Unless otherwise indicated, financial information in the MD&A is presented in accordance with accounting principles generally accepted in the United States of America ("GAAP"). See Note 2 to the Consolidated Financial Statements for additional information regarding the Company's significant accounting policies. We measure the financial results of our segments using "segment earnings (loss)", defined as shareholders' net income (loss) before after-tax realized investment results. In this MD&A, we also present information using adjusted income from operations on both a consolidated and segment basis. Adjusted income (loss) from operations is another measure of profitability used by our management because it presents the underlying results of operations of our businesses and permits analysis of trends in underlying revenue, expenses and shareholders' net income. Adjusted income (loss) from operations is defined as segment earnings (loss) excluding special items (described in the table on page 36 of this Form 10-K) and results of the GMIB business. This measure is not determined in accordance with GAAP and should not be viewed as a substitute for the most directly comparable GAAP measures, which are shareholders' net income on a consolidated basis and segment earnings (loss) on a segment basis. We exclude special items because management does not believe they are representative of our underlying results of operations. We also exclude the results of the GMIB business because, prior to February 4, 2013, the changes in the fair value of GMIB assets and liabilities were volatile and unpredictable. In some of our financial tables in this MD&A, we present either percentage changes or "N/M" when those changes are so large as to become not meaningful, and changes in percentages are expressed in basis points ("bps").
As explained in Note 22 to the Consolidated Financial Statements, effective with the first quarter of 2014, we began combining the results of our run-off reinsurance business with other immaterial operating segments in Other Operations for segment reporting purposes. Prior year segment information has been conformed to the current year presentation.
We present the financial results of our businesses in the following three reportable segments:
The following is a summary of key transactions and other significant items since January 1, 2012 affecting period-to-period comparisons of our results.
Run-off Reinsurance Transaction. Prior to February 4, 2013, our run-off reinsurance business had significant exposures, primarily from our guaranteed minimum death benefits ("GMDB" also known as "VADBe") and guaranteed minimum income benefits ("GMIB") businesses. Effective February 4, 2013, we entered into an agreement with Berkshire to reinsure future exposures for this business, net of existing retrocessional arrangements, up to a specified limit, for a payment of $2.2 billion. The reinsurance transaction aligned with our strategy of increasing financial flexibility by accomplishing an effective exit from the GMDB and GMIB businesses. As a result of this transaction, we recorded an after-tax charge of $507 million in the first quarter of 2013 that was reported as a special item. See Note 7 to the Consolidated Financial Statements and the Other Operations section of this MD&A for additional information.
Organizational Efficiency Plans. We regularly evaluate ways to deliver our products and services more efficiently and at a lower cost. During 2013 and 2012, we adopted specific plans to increase our organizational efficiency, resulting in a charge of $60 million pre-tax ($40 million after-tax) in 2013 and $77 million pre-tax ($50 million after-tax in 2012. See Note 6 to the Consolidated Financial Statements for additional information.
Health Care Reform and the implementing regulations have resulted in broad changes that are meaningfully impacting the industry, including relationships with customers and health care providers, the design of products and services, and pricing and delivery systems. In 2013, the industry saw government-prescribed reductions to Medicare reimbursement rates (i.e., sequestration), ongoing payment reductions for Medicare Advantage plans by the Centers for Medicare and Medicaid Services ("CMS") and changes in requirements associated with operational and performance metrics used to determine Medicare Advantage payments and benefits. For 2014, there have been further changes resulting from Health Care Reform and the implementing regulations including public exchanges, a non-deductible industry tax in addition to fees and assessments, and minimum medical loss ratio requirements for Medicare Advantage and Medicare Part D plans. Collectively, these changes have had a significant impact on our business and customers, requiring adjustments to our business model to mitigate their effects on our results of operations and cash flows.
Consolidated Results of Operations: 2014 Compared to 2013 and 2013 Compared to 2012
•Global Health Care medical claims expense. See the Global Health Care section of this MD&A for further discussion.
•Other benefit expenses. The decrease in other benefit expenses in 2014 compared with 2013 resulted from the absence of the charges recorded in the first quarter of 2013 associated with the reinsurance agreement with Berkshire ($727 million pre-tax), partially offset by continued business growth in the Global Supplemental and Group Disability and Life segments. In 2013, the increase compared with 2012 reflected the charges recorded in the first quarter of 2013 associated with the reinsurance agreement with Berkshire and, to a lesser extent, continued business growth in the Global Supplemental and Group Disability and Life segments.
•Mail order pharmacy costs. The increases in both 2014 and 2013 are due to volume increases for specialty medications (injectibles) and higher unit costs.
•Adjusted income from operations. In 2014, the increase in adjusted income from operations compared with 2013 was largely driven by higher earnings in our ongoing business segments (Global Health Care, Global Supplemental Benefits, and Group Disability and Life), partially offset by higher taxes in Corporate related to Health Care Reform and the absence of favorable tax benefits recorded in the third quarter of 2013. The increase in adjusted income from operations in 2013 compared with 2012 was largely attributable to earnings growth in all of our ongoing business segments (Global Health Care, Global Supplemental Benefits, and Group Disability and Life). See the segment discussions later in this MD&A for further information.
• operating expense requirements, primarily for employee compensation and benefits, information technology and real estate. Our subsidiaries normally meet their operating requirements by:
• maintaining appropriate levels of cash, cash equivalents and short-term investments;
• matching investment durations to those estimated for the related insurance and contractholder liabilities; and
• borrowing from the parent company. Liquidity requirements at the parent company level generally consist of:
Cash flows from operating activities consist of cash receipts and disbursements for premiums and fees, mail order pharmacy, other revenues, investment income, taxes, benefits and expenses, and, prior to February 4, 2013, gains and losses recognized in connection with our GMDB and GMIB equity hedge programs. Because certain income and expense transactions do not generate cash, and because cash transactions related to revenues and expenses may occur in periods different from when those revenues and expenses are recognized in shareholders' net income, cash flows from operating activities can be significantly different from shareholders' net income.
