve development, which could result in the actual loss developing closer to, or even above, the higher end of the Company’s estimated reserve variability. Accordingly, due to these factors and the other factors enumerated throughout the MD&A and the inherent limitations of the loss reserving estimation methodologies, the estimated and illustrated reserve variability may not necessarily be indicative of the Company’s future reserve variability, which could ultimately be greater than the estimated and illustrated variability. In addition, as previously noted, development will emerge in all of the Company’s product lines over time. Accordingly, the Company’s future reserve variability could ultimately be greater than the illustrated variability. Additional information pertaining to the estimation of, and development of, the Company’s Property and Casualty Insurance Reserves is contained in Item 1 of Part I of this 2017 Annual Report under the heading “Property and Casualty Loss and Loss Adjustment Expense Reserves.”
The process of estimating the Company’s pension benefit obligations and pension benefit costs is inherently uncertain and the actual cost of benefits may vary materially from the estimates recorded. These liabilities are particularly volatile due to their long-term nature and are based on several assumptions. The main assumptions used in the valuation of the Company’s pension benefit obligations and pension costs are:
A change in any one or more of these assumptions is likely to result in a projected benefit obligation or pension cost that differs from the actuarial estimates at December 31, 2017. Such changes in estimates may be material. For example, a one-percentage point decrease in the Company’s estimated discount rate would increase the pension benefit obligation at December 31, 2017 by $95.3 million, while a one-percentage point increase in the rate would decrease the pension benefit obligation at December 31, 2017 by $76.3 million. A one-percentage point decrease in the Company’s estimated long-term rate of return on plan assets would increase the pension expense for the year ended December 31, 2017 by $5.3 million, while a one-percentage point increase in the rate would decrease pension expense by $5.3 million for the same period.
The Company has adopted all recently issued accounting pronouncements with effective dates prior to January 1, 2018. See Note 2, “Summary of Accounting Policies and Accounting Changes” for discussion on adoption of these ASUs and impacts to the Company’s financial statements, which were not material. For all recently issued accounting pronouncements with effective dates after December 31, 2017, the Company does not expect adoption to have a material impact on its financial statements, with the possible exceptions of ASU 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities, ASU 2016-02, Leases (Topic 842) and ASU 2016-13, Financial Instruments-Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments.
The preparation of financial statements in conformity with GAAP requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates and assumptions.
Fair Value Option Investments include investments in certain hedge funds, which the Company has elected the fair value option (“FVO”) to account for such investments. Under the FVO method of accounting, the Company reports changes in the fair value of such investments in Net Investment Income in the Consolidated Statements of Income. The hedge funds are designed to preserve liquidity, while providing higher returns than Kemper would otherwise expect to earn had it invested in other short-term investments.
For traditional life insurance products, the reserves for future policy benefits are estimated on the net level premium method using assumptions as of the issue date for mortality, interest, policy lapses and expenses, including provisions for adverse mortality. These assumptions vary by such characteristics as plan, age at issue and policy duration. Mortality assumptions are based on the Company’s historical experience and industry standards. Interest rate assumptions principally range from 3% to 7%. Lapse rate assumptions are based on actual and industry experience. Insurance Reserves for life insurance products are comprised of reserves for future policy benefits plus an estimate of the Company’s liability for unpaid life insurance claims and claims adjustment expenses, which includes an estimate for IBNR life insurance claims. Prior to the third quarter of 2016, except when required by applicable law, the Company did not utilize the database of reported deaths maintained by the Social Security Administration or any other comparable database (a “Death Master File” or “DMF”) in its operations, including to determine its IBNR liability for life insurance products. Instead of using such a database, the Company calculated its IBNR liability for life insurance products using Company-specific historical information, which included analyzing average paid claims and the average lag between date of death and the date reported to the Company for claims for which proof of death had been provided. In the third quarter of 2016, the Company initiated a voluntary enhancement of its claims handling procedures for its life insurance policies. The Company is now utilizing a DMF to identify potential situations where the Company has yet to be notified of an insured’s death and, as appropriate, initiating an outreach process to identify and contact beneficiaries and settle claims. Policyholders’ Benefits and Incurred Losses and Loss Adjustment Expenses for the year ended December 31, 2016 include a charge of $77.8 million to recognize the initial impact of using a DMF in the Company’s operations, including to determine its IBNR liability for unpaid claims and claims adjustment expenses for life insurance products. No such charge was recorded during the year ended December 31, 2017 or December 31, 2015.