Cash used in financing activities increased in 2014 compared with the same period in 2013, primarily reflecting $0.6 billion in higher repurchases of common stock. Cash used in financing activities in 2013 increased by $0.7 billion compared with 2012 primarily due to higher repurchases of common stock.
In 2014, we repurchased 18.5 million shares for $1.6 billion. From January 1, 2015 through February 25, 2015 we repurchased 1.9 million shares for $217 million. On February 25, 2015, the Company's Board of Directors increased share repurchase authority by $500 million. Accordingly, the total remaining share repurchase authorization as of February 25, 2015 was $966 million. In 2013, the Company repurchased 13.6 million shares for $1.0 billion and, in 2012, we repurchased 4.4 million shares for $208 million.
At December 31, 2014, there was approximately $400 million in cash and short-term investments available at the parent company level. In 2015, the parent company's combined cash obligations are expected to be approximately $380 million to pay for commercial paper maturities, interest, dividends and required pension contributions.
agreement was available to us. Within the maximum debt leverage covenant in the line of credit agreement, we have $6.5 billion of borrowing capacity in addition to the $5.2 billion of debt outstanding.
We maintain a capital management strategy to retain overseas a significant portion of the earnings from our foreign operations. These undistributed earnings are deployed outside of the U.S. in support of the liquidity and capital needs of our foreign operations. As of December 31, 2014 undistributed earnings were approximately $1.8 billion. Approximately $15 million of cash and cash equivalents held overseas would, if repatriated, be subject to a charge representing the difference between the U.S. and foreign tax rates. This strategy does not materially limit our ability to meet our liquidity and capital needs in the United States. Cash and cash equivalents in foreign operations are held primarily to meet local liquidity and surplus needs with excess funds generally invested in longer duration, high quality securities.
•Short-term debt represents commercial paper, current maturities of long-term debt, and current obligations under capital leases.
Operating leases. For additional information, see Note 21 to the Consolidated Financial Statements.
We are contingently liable for various financial and other guarantees provided in the ordinary course of business. See Note 23 to the Consolidated Financial Statements for additional information on guarantees.
Fair value of a reporting unit was estimated using models and assumptions that we believe a hypothetical market participant would use to determine a current transaction price. The significant assumptions and estimates used in determining fair value include the discount rate and future cash flows. A range of discount rates was used, corresponding with the reporting unit's weighted average cost of capital, consistent with that used for investment decisions considering the specific and detailed operating plans and strategies within the reporting units. Projections of future cash flows were consistent with our annual planning process for revenues, claims, operating expenses, taxes, capital levels and long-term growth rates.
Our Cigna-HealthSpring business (reported in the Government operating segment that is also the reporting unit) contracts with CMS and various state governmental agencies to provide managed health care services, including Medicare Advantage plans and Medicare-approved prescription drug plans. Estimated future cash flows for this business incorporated the potential effects of sequestration and Medicare Advantage reimbursement rates for 2015 and beyond as discussed in the "Overview" section of this MD&A. Revenues from the Medicare programs are dependent, in whole or in part, upon annual funding from the federal government through CMS. Funding for these programs is dependent on many factors including general economic conditions, continuing government efforts to contain health care costs and budgetary constraints at the federal level and general political issues and priorities.
If we do not achieve our earnings objectives or the cost of capital rises significantly, the assumptions and estimates underlying these impairment evaluations could be adversely affected and result in future impairment charges that would negatively impact our operating results. Future reductions in the funding for our Medicare programs by the federal government would reduce Cigna-HealthSpring's revenues and profitability and adversely impact the fair value of the Government operating segment. The estimated fair value of each reporting unit exceeded its carrying value by a substantial margin based on our annual evaluations of goodwill for impairment during the third quarter of 2014.
Global Health Care medical claims payable Medical claims payable for the Global Health Care segment include both reported claims and estimates for losses incurred but not yet reported.
See Notes 2 and 5 to the Consolidated Financial Statements for additional information regarding assumptions and methods used to estimate this liability.
The impact of this favorable prior year development was an increase to shareholders' net income of $53 million in 2014. The change in the amount of the incurred claims related to prior years in the medical claims payable liability does not directly correspond to an increase or decrease in shareholders' net income as explained in Note 5 to the Consolidated Financial Statements.
•medical expense as a percentage of premiums (medical care ratio or "MCR").
The increase in Global Health Care's segment earnings and adjusted income from operations in 2013, compared with 2012, reflected revenue growth from a higher customer base and rate increases consistent with underlying medical cost trends. Results in 2013 also benefited from increased specialty contributions and higher net investment income.
These favorable effects were partially offset by a higher MCR in Medicare Advantage in 2013 driven by lower per member government reimbursements and higher inpatient and outpatient medical costs. In 2013, results also included higher operating expenses associated with customer growth and enhancements to our capabilities, partially offset by operating cost efficiencies.
The table below shows premiums by product line for the Global Health Care segment:
Premiums increased in 2013, compared with 2012, in the U.S. Commercial segment due to customer growth and rate increases consistent with underlying medical cost trends. In addition, Medicare Advantage premiums were higher due to timing of the HealthSpring acquisition and customer growth.
Net investment income. The increases in both 2014 and 2013, compared with each prior year, were due to higher assets and higher income from partnership investments, with the 2014 increase partially offset by lower yields.
The Medicare Advantage medical care ratio decreased in 2014, compared to 2013, reflecting improved per-customer revenues. The ratio increased in 2013, compared with 2012, driven by lower government reimbursement rates as well as higher medical costs.
The Medicare Part D medical care ratio increased in 2014, compared with 2013, primarily due to higher pharmacy costs including some impact from the mix and channel of customer drug purchases as well as increased specialty medication costs.
Operating expenses. Operating expenses increased 8% in 2014 compared with 2013. Excluding the 2013 special items and the Health Care Reform taxes and fees that became effective in 2014, operating expenses increased 3% in 2014 compared with 2013. The increase primarily reflects higher volume-related expenses and greater spending to enhance our capabilities, partially offset by cost efficiencies.
Operating expenses increased 5% in 2013 compared with 2012, primarily reflecting customer growth, increased spending to enhance our capabilities, including costs associated with our new PBM arrangement, and the timing of the HealthSpring acquisition, partially offset by cost efficiencies.
The operating expense ratios, both including and excluding special items, are essentially flat in 2014, compared with 2013. Excluding the Health Care Reform taxes and fees that became effective in 2014, the operating expense ratios decreased in 2014 compared with 2013, reflecting cost efficiencies and higher revenue, partially offset by higher spending to enhance our capabilities.
Effective Tax Rates. The increase in the segment's effective tax rate in 2014 compared with 2013 was attributable to the 2014 health insurance industry tax that is not tax deductible. The slight decline in the effective tax rate in 2013 compared with 2012 primarily reflected the recognition of tax benefits in certain of the segment's foreign operations.
Medical claims payable increased 6% in 2014 compared with 2013, primarily driven by growth in the individual and stop loss books of business. Medical claims payable increased 10% in 2013 compared with 2012, primarily reflecting growth in the stop loss and HealthSpring books of business.
• is covered under an insurance policy or service agreement issued by the Company;
Excluding limited benefits customers, medical customers increased 2% in 2013 compared to 2012, primarily reflecting continued ASO customer growth due to strong retention and sales in targeted market segments.
• benefits expense as a percentage of earned premium (loss ratio);
• the effective tax rate. Throughout this discussion, prior period currency adjusted income from operations, revenues, and benefits and expenses are being calculated by applying the current period's exchange rates to reported results in the prior period. A strengthening U.S. Dollar against foreign currencies will decrease segment earnings, while a weakening U.S. Dollar produces the opposite effect.
The increase in segment earnings and adjusted income from operations was primarily driven by business growth, primarily in South Korea, lower acquisition costs in Europe reflecting a decision to cease selling activities in certain markets, and earnings of the acquisitions during the second half of 2013, partially offset by higher acquisition and benefits expenses.
Premiums increased in both 2014 and 2013 compared with each prior year. When applying 2014 exchange rates to 2013 and 2012 results, premiums increased by 13% in 2014 and 25% in 2013. These increases were primarily attributable to new sales, particularly in South Korea and the U.S. reflecting both customer growth and sales of higher premium products. In 2013, the increase was also due to the impact of the acquisitions in the second half of 2012.
Net investment income. In 2014, net investment income increased compared with 2013, primarily due to asset growth in South Korea. Net investment income increased in 2013 compared with 2012, primarily due to the impact of the acquisitions in the second half of 2012.
The expense ratio (excluding acquisition costs) was flat in 2014 compared with 2013 reflecting strategic business investments largely offset by operating efficiencies. In 2013, the expense ratio decreased compared with 2012 primarily due to the lower expense ratios associated with our supplemental benefits business in the U.S., partially offset by strategic business investments.
Effective tax rates. The effective tax rate for the Global Supplemental Benefits segment decreased in 2014 compared with 2013, due to favorable tax related items reported in the third quarter of 2014, primarily the favorable effect of expanding our capital management strategy to retain a significant portion of our foreign operations' earnings overseas. Effective tax rates in 2013 and 2012 largely reflect the continuing favorable impact of this capital management strategy.
For our Global Supplemental Benefits segment, South Korea is the single largest geographic market. South Korea generated 52% of the segment's revenues and 76% of the segment's earnings in 2014. Due to the concentration of business in South Korea, the Global Supplemental Benefits segment is exposed to potential losses resulting from economic, regulatory and geopolitical developments in that country, as well as foreign currency movements affecting the South Korean won, that could have a significant impact on the segment's results and our consolidated financial results. In South Korea and certain other geographic markets, we continue to innovate and broaden our product and channel distribution capabilities to support business growth and mitigate potential adverse effects of increased data privacy regulatory requirements and other risks to telemarketing distribution. In 2014, our Global Supplemental Benefits segment operations in South Korea represented 4% of our total consolidated revenues and 8% of shareholders' net income.
• other operating expense as a percentage of earned premiums and fees (expense ratio).
Cigna's COLI business contributes the majority of earnings in Other Operations. In the first quarter of 2014, we combined the results of the Run-off Reinsurance segment with other immaterial segments in Other Operations, because the results are expected to be immaterial subsequent to the reinsurance transaction with Berkshire in 2013. Cigna's Other Operations segment also includes the results from the run-off settlement annuity business, as well as the remaining deferred gains recognized from the sale of the individual life insurance and annuity and retirement benefits businesses. Prior year information has been conformed to the current year presentation.
Premiums reflect revenue primarily on universal and whole life insurance policies in the COLI business. Premiums increased in 2014 compared with 2013 driven primarily by strong persistency as well as the impact of higher mortality in 2014 on experience-rated business. In 2013, premiums decreased compared with 2012, due to the absence of VADBe premium in 2013 because of the reinsurance transaction, partially offset by higher COLI premium.
Corporate reflects amounts not allocated to operating segments, such as net interest expense (defined as interest on corporate debt less net investment income on investments not supporting segment operations), interest on uncertain tax positions, certain litigation matters, intersegment eliminations, compensation cost for stock options, expense associated with our frozen pension plans and certain overhead and project costs.