Insurance licenses acquired in business combinations and other indefinite life intangibles are not amortized, but rather tested periodically for recoverability.
The Company accounts for the present value of the future profits embedded in life insurance in force acquired (“Life VIF”) based on actuarial estimates of the present value of estimated net cash flows. Life VIF was $25.5 million and $28.9 million at December 31, 2017 and 2016, respectively. Life VIF is amortized using the effective interest method using interest rates consistent with the rates in the underlying insurance contracts. The Company estimates that it will record Life VIF amortization, net of interest, of $3.0 million in 2018, $2.8 million in 2019, $2.3 million in 2020, $2.0 million in 2021 and $1.9 million in 2022. The Company evaluates the Life VIF for recoverability annually.
The Company accounts for the present value of the future profits embedded in Property and Casualty Insurance Customer Relationships Acquired (“P&C Customer Relationships”) based on the present value of estimated future cash flows from the customer relationships acquired. P&C Customer Relationships was $7.3 million and $9.0 million at December 31, 2017 and 2016, respectively. P&C Customer Relationships is amortized using the effective interest method. P&C Customer Relationships is tested for recoverability using undiscounted projections of future cash flows and written down to estimated fair value if the carrying value exceeds the sum of such projections of undiscounted cash flows.
Effective January 1, 2016, the Company changed its method for estimating the interest and service cost components of expense recognized for its pension and other postretirement employee benefit plans. As a result, the Company elected to use a full yield curve approach to estimate these components of benefit cost by applying the specific spot rates along the yield curve used in the determination of the benefit obligation to the relevant projected cash flows. Prior to 2016, the interest and service cost components were estimated using a single weighted-average discount rate derived from the yield curve used to measure the projected benefit obligation or accumulated postretirement benefit obligation, as relevant, at the beginning of the period. The change provides a more precise measurement of interest and service costs by improving the correlation between projected benefit cash flows to the corresponding spot yield curve rates. The Company has accounted for this change as a change in accounting estimate that is inseparable from a change in accounting principle and, accordingly, recognized the effect prospectively in 2016. The change in method for estimating the interest and service cost components decreased pension expense for the year ended December 31, 2016 by approximately $2.7 million, but had no impact on the measurement of benefit obligations.
In May 2015, the FASB issued ASU 2015-07 Fair Value Measurement (Topic 820), Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent). ASU 2015-07 removes the requirement to categorize within the fair value hierarchy all investments for which fair value is measured using the net asset value per share practical expedient. The amendments also remove the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the net asset value per share practical expedient. Rather, those disclosures are limited to investments for which the entity has elected to measure the fair value using that practical expedient. The Company adopted ASU 2015-07 in the first quarter of 2016 and applied its provisions on a retrospective basis. Except for the change in disclosure requirements, adoption of ASU 2015-07 did not impact the Company’s financial statements.
In January 2016, the FASB issued ASU 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. ASU 2016-01 addresses certain aspects of recognition, measurement, presentation and disclosure of financial instruments. Most significantly, ASU 2016-01 requires companies to measure equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) at fair value with changes in fair value recognized in net income. However, an entity may choose to measure equity investments that do not have readily-determinable fair values at cost minus impairment, if any, plus or minus
Codification (“ASC”) and creating a new topic on accounting for leases. ASU 2016-02 introduces a lessee model that requires most leases to be reported on the balance sheet of a lessee. ASU 2016-02 also aligns many of the underlying principles of the new lessor model with those in ASC Topic 606, Revenue from Contracts with Customers, the FASB’s new revenue recognition standard (e.g., those related to evaluating when profit can be recognized). Furthermore, ASU 2016-02 addresses other concerns related to the current leases model. For example, ASU 2016-02 eliminates the requirement in current GAAP for an entity to use bright-line tests in determining lease classification. ASU 2016-02 also requires lessors to increase the transparency of their exposure to changes in value of their residual assets and how they manage that exposure. ASU 2016-02 is effective for fiscal years beginning after December 15, 2018 and interim periods within those years with early adoption permitted. The Company is currently evaluating the impact of this guidance on its financial statements.
The Company completed the allocation of the purchase price to the assets acquired and liabilities assumed in 2015. The final allocation of the purchase price to the fair values of the assets acquired and liabilities assumed is presented below.
The amortized cost and estimated fair values of the Company’s Investments in Fixed Maturities at December 31, 2016 were:
Included in the fair value of Other Mortgage- and Asset-backed investments at December 31, 2016 are $0.9 million of collateralized debt obligations and $1.2 million of non-governmental residential mortgage-backed securities.