Corporate's segment loss and adjusted loss from operations increased in 2014 compared with 2013, primarily due to an increase in taxes related to certain employee stock compensation costs that are not deductible for income tax purposes under Health Care Reform.
The following table presents our invested asset portfolio, excluding separate account assets, as of December 31, 2014 and 2013. Additional information regarding our investment assets and related accounting policies is included in Notes 2, 10, 11, 12, 13, 14 and 17 to the Consolidated Financial Statements.
We invest in high quality foreign government obligations, with an average quality rating of Aa3 as of December 31, 2014. These investments are primarily concentrated in Asia consistent with the geographic distribution of our international business operations. Foreign government obligations also include $218 million of investments in European sovereign debt, none of which are in countries with significant political or economic concerns (Portugal, Italy, Ireland, Greece, and Spain).
We completed an annual in-depth review of our commercial mortgage loan portfolio during the second quarter of 2014. This review included an analysis of each property's year-end 2013 financial statements, rent rolls, operating plans and budgets for 2014, a physical inspection of the property and other pertinent factors. Based on property values and cash flows estimated as part of this review and subsequent fundings and repayments, the portfolio's average loan-to-value ratio improved to 63% at December 31, 2014, from 64% as of December 31, 2013, reflecting a modest increase in values for high quality commercial real estate. The portfolio's average debt service coverage ratio also improved, increasing to 1.66 at December 31, 2014 from 1.62 as of December 31, 2013. See Note 11 to the Consolidated Financial Statements for further information.
The commercial mortgage loan portfolio contains approximately 80 loans, including five impaired loans with a carrying value totaling $166 million that are classified as problem or potential problem loans. Two of these loans totaling $86 million, net of $4 million in reserves, are current based on restructured terms and three loans totaling
$80 million, net of $8 million in reserves, are current. All of the remaining loans continue to perform under their contractual terms. We have $247 million of loans maturing in the next twelve months. Given the quality and diversity of the underlying real estate, positive debt service coverage and significant borrower cash investment averaging 30%, we remain confident that the vast majority of borrowers will continue to perform as expected under the contract terms.
"Problem" bonds and commercial mortgage loans are either delinquent by 60 days or more or have been restructured as to terms, including concessions by us for modification of interest rate, principal payment or maturity date. "Potential problem" bonds and commercial mortgage loans are considered current (no payment more than 59 days past due), but management believes they have certain characteristics that increase the likelihood that they may become problems. The characteristics management considers include, but are not limited to, the following:
Net problem and potential problem investments representing approximately 1% of total investments, excluding policy loans at December 31, 2014, increased by approximately $30 million from December 31, 2013, primarily due to the addition of one commercial mortgage loan to problem investments.
Although financial markets in the United States continued to stabilize during 2014, they have more recently been impacted by continuing global uncertainty. Fixed income asset values have appreciated broadly since the beginning of the year, however the changes in valuation have varied amongst investment sectors depending on perceived risk in the global markets. Future realized and unrealized investment results will be driven largely by market conditions that exist when a transaction occurs or at the reporting date. These future conditions are not reasonably predictable. We believe that the vast majority of our fixed maturity investments will continue to perform under their contractual terms and that the commercial mortgage loan portfolio is positioned to perform well due to its solid aggregate loan-to-value ratio and strong debt service coverage. Based on our strategy to match the duration of invested assets to the duration of insurance and contractholder liabilities, we expect to hold a significant portion of these assets for the long term. Although future impairment losses resulting from credit deterioration and interest rate movements remain possible, we do not expect these losses to have a material adverse effect on our financial condition or liquidity.
•Interest-rate risk on fixed-rate, medium-term instruments. Changes in market interest rates affect the value of instruments that promise a fixed return and our employee pension liabilities.
• Investment/liability matching. We generally select investment assets with characteristics (such as duration, yield, currency and liquidity) that correspond to the underlying characteristics of our related insurance and contractholder liabilities so that we can match the investments to our obligations. Shorter-term investments support generally shorter-term life and health liabilities. Medium-term, fixed-rate investments support interest-sensitive and health liabilities. Longer-term investments generally support products with longer pay out periods such as annuities and long-term disability liabilities.
•changes in the fair values of other significant assets and liabilities such as goodwill, deferred policy acquisition costs, taxes, and various accrued liabilities have been excluded; because they are not financial instruments, their primary risks are other than market risk. The effects of hypothetical changes in market rates or prices on the fair values of certain of our financial instruments, subject to the exclusions noted above (particularly insurance liabilities), would have been as follows as of December 31:
The effect of a hypothetical increase in interest rates was determined by estimating the present value of future cash flows using various models, primarily duration modeling. The impact of a hypothetical increase to interest rates at December 31, 2014 was greater than that at December 31, 2013 reflecting increased asset purchases as well as valuation increases resulting from lower market yields of fixed maturities during 2014.
Cigna Corporation, together with its subsidiaries (either individually or collectively referred to as "Cigna," the "Company," "we," "our" or "us") is a global health services organization dedicated to a mission of helping individuals improve their health, well-being and sense of security. To execute on our mission, Cigna's strategy is to "Go Deep", "Go Global" and "Go Individual" with a differentiated set of medical, dental, disability, life and accident insurance and related products and services offered by our subsidiaries. The majority of these
The Consolidated Financial Statements include the accounts of Cigna Corporation and its subsidiaries. Intercompany transactions and accounts have been eliminated in consolidation. These Consolidated Financial Statements were prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP"). Amounts recorded in the Consolidated Financial Statements necessarily reflect management's estimates and assumptions about medical costs, investment valuation, interest rates and other factors. Significant estimates are discussed throughout these Notes; however, actual results could differ from those estimates. The impact of a change in estimate is generally included in earnings in the period of adjustment. Certain reclassifications have been made to prior year amounts to conform to the current presentation. Beginning in the first quarter of 2014, the Company combined the results of its run-off reinsurance business with Other Operations for segment reporting purposes. See Note 22 for additional information.
Accounting for Health Care Reform's Risk Mitigation Programs. Beginning in 2014, as prescribed by the Patient Protection and Affordable Care Act (referred to as "Health Care Reform"), programs went into effect to reduce the risk for participating health insurance companies selling coverage on the public exchanges.
For the premium stabilization program, the Company records receivables or payables as adjustments to premium revenue based on our year-to-date experience when the amounts are reasonably estimable and collection is reasonably assured. Final revenue adjustments are determined by HHS in the year following the policy year.
Amendments to the Consolidation Analysis (ASU 2015-2). In February 2015, the FASB issued guidance to improve targeted areas of consolidation guidance for legal entities such as limited partnerships, limited liability companies and securitization structures. In addition to reducing the number of consolidation models, the new standard aims to simplify and improve U.S. GAAP by placing more emphasis on risk of loss when determining a controlling financial interest. This new standard is effective beginning on January 1, 2016, with early adoption permitted. The Company is evaluating this guidance for applicable legal entities to determine any resulting estimated effects on the financial statements.
Short-term investments. Security investments with maturities of greater than 90 days but less than one year from time of purchase are classified as short-term, available for sale and carried at fair value, which approximates cost.
Derivative financial instruments. The Company applies hedge accounting when derivatives are designated, qualified and highly effective as hedges. Effectiveness is formally assessed and documented at inception and each period throughout the life of a hedge using various quantitative methods appropriate for each hedge, including regression analysis and dollar offset. Under hedge accounting, the changes in fair value of the derivative and the hedged risk are generally recognized together and offset each other when reported in shareholders' net income.
• Derivatives are reported on the balance sheet at fair value with changes in fair values reported in shareholders' net income or accumulated other comprehensive income.
• Changes in the fair value of a derivative instrument may not always equal changes in the fair value of the hedged item (referred to as "hedge ineffectiveness"). The Company generally reports hedge ineffectiveness in realized investment gains and losses.
Unrealized gains and losses on fixed maturities and equity securities carried at fair value and certain derivatives are included in accumulated other comprehensive income (loss), net of deferred income taxes and amounts required to adjust future policy benefits for the run-off settlement annuity business.
Cash equivalents consist of short-term investments with maturities of three months or less from the time of purchase. The Company reclassifies cash overdraft positions to accounts payable, accrued expenses and other liabilities when the legal right of offset does not exist.
Premiums, accounts and notes receivable and reinsurance recoverables are reported net of allowances for doubtful accounts and unrecoverable reinsurance of $105 million as of December 31, 2014 and $47 million as of December 31, 2013. The Company estimates these allowances for doubtful accounts and unrecoverable reinsurance using management's best estimates of collectability, taking into consideration the age of the outstanding amounts, historical collection patterns and other economic factors.
Costs eligible for deferral include incremental, direct costs of acquiring new or renewal insurance and investment contracts and other costs directly related to successful contract acquisition. Examples of deferrable costs include commissions, sales compensation and benefits, policy issuance and underwriting costs and premium
taxes. The Company records acquisition costs differently depending on the product line. Acquisition costs for:
Property and equipment is carried at cost less accumulated depreciation. When applicable, cost includes interest, real estate taxes and other costs incurred during construction. Also included in this category is internal-use software that is acquired, developed or modified solely to meet the Company's internal needs, with no plan to market externally. Costs directly related to acquiring, developing or modifying internal-use software are capitalized.
Goodwill represents the excess of the cost of businesses acquired over the fair value of their net assets. The resulting goodwill is assigned to those reporting units expected to realize cash flows from the acquisition, allocated to reporting units based on relative fair values and reported in the Global Health Care segment ($5.7 billion) and the Global Supplemental Benefits segment ($331 million). The Company evaluates goodwill for impairment at least annually during the third quarter at the reporting unit level and writes it down through results of operations if impaired. Fair value of a reporting unit is generally estimated based on a discounted cash flow analysis using assumptions that the Company believes a hypothetical market participant would use to determine a current transaction price. The significant assumptions and estimates used in determining fair value include the discount rate and future cash flows. A range of discount rates is used that corresponds with the reporting unit's weighted average cost of capital, consistent with that used for investment decisions considering the specific and detailed operating plans and strategies within the reporting units. Projections of future cash flows for the reporting units were consistent with our annual planning process for revenues, claims, operating expenses, taxes, capital levels and long-term growth rates. Cash flows for the Cigna-HealthSpring business incorporate the effects of sequestration and 2015 government reimbursement rates. In 2014, the resulting discounted cash flow analyses indicated that estimated fair values for the reporting units significantly exceeded their carrying values, including goodwill and other intangibles. See Note 8 for additional information.
Other assets primarily consist of guaranteed minimum income benefits ("GMIB") assets and various insurance-related assets. The Company's other intangible assets include purchased customer and producer relationships, provider networks and trademarks. The fair value of purchased customer relationships and the amortization method were determined using an income approach that relies on projected future net cash flows including key assumptions for the customer attrition rate and discount rate. The Company amortizes other intangibles on an accelerated or straight-line basis over periods from 3 to 30 years. Management revises amortization periods if it believes there has been a change in the length of time that an intangible asset will continue to have value. Costs incurred to renew or extend the terms of these intangible assets are generally expensed as incurred. See Notes 8 and 10 for additional information.