The amortized cost and estimated fair values of the Company’s Investments in Fixed Maturities at December 31, 2017 by contractual maturity were:
The expected maturities of the Company’s Investments in Fixed Maturities may differ from the contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties. Investments in Mortgage- and Asset-backed Securities Not Due at a Single Maturity Date at December 31, 2017 consisted of securities issued by the Government National Mortgage Association with a fair value of $352.9 million, securities issued by the Federal National Mortgage Association with a fair value of $10.7 million, securities issued by the Federal Home Loan Mortgage Corporation with a fair value of $3.9 million and securities of other non-governmental issuers with a fair value of $140.8 million.
An aging of unrealized losses on the Company’s Investments in Fixed Maturities and Equity Securities at December 31, 2017 is presented below.
Equity Method Limited Liability Investments include investments in limited liability investment companies and limited partnerships in which the Company’s interests are not deemed minor and are accounted for under the equity method of accounting. The Company’s investments in Equity Method Limited Liability Investments are generally of a passive nature in that the Company does not take an active role in the management of the investment entity. In 2017, 2016 and 2015, aggregate investment income (losses) from Equity Method Limited Liability Investments exceeded 10% of the Company’s pretax consolidated net income. Accordingly, the Company is disclosing aggregated summarized financial data for its Equity Method Limited Liability Investments. Such aggregated summarized financial data does not represent the Company’s proportionate share of the Equity Method Limited Liability Investment assets or earnings. Aggregate total assets of the Equity Method Limited Liability Investments in which the Company invested totaled $2,393.7 million, $2,618.1 million and $3,801.7 million, as of December 31, 2017, 2016 and 2015, respectively. Aggregate total liabilities of the Equity Method Limited Liability Investments in which the Company invested totaled $899.7 million, $828.0 million and $879.1 million, as of December 31, 2017, 2016 and 2015, respectively. Aggregate net income of the Equity Method Limited Liability Investments in which the Company invested totaled $209.3 million, $85.0 million and $159.6 million for the years ended December 31, 2017, 2016 and 2015, respectively. The aggregate summarized financial data is based on the most recent and sufficiently-timely financial information available to the Company as of the respective reporting dates and periods. The Company’s maximum exposure to loss at December 31, 2017 is limited to the total carrying value of $161.0 million. In addition, the Company had outstanding commitments totaling approximately $101.0 million to fund Equity Method Limited Liability Investments at December 31, 2017.
The Company tests goodwill for recoverability at the reporting unit level on an annual basis as of the beginning of the first quarter and, if circumstances or events indicate that the fair value of a reporting unit may have declined below its carrying value, such tests are performed at intervening interim periods. The Company performed a quantitative goodwill impairment assessment for all reporting units as of January 1, 2017 and 2016, principally using projections of discounted future cash flows to estimate the fair values of the reporting units. For each reporting unit tested, the estimated fair value exceeded the carrying value of the reporting unit, and the Company concluded that the associated goodwill was recoverable at the aforementioned dates tested.
The following tables contain information about incurred and paid claims development as of and for the year ended December 31, 2017, net of reinsurance and indemnification, as well as cumulative claim frequency and the total of IBNR liabilities, including expected development on reported claims included within the net incurred losses and allocated LAE amounts. The tables are grouped by major product line and, if relevant, coverage. The information about incurred and paid claims development for the years ended December 31, 2013 through 2015 is presented as supplementary information and is unaudited.
The following is supplementary information about average historical claims duration as of December 31, 2017.
development of $0.9 million from continuing operations and favorable development of $1.5 million from discontinued operations.
Reinsurance and indemnification recoverables on property and casualty insurance reserves were $53.1 million and $50.2 million at December 31, 2017 and 2016, respectively. These recoverables are concentrated with several reinsurers, the vast majority of which are highly rated by one or more of the principal investor and/or insurance company rating agencies. While most of these recoverables were unsecured at December 31, 2017 and 2016, the agreements with the reinsurers generally provide for some form of collateralization upon the occurrence of certain events.
The Company designates debt obligations as either short-term or long-term based on maturity date at issuance. Total amortized cost of Long-term Debt, Current and Non-current, outstanding at December 31, 2017 and 2016 was:
There were no outstanding borrowings at either December 31, 2017 or December 31, 2016 under Kemper’s $225.0 million, unsecured, revolving credit agreement which expires June 2, 2020.
During the fourth quarter of 2016, in anticipation of a debt issuance in 2017 and for risk management purposes, the Company entered into a derivative transaction to hedge the risk of changes in the debt cash flows attributable to changes in the benchmark U.S. Treasury interest rate during the period leading up to the probable debt issuance (“Treasury Lock”). The Treasury Lock was formally designated as a cash flow hedge at inception and qualified for hedge accounting treatment. In the second quarter of 2017, the Company de-designated a portion of the cash flow hedge because the anticipated principal issuance was less than the notional amount of the Treasury Lock and recorded a pre-tax charge of $1.1 million in Other Expenses. The effective portion of the loss on the derivative instrument upon discontinuance was $4.5 million before taxes, and is reported as a component of Accumulated Other Comprehensive Income. Beginning with the additional issuance of the 2025 Senior Notes described in the preceding paragraph, such loss is being amortized into earnings and reported in Interest Expense in the same periods that the hedged items affect earnings. Amortization, reported in Interest Expense, was $0.2 million for the year ended December 31, 2017. The Company expects to reclassify $0.4 million of net losses on derivative instruments from AOCI to earnings for the twelve months ended December 31, 2018 as interest expense on the debt is recognized. The Treasury Lock was in a gain position of $1.6 million at December 31, 2016 and, accordingly, such gain was included in Other Assets in the Consolidated Balance Sheet at such date.
Interest Expense, including facility fees, accretion of discount and amortization of issuance costs, was $34.9 million, $44.4 million and $46.5 million for the years ended December 31, 2017, 2016 and 2015, respectively. Interest paid, including facility fees, was $34.7 million, $44.2 million and $44.1 million for the years ended December 31, 2017, 2016 and 2015, respectively.
Future minimum lease payments under capital and operating leases at December 31, 2017 were:
The total of minimum rentals to be received in the future under non-cancelable subleases was $0.4 million at December 31, 2017.
Kemper did not repurchase any of its common stock in open market transactions in 2017. Kemper repurchased and retired 0.1 million shares of its common stock in open market transactions at an aggregate cost of $3.8 million in 2016. Kemper repurchased and retired 1.2 million shares of its common stock in open market transactions at an aggregate cost of $43.5 million in 2015.
Kemper’s insurance subsidiaries are required to file financial statements prepared on the basis of statutory insurance accounting practices, a comprehensive basis of accounting other than GAAP. Statutory capital and surplus for the Company’s life and health insurance subsidiaries was $414.3 million and $403.7 million at December 31, 2017 and 2016, respectively. Statutory net income for the Company’s life and health insurance subsidiaries was $84.1 million, $29.7 million and $62.8 million for the years ended December 31, 2017, 2016 and 2015, respectively. Statutory capital and surplus for the Company’s property and casualty insurance subsidiaries was $855.3 million and $928.9 million at December 31, 2017 and 2016, respectively. Statutory net income for the Company’s property and casualty insurance subsidiaries was $56.9 million, $1.4 million and $58.9 million for the years ended December 31, 2017, 2016 and 2015, respectively. Statutory capital and surplus and statutory net income exclude parent company operations.
Kemper’s insurance subsidiaries are also required to hold minimum levels of statutory capital and surplus to satisfy regulatory requirements. The minimum statutory capital and surplus, or company action level RBC, necessary to satisfy regulatory requirements for the Company’s life and health insurance subsidiaries collectively was $120.9 million at December 31, 2017. The minimum statutory capital and surplus necessary to satisfy regulatory requirements for the Company’s property and casualty insurance subsidiaries collectively was $340.5 million at December 31, 2017. Company action level RBC is the level at which a company is required to file a corrective action plan with its regulators and is equal to 200% of the authorized control level RBC.
The design of the Omnibus Plan provides for fungible use of shares to determine the number of shares available for future grants, with a fungible conversion factor of three to one, such that the Share Authorization will be reduced at two different rates, depending on the type of award granted. Each share of Kemper common stock issuable upon the exercise of stock options or stock appreciation rights will reduce the number of shares available for future grant under the Share Authorization by one share, while each share of Kemper common stock issued pursuant to “full value awards” will reduce the number of shares available for future grant under the Share Authorization by three shares. “Full value awards” are awards, other than stock options or stock appreciation rights, that are settled by the issuance of shares of Kemper common stock and include time-based restricted stock awards and time-based restricted stock units (collectively “RSUs”), performance-based restricted stock units (“PSUs”) and deferred stock units (“DSUs”).