Separate account assets and liabilities are contractholder funds maintained in accounts with specific investment objectives. The assets of these accounts are legally segregated and are not subject to claims that arise out of any of the Company's other businesses. These separate account assets are carried at fair value with equal amounts for related separate account liabilities. The investment income, gains and losses of these accounts generally accrue to the contractholders and, together with their deposits and withdrawals, are excluded from the Company's Consolidated Statements of Income and Cash Flows. Fees and charges earned for mortality risks, asset management or administrative services and are reported in either premiums or fees and other revenues.
Future policy benefits represent the present value of estimated future obligations under long-term life and supplemental health insurance policies and annuity products currently in force. These obligations are estimated using actuarial methods and primarily consist of reserves for annuity contracts, life insurance benefits, guaranteed minimum death benefit ("GMDB") contracts (see Note 7 for additional information) and certain health, life and accident insurance products of our Global Supplemental Benefits segment.
Liabilities for unpaid claims and claim expenses are estimates of future payments under insurance coverages (primarily long-term disability, life and health) for reported claims and for losses incurred but not yet reported. When estimates of these liabilities change, the Company immediately records the adjustment in benefits and expenses.
The Company's liability for disability claims reported but not yet paid is the present value of estimated future benefit payments over the expected disability period. The Company projects the expected disability period by using historical resolution rates combined with an analysis of current trends and operational factors to develop current estimates of resolution rates. Using the Company's experience, expected claim resolution rates may vary based upon the anticipated disability period, the covered benefit period, cause of disability, benefit design and the policyholder's age, gender and income level. The gross monthly benefit is reduced (offset) by disability income received under other benefit programs, such as Social Security Disability Income, workers' compensation, statutory disability or other group benefit plans. For offsets not yet finalized, the Company estimates the probability and amount of the offset based on the Company's experience over the past three to five years.
The Company discounts certain unpaid claim liabilities because benefit payments are made over extended periods. Substantially all of these liabilities are associated with the group long-term disability business. Discount rate assumptions for that business are based on projected investment returns for the asset portfolios that support these liabilities and range from 4.1% to 5.5%. Discounted liabilities were $3.9 billion at December 31, 2014 and $3.5 billion at December 31, 2013.
deductibles, changes in provider practices and changes in consumer demographics and consumption behavior.
The Company offers products and services in Turkey and India through joint venture entities. The redeemable noncontrolling interest on our consolidated balance sheet represents our joint venture partners' preferred and common stock interests in these entities. Our joint venture partners may, at their election, require the Company to purchase their redeemable noncontrolling interests. We also have the right to require our joint venture partners to sell their redeemable noncontrolling interests to us. The redeemable noncontrolling interests were recorded at fair value on the dates of purchase. When the estimated redemption value for a redeemable noncontrolling interest exceeds its carrying value, an adjustment to increase the redeemable noncontrolling interest is recorded and its effect is included in shareholders' net income per share.
Premium revenue also includes an adjustment to reflect the estimated effect of rebates due to customers under the commercial minimum medical loss ratio provisions of Health Care Reform. These rebates are settled in the year following the policy year.
• Net investment income on assets supporting universal life products is recognized as earned.
• Charges for mortality, administration and policy surrender are recognized in premiums as earned. Administrative fees are considered earned when services are provided. Benefits and expenses for universal life products consist of benefit claims in excess of policyholder account balances. Expenses are recognized when claims are submitted, and income is credited to policyholders in accordance with contract provisions.
Contract fees for administrative services only ("ASO") programs and pharmacy programs and services are recognized in fees and other revenues as services are provided, net of pharmaceutical manufacturer rebates payable to clients and estimated refunds under performance guarantees. In some cases, the Company provides performance guarantees associated with meeting certain service standards, clinical outcomes or financial metrics. If these service standards, clinical outcomes or financial metrics are not met, the Company may be financially at risk up to a stated percentage of the contracted fee or a stated dollar amount. The Company establishes deferred revenues for estimated payouts associated with these performance guarantees. Approximately 12% of ASO fees reported for the year ended December 31, 2014 were at risk, with reimbursements estimated to be approximately 1%. Expenses associated with these programs and services are recognized in other operating expenses as incurred, net of pharmaceutical rebates from manufacturers.
The Company records compensation expense for stock awards and options over their vesting periods primarily based on the estimated fair value at the grant date. For stock options, fair value is estimated using an option-pricing model, whereas for restricted stock grants and units, fair value is equal to the market price of the Company's common stock on the date of grant. Compensation expense for strategic performance shares is recorded over the performance period. For strategic performance shares with payment dependent on a market condition, fair value is determined at the grant date using a Monte Carlo simulation model and not subsequently adjusted regardless of the final outcome. For strategic performance shares with payment dependent on performance conditions, expense is initially accrued based on the most likely outcome, but evaluated for adjustment each period for updates in the expected outcome. At the end of the performance period, expense is adjusted to the actual outcome (number of shares awarded times the share price at the grant date).
Deferred income tax assets and liabilities are recognized for differences between the financial and income tax reporting bases of the underlying assets and liabilities and established based upon enacted tax rates and laws. Deferred income tax assets are recognized when available evidence indicates that realization is more likely than not. The deferred income tax provision generally represents the net change in deferred income tax assets and liabilities during the year, exclusive of amounts reported as adjustments to accumulated other comprehensive income or amounts initially recorded due to business combinations. The current income tax provision generally represents the estimated amounts due on the various income tax returns for the year reported plus the effect of any uncertain tax positions. Uncertain tax positions are evaluated in accordance with the model set forth in FASB guidance.
Income tax provisions related to the Company's foreign operations are generally determined based upon the local country income tax rate.
The Company may from time to time acquire or dispose of assets, subsidiaries or lines of business. The three significant transactions described below were completed in 2012. The combined pro forma effect of these transactions was not material to the Company's 2012 consolidated revenue and net income.