The Company uses the Black-Scholes option pricing model to estimate the fair value of each Tandem Award on the date of grant. The expected terms of Tandem Awards are developed by considering the Company’s historical Tandem Award exercise experience, demographic profiles, historical share retention practices of employees and assumptions about their propensity for early exercise in the future. Expected volatility is estimated using weekly historical volatility. The Company believes that historical volatility is currently the best estimate of expected volatility. The dividend yield in 2017, 2016 and 2015 was calculated by taking the natural logarithm of the annualized yield divided by the Kemper common stock price on the date of grant. The risk-free interest rate was the yield on the grant date of U.S. Treasury zero coupon issues with a maturity comparable to the expected term of the option.
Tandem Award activity for the year ended December 31, 2017 is presented below.
Information pertaining to Tandem Awards outstanding at December 31, 2017 is presented below.
The grant-date fair values of RSUs, both time-based restricted stock awards and time-based restricted stock units, are determined using the closing price of Kemper common stock on the date of grant. Activity related to nonvested RSUs for the year ended December 31, 2017 is presented below.
Activity related to nonvested PSU awards for the year ended December 31, 2017 is presented below.
Fifty percent of the PSU awards granted to employees and officers in 2017 and 2016 are measured using a market performance condition. All of the PSU awards granted to employees and officers in 2015 are measured using a market performance condition. Fair value for these awards was estimated using the Monte Carlo simulation method described above. Final payout for these awards, and any forfeitures of units for performance below the “target” performance level, will be based on Kemper’s total shareholder return, relative to a peer group comprised of all the companies in the S&P Supercomposite Insurance Index, over a three-year performance period. The three-year performance periods for the 2017, 2016 and 2015 awards end on January 31, 2020, February 28, 2019, and December 31, 2017, respectively. Compensation cost for these awards is recognized ratably over the requisite service period. In the event that the market performance condition is not satisfied, previously recognized compensation cost would not reverse, but it would reverse if the requisite service period is not met.
Activity related to DSU awards for the year ended December 31, 2017 is presented below.
The Company’s awards of restricted stock contain rights to receive non-forfeitable dividends and participate in the undistributed earnings with common shareholders. The Company’s awards of RSUs, PSUs and DSUs contain rights to receive non-forfeitable dividend equivalents and participate in the undistributed earnings with common shareholders. Accordingly, the Company is required to apply the two-class method of computing basic and diluted earnings per share. A reconciliation of the numerator and denominator used in the calculation of Basic Income from Continuing Operations Per Unrestricted Share and Diluted Income from Continuing Operations Per Unrestricted Share for the years ended December 31, 2017, 2016 and 2015 is presented below.
NOTE 12. OTHER COMPREHENSIVE INCOME (LOSS) AND ACCUMULATED OTHER COMPREHENSIVE INCOME
The components of Other Comprehensive Income (Loss) Before Income Taxes for the years ended December 31, 2017, 2016 and 2015 were:
The components of AOCI at December 31, 2017 and 2016 were:
Components of AOCI were reclassified to the following lines of the Consolidated Statements of Income for the years ended December 31, 2017, 2016 and 2015:
Insurance Expenses for the years ended December 31, 2017, 2016 and 2015 were:
The Company had not previously provided for Federal income taxes on $14.7 million of Mutual Savings Life’s income earned prior to 1984, which was not subject to income taxes under certain conditions prior to the Tax Act. Under the Tax Act, such income is now subject to taxation. Accordingly, the Company recognized current income tax expense of $3.1 million in the Company’s Consolidated Statement of Income for the year ended December 31, 2017.
The expiration of federal net operating loss (“NOL”) carryforwards and their related deferred income tax assets at December 31, 2017 is presented below by year of expiration.
A reconciliation of the beginning and ending amount of Unrecognized Tax Benefits for the years ended December 31, 2017, 2016 and 2015 is presented below.
During March of 2017, the Internal Revenue Service commenced an examination of Kemper and its eligible subsidiaries’ consolidated Federal income tax return for the years ended December 31, 2014, and 2015.
Unrecognized Tax Benefits at December 31, 2017, 2016 and 2015 include $7.6 million, $4.6 million and $3.3 million, respectively, for tax positions for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductibility. Because of the impact of deferred income tax accounting, other than for interest and penalties, the disallowance of the shorter deductibility period would not affect the effective income tax rate but would accelerate the payment of cash to the taxing authority to an earlier period.
The statute of limitations related to Kemper and its eligible subsidiaries’ consolidated Federal income tax returns is closed for all tax years up to and including 2013. The statute of limitations related to Kemper and its eligible subsidiaries’ consolidated Federal income tax return for the tax year ended December 31, 2014 has been extended to March 15, 2019. The expiration of the statute of limitations related to the various state income tax returns that Kemper and its subsidiaries file varies by state.
The Company sponsors a qualified defined benefit pension plan (the “Pension Plan”). The Pension Plan covers approximately 9,000 participants and beneficiaries, of which 1,600 are active employees. The Pension Plan is closed to new employees hired after January 1, 2006. The Pension Plan is generally non-contributory, but participation requires or required some employees to contribute 3% of pay, as defined, per year. Benefits for participants who are or were required to contribute to the Pension Plan are based on compensation during plan participation and the number of years of participation. Benefits for the vast majority of participants who are not required to contribute to the Pension Plan are based on years of service and final average pay, as defined. The Company funds the Pension Plan in accordance with the requirements of ERISA.
On May 12, 2016, the Company amended the Pension Plan to freeze benefit accruals, effective June 30, 2016, for substantially all of the participants under the plan. Accordingly, plan assets and liabilities were re-measured, resulting in balances in accumulated unrecognized pension loss and unamortized prior service credit prior to the freeze of $191.2 million and $0.3 million, respectively. In recognizing the curtailment, the Company recorded income of $0.3 million before income taxes in the second quarter of 2016 to immediately recognize the remaining unamortized prior service credit in the Pension Plan. The curtailment reduced the accumulated unrecognized pension loss by $23.3 million. The remaining accumulated unrecognized pension loss of $167.9 million as of the re-measurement date is being amortized over approximately 25 years, the remaining average estimated life expectancy of participants. Prior to the amendment, the accumulated unrecognized pension loss was being amortized over approximately 5 years, the remaining average service life of active participants.
Changes in Fair Value of Plan Assets and Changes in Projected Benefit Obligation for the Pension Plan for the years ended December 31, 2017 and 2016 is presented below.
The investment objective of the Pension Plan is to produce current income and long-term capital growth through a combination of equity and fixed income investments which, together with appropriate employer contributions and any required employee contributions, is adequate to provide for the payment of the benefit obligations of the Pension Plan. The assets of the Pension Plan may be invested in fixed income and equity investments or any other investment vehicle or financial instrument deemed appropriate. Fixed income investments may include cash and short-term instruments, U.S. Government securities, corporate bonds, mortgages and other fixed income investments. Equity investments may include various types of stock, such as large-cap, mid-cap and small-cap stocks, and may also include investments in investment companies, collective investment funds and Kemper common stock (subject to Section 407 and other requirements of ERISA). The Pension Plan has not invested in Kemper common stock.
The Company determines its Expected Long Term Rate of Return on Plan Assets based primarily on the Company’s expectations of future returns, with consideration to historical returns, for the Pension Plan’s investments, based on target allocations of the Pension Plan’s investments.
Additional information pertaining to the changes in the fair value of the Pension Plan’s assets classified as Level 3 in the two preceding tables for the years ended December 31, 2017 and 2016 is presented below.
The unfunded liability related to the Supplemental Plan was $26.3 million and $25.4 million at December 31, 2017 and 2016, respectively. Pension expense for the Supplemental Plan was $0.8 million for the year ended December 31, 2017, compared to pension income of $1.0 million and pension expense $2.1 million for the years ended December 31, 2016, and 2015, respectively. An actuarial loss of $1.6 million before taxes, an actuarial gain of $4.8 million before taxes and an actuarial gain of $1.5 million before taxes are included in Other Comprehensive Income (Loss) for the years ended December 31, 2017, 2016 and 2015, respectively.
Changes in Fair Value of Plan Assets and Changes in Accumulated Postretirement Benefit Obligation for the years ended December 31, 2017 and 2016 were:
The measurement dates of the assets and liabilities at end of year in the preceding table under the headings “2017” and “2016” were December 31, 2017 and December 31, 2016, respectively.
The weighted-average discount rate and rate of increase in future compensation levels used to develop the components of the Accumulated Postretirement Benefit Obligation at December 31, 2017 and 2016 were:
The Company estimates that OPEB Expense for the year ended December 31, 2018 will include income of $3.0 million resulting from the amortization of the related accumulated actuarial gain and prior service credit included in AOCI at December 31, 2017.
The Company expects to contribute $1.6 million, net of the expected Medicare Part D subsidy, to its OPEB Plan to fund benefit payments in 2018.
Segment Revenues, including a reconciliation to Total Revenues, for the years ended December 31, 2017, 2016 and 2015 were:
Segment Operating Profit, including a reconciliation to Income from Continuing Operations before Income Taxes, for the years ended December 31, 2017, 2016 and 2015 was:
Summary financial information included in Income from Discontinued Operations for the years ended December 31, 2017, 2016 and 2015 is presented below.