On January 31, 2012 the Company acquired the outstanding shares of HealthSpring, Inc. ("HealthSpring") for $55 per share in cash and Cigna stock awards, representing a cost of approximately $3.8 billion. At the time of the acquisition, HealthSpring provided Medicare Advantage coverage in 15 states and the District of Columbia, as well as a large, national stand-alone Medicare prescription drug business. Results of this business and the related goodwill and intangible assets (see Note 8 for additional information) are reported in the Global Health Care segment. During 2012, the Company recorded $53 million pre-tax ($40 million after-tax: $7 million in Global Health Care and $33 million in Corporate) of acquisition-related costs in other operating expenses.
For the year ended December 31, 2013, actual experience differed from the Company's key assumptions, resulting in favorable incurred claims related to prior years' medical claims payable of $182 million, or 1.3% of the current year incurred claims as reported for the year ended December 31, 2012. Actual completion factors accounted for $74 million of favorability, or 0.5%, while actual medical cost trend resulted in the remaining $108 million, or 0.8%.
The impact of prior year development on shareholders' net income was $53 million for the year ended December 31, 2014 compared with $77 million for the year ended December 31, 2013. The favorable effect of prior year development for both years primarily reflects low utilization of medical services. The change in the amount of the incurred claims related to prior years in the medical claims payable liability does not directly correspond to an increase or decrease in the Company's shareholders' net income recognized for the following reasons:
The Company is regularly evaluating ways to deliver its products and services more efficiently and at a lower cost. During 2013 and 2012, the Company adopted specific plans to increase its organizational efficiency as follows:
2013 Plan. During the fourth quarter of 2013, the Company committed to a plan to increase its organizational efficiency and reduce costs through a series of actions that includes employee headcount reductions. As a result, the Company recognized charges in other operating expenses of $60 million pre-tax ($40 million after-tax) in the fourth quarter of 2013, primarily for severance costs. The Company expects most of the severance to be paid by the end of 2015.
Summarized below is the activity for the 2013 plan described above.
The Company's insurance subsidiaries enter into agreements with other insurance companies to assume and cede reinsurance. Reinsurance is ceded primarily to limit losses from large exposures and to permit recovery of a portion of direct or assumed losses. Reinsurance is also used in acquisition and disposition transactions when the underwriting company is not being acquired. Reinsurance does not relieve the originating insurer of liability. The Company regularly evaluates the financial condition of its reinsurers and monitors concentrations of its credit risk.
On February 4, 2013, the Company entered into an agreement with Berkshire Hathaway Life Insurance Company of Nebraska ("Berkshire") to effectively exit the GMDB and GMIB businesses via a reinsurance transaction. Berkshire reinsured 100% of the Company's future claim payments in these businesses, net of retrocessional arrangements existing at that time. The reinsurance agreement is subject to an overall limit with approximately $3.7 billion remaining.
The Company's dynamic hedge programs were discontinued at the time of the Berkshire reinsurance transaction in 2013. These hedge programs generated losses (included in Other Revenues) of $32 million in 2013, and $105 million in 2012.
The following table presents direct, assumed and ceded premiums for both short-duration and long-duration insurance contracts. It also presents reinsurance recoveries that have been netted against direct benefits and expenses in the Company's Consolidated Statements of Income.
Recoveries were higher in 2014 primarily due to the absence of the 2013 activity related to the Berkshire transaction, including the initial payment. The increase in long-duration assumed premiums in 2013 largely results from the acquisition of Great American Supplemental Benefits in 2012.
The majority of the Company's reinsurance recoverables resulted from acquisition and disposition transactions in which the underwriting company was not acquired. Components of the Company's reinsurance recoverables are presented below:
Over 90% of the Company's reinsurance recoverables were from companies that are rated A or higher by Standard & Poor's at December 31, 2014. The Company reviews its reinsurance arrangements and establishes reserves against the recoverables in the event that recovery is not considered probable. As of December 31, 2014, the Company's recoverables were net of a reserve of $4 million.
Goodwill is primarily reported in the Global Health Care segment ($5.7 billion) and, to a lesser extent, the Global Supplemental Benefits segment ($331 million).
Other property and equipment includes assets recorded under capital leases with a cost of $84 million, accumulated amortization of $36 million, and a net carrying value of $48 million as of December 31, 2014. Other property and equipment includes assets recorded under capital leases with a cost of $306 million, accumulated amortization of $16 million, and a net carrying value of $290 million as of December 31, 2013. The reduction in assets recorded under capital leases in 2014, compared with the prior year, was primarily related to the Company's purchase of a building in South Korea that it had previously leased. Current capital lease agreements are for equipment and generally have a term of 48 months with the equipment returned to the lessor at the end of the term.
Other property and equipment includes amortization on assets recorded under capital leases of $20 million in 2014 and $16 million in 2013.
The Company and certain of its subsidiaries provide pension, health care and life insurance defined benefits to eligible retired employees, spouses and other eligible dependents through various domestic and foreign plans. The effect of its foreign pension and other postretirement benefit plans is immaterial to the Company's results of operations, liquidity and financial position. The Company froze its defined benefit postretirement medical plan in the first quarter of 2013 and its primary domestic pension plans in 2009.
As further discussed in Note 23, the Company and the Cigna Pension Plan are defendants in a class action lawsuit that has yet to be resolved. When the parties agree on a final plan amendment, the pension benefit obligation will be updated to reflect additional benefits resulting from this litigation.
The Company measures the assets and liabilities of its domestic pension and other postretirement benefit plans as of December 31. The following table summarizes the projected benefit obligations and assets related to the Company's domestic and international pension and other postretirement benefit plans as of, and for the year ended, December 31:
Pension benefits. The Company's pension plans were underfunded by $1.1 billion in 2014 and $0.6 billion in 2013 and had related accumulated benefit obligations of $5.3 billion as of December 31, 2014 and $4.7 billion as of December 31, 2013.
The Company funds its qualified pension plans at least at the minimum amount required by the Employee Retirement Income Security Act of 1974 and the Pension Protection Act of 2006. For 2015, the Company expects to make minimum required contributions totaling approximately $5 million. Future years' contributions will ultimately be based on a wide range of factors including but not limited to asset returns, discount rates, and funding targets.
The Company expects to recognize $3 million pre-tax gains related to amortization of prior service cost and no pre-tax gains from amortization of past experience in 2015. The amortization period is based on an average expected remaining life of plan participants of 29 years.
As of December 31, 2014, pension plan assets included $3.8 billion invested in the separate accounts of Connecticut General Life Insurance Company ("CGLIC") and Life Insurance Company of North America, that are subsidiaries of the Company, as well as an additional $361 million invested directly in funds offered by the buyer of the retirement benefits business.
• fixed income and international equity funds priced using their daily net asset value that is the exit price; and
• fixed maturities valued using recent trades of similar securities or pricing models as described below. Plan assets classified in Level 3 include investments primarily in securities partnerships, equity real estate and hedge funds generally valued based on the pension plan's ownership share of the equity of the investee including changes in the fair values of its underlying investments.
Based on a 2014 study of the Company's mortality experience over the past several years, it was determined that the new Society of Actuaries mortality table and projection scale published in the fourth quarter of 2014 should be adopted for the Company's defined benefit pension and other postretirement plans as of December 31, 2014.
Expected long-term rates of return on plan assets were developed considering actual long-term historical returns, expected long-term market conditions, plan asset mix and management's investment strategy, that continues a significant allocation to domestic and foreign equity securities as well as real estate, securities partnerships and hedge funds. Expected long-term market conditions take into consideration certain key macroeconomic trends including expected domestic and foreign GDP growth, employment levels and inflation. The expected return assumption was considered reasonable for 2014. The Company will reconsider its expected return assumption for 2015 given some changes in asset mix and re-evaluation of future return expectations among various asset classes.
To measure pension costs, the Company uses a market-related asset valuation for domestic pension plan assets invested in non-fixed income investments. The market-related value of these pension assets recognizes the difference between actual and expected long-term returns in the portfolio over 5 years, a method that reduces the short-term impact of market fluctuations on pension cost. At December 31, 2014, the market-related asset value was approximately $3.9 billion compared with a market value of approximately $4.2 billion.
The following tables provide information as of December 31, 2014 and 2013 about the Company's financial assets and liabilities carried at fair value. Separate account assets that are also recorded at fair value on the Company's Consolidated Balance Sheets are reported separately under the heading "Separate account assets" as gains and losses related to these assets generally accrue directly to policyholders.
(3) Other derivative assets included $5 million of interest rate and foreign currency swaps qualifying as cash flow hedges and $1 million of interest rate swaps qualifying as fair value hedges. Other derivative liabilities reflected interest rate and foreign currency swaps qualifying as cash flow hedges. See Note 12 for additional information.
(1) Fixed maturities included $458 million of net appreciation required to adjust future policy benefits for the run-off settlement annuity business including $60 million of appreciation for securities classified in Level 3.
(2) The GMIB assets represented retrocessional contracts in place from three external reinsurers that cover the exposures on these contracts.
Fixed maturities and equity securities. Approximately 94% of the Company's investments in fixed maturities and equity securities are classified in Level 2 including most public and private corporate debt and equity securities, federal agency and municipal bonds, non-government mortgage-backed securities and preferred stocks. Because many fixed maturities do not trade daily, third-party pricing services and internal methods often use recent trades of securities with similar features and characteristics. When recent trades are not available, pricing models are used to determine these prices. These models calculate fair values by discounting future cash flows at estimated market interest rates. Such market rates are derived by calculating the appropriate spreads over comparable U.S. Treasury securities, based on the credit quality, industry and structure of the asset. Typical inputs and assumptions to pricing models include, but are not limited to, a combination of benchmark yields, reported trades, issuer spreads, liquidity, benchmark securities, bids, offers, reference data, and industry and economic events. For mortgage-backed securities, inputs and assumptions may also include characteristics of the issuer, collateral attributes, prepayment speeds and credit rating.
Short-term investments are carried at fair value which approximates cost. On a regular basis the Company compares market prices for
Other derivatives classified in Level 2 represent over-the-counter instruments such as interest rate and foreign currency swap contracts. Fair values for these instruments are determined using market observable inputs including forward currency and interest rate curves and widely published market observable indices. Credit risk related to the counterparty and the Company is considered when estimating the fair values of these derivatives. However, the Company is largely protected by collateral arrangements with counterparties and determined that no adjustment for credit risk was required as of December 31, 2014 or December 31, 2013. Level 2 also includes exchange-traded interest rate swap contracts. Credit risk related to the clearinghouse counterparty and the Company is considered minimal when estimating the fair values of these derivatives because of upfront margin deposits and daily settlement requirements. The nature and use of these other derivatives are described in Note 12.
The Company classifies certain newly issued, privately-placed, complex or illiquid securities, as well as assets and liabilities relating to GMIB, in Level 3. Approximately 5% of fixed maturities and equity securities are priced using significant unobservable inputs and classified in this category.
The following tables summarize the fair value and significant unobservable inputs used in pricing Level 3 securities that were developed directly by the Company as of December 31, 2014 and 2013. The range and weighted average basis point amounts for fixed maturity spreads (adjustment to discount rates) and price to earnings multiples for equity investments reflect the Company's best estimates of the unobservable adjustments a market participant would make to calculate the fair values.
Significant increases in fixed maturity spreads would result in a lower fair value measurement while decreases in these inputs would result in a higher fair value measurement. Significant decreases in equity price to earnings multiples would result in a lower