The Property & Casualty Insurance segment’s catastrophe reinsurance in 2017, 2016 and 2015 also included reinsurance coverage from the Florida Hurricane Catastrophe Fund (the “FHCF”) for hurricane losses in Florida at retentions lower than those described above. The Life & Health Insurance segment also purchases reinsurance from the FHCF for hurricane losses in Florida. Except for the coverage provided by the FHCF, the Life & Health Insurance segment does not carry any other catastrophe reinsurance coverage.
Total catastrophe loss and LAE reserves, net of reinsurance recoverables, developed favorably by $4.5 million, $19.3 million and $7.8 million in 2017, 2016 and 2015, respectively. The Property & Casualty Insurance segment reported favorable catastrophe reserve development of $5.0 million, $19.2 million and $7.9 million in 2017, 2016 and 2015, respectively. The Life & Health Insurance segment reported adverse catastrophe reserve development of $0.5 million in 2017, favorable catastrophe reserve development of $0.1 million in 2016, and adverse catastrophe reserve development of $0.1 million in 2015.
Earned Premiums ceded on long-duration and short-duration policies were $18.2 million, $19.0 million and $20.6 million for the years ended December 31, 2017, 2016 and 2015, respectively, of which $11.0 million, $12.0 million and $12.9 million, respectively, was related to catastrophe reinsurance. See Note 20, “Catastrophe Reinsurance,” to the Consolidated Financial Statements for additional information regarding the Company’s catastrophe reinsurance programs. Certain insurance subsidiaries assume business from other insurance companies and involuntary pools. Earned Premiums assumed on long-duration and short-duration policies were $72.9 million, $67.3 million and $60.0 million for the years ended December 31, 2017, 2016 and 2015, respectively.
Trinity and Capitol County Mutual Fire Insurance Company (“Capitol”) are parties to a quota share reinsurance agreement whereby Trinity assumes 100% of the business written by Capitol, subject to a cap, for ceded losses for dwelling coverage. Earned Premiums assumed by Trinity from Capitol were $20.7 million, $21.3 million and $21.8 million for the years ended December 31, 2017, 2016 and 2015, respectively. Capitol is a mutual insurance company and, accordingly, is owned by its policyholders. Trinity and Old Reliable Casualty Company (“ORCC”), a subsidiary of Capitol, are parties to a quota share reinsurance agreement whereby Trinity assumes 100% of the business written by ORCC, subject to a cap for ceded losses for dwelling coverage. Earned Premiums assumed by Trinity from ORCC were $5.9 million, $6.2 million and $6.5 million for the years ended December 31, 2017, 2016 and 2015, respectively.
The valuation of assets and liabilities measured at fair value in the Company’s Consolidated Balance Sheet at December 31, 2017 is summarized below.
At December 31, 2017, the Company had unfunded commitments to invest an additional $141.3 million in certain limited liability investment companies and limited partnerships that will be included in Other Equity Interests when funded.
The Company’s investments in Fixed Maturities that are classified as Level 1 in the two preceding tables primarily consist of U.S. Treasury Bonds and Notes. The Company’s investments in Equity Securities that are classified as Level 1 in the two preceding tables consist either of investments in publicly-traded common stocks or exchange traded funds. The Company’s investments in Fixed Maturities that are classified as Level 2 in the two preceding tables primarily consist of investments in corporate bonds, obligations of states and political subdivisions, and bonds and mortgage-backed securities of U.S. government agencies. The Company’s investments in Equity Securities that are classified as Level 2 in the two preceding tables primarily consist of investments in preferred stocks. The Company uses a leading, nationally recognized provider of market data and analytics to price the vast majority of the Company’s Level 2 measurements. The provider utilizes evaluated pricing models that vary by asset class and incorporate available trade, bid and other market information. Because many fixed maturity securities do not trade on a daily basis, the provider’s evaluated pricing applications apply available information through processes such as benchmark curves, benchmarking of like securities, sector groupings, and matrix pricing to prepare evaluations. In addition, the provider uses model processes to develop prepayment and interest rate scenarios. The pricing provider’s models and processes also take into account market convention. For each asset class, teams of its evaluators gather information from market sources and integrate relevant credit information, perceived market movements and sector news into the evaluated pricing applications and models. The Company generally validates the measurements obtained from its primary pricing provider by comparing them with measurements obtained from one additional pricing provider that provides either prices from recent market transactions or quotes in inactive markets or evaluations based on its own proprietary models.
The Company’s policy is to recognize transfers between levels as of the end of the reporting period. There were no transfers between Levels 1 and 2 for the year ended December 31, 2017. Transfers out of Level 3 were $45.4 million for the year ended December 31, 2017, of which $3.5 million was transferred into Level 1 due to an issuer’s initial public offering of the security and $41.9 million was transferred into Level 2 due to changes in the availability of market observable inputs.
The fair value of Debt is estimated using quoted prices for similar liabilities in markets that are not active. The inputs used in the valuation are considered Level 2 measurements. The fair value of Short-term Investments is estimated using inputs that are considered Level 1 or Level 2 measurements.
In April 2017, the parties participated in an evidentiary hearing before a AAA-appointed arbitrator. Subsequently, the parties submitted post-hearing briefs, held closing arguments, and submitted proposed awards to the arbitrator.
In October 2017, the arbitrator issued a Partial Final Award finding that CSC had breached the Agreements and awarding KCSI direct damages of $84.3 million plus pre-judgment interest at an annual rate of 9% pursuant to applicable law. KCSI subsequently filed a Motion to Confirm Arbitration Award in the U.S. District Court for the Northern District of Texas seeking confirmation and enforcement of the Partial Final Award and also submitted to the arbitrator a supplemental petition providing pre-judgment interest calculations and seeking an award for certain costs and expenses. In November 2017, the arbitrator issued a Final Award awarding KCSI direct damages against CSC of $84.3 million, prejudgment interest at the annual rate of 9% and costs and expenses in the amount of $7.2 million. KCSI then filed an Amended Motion to Confirm Arbitration Award seeking confirmation and enforcement of the Final Award.
The Company cannot make any assurance as to the final amount of the judgment that may be entered in favor of KCSI or when it will be collected. The Final Award is treated as gain contingency for accounting purposes and accordingly, is not recognized in these Consolidated Financial Statements.
The Company’s Pension Plan had $171.8 million, $148.4 million and $137.2 million in assets managed by FS&C at December 31, 2017, 2016 and 2015, respectively, under an agreement with FS&C whereby FS&C provides investment management services with respect to certain funds of the plan. Investment Expenses incurred in connection with such agreement were $0.9 million, $0.8 million and $0.4 million for the years ended December 31, 2017, 2016 and 2015, respectively.
On February 13, 2018, Kemper, Kemper Merger Sub and Infinity entered into the Infinity Merger Agreement under which Kemper will acquire Infinity in a cash and stock transaction valued at approximately $1.4 billion, plus assumption of certain of Infinity’s debt, or $129.00 per Infinity share; the exchange ratio for stock consideration to be issued in the merger is fixed and was determined based on Kemper’s 20-trading day volume weighted average price as of February 12, 2018 of $64.40. Based on Kemper’s February 12, 2018 closing stock price of $57.75, the implied total consideration is approximately $1.3 billion, or $121.01 per Infinity share. Pursuant to the Infinity Merger Agreement, Kemper Merger Sub will merge with and into Infinity, with Infinity surviving as a wholly owned subsidiary of Kemper. Infinity is a national provider of auto insurance focused on serving the specialty, nonstandard segment. With approximately 2,300 employees, 10,600 independent agents and $1.4 billion in 2017 direct written premiums, Infinity is one of the largest nonstandard auto insurers in the United States.
The Infinity Merger has been approved by the Board of Directors of each company and is expected to close in the third quarter of 2018, subject to the satisfaction or waiver of applicable closing conditions. Such closing conditions to which the completion of the Infinity Merger is subject include, among others, (i) adoption by Infinity shareholders of the Infinity Merger Agreement, (ii) approval by Kemper stockholders of the issuance of Kemper common stock in connection with the Infinity Merger, (iii) the expiration or termination of any applicable waiting period (or extensions thereof) under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 and the receipt of certain other regulatory approvals, (iv) the absence of any effective order issued by any court of competent jurisdiction or other legal restraint prohibiting or preventing the consummation of the Infinity Merger and (v) other closing conditions.
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheets of Kemper Corporation and subsidiaries (the “Company”) as of December 31, 2017 and 2016, and the related consolidated statements of income, comprehensive income (loss), shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2017, and the related notes and the schedules listed in the Index at Item 15 (collectively referred to as the “financial statements”). We also have audited the Company’s internal control over financial reporting as of December 31, 2017, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
Our audits of the financial statements included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures to respond to those risks. Such procedures include examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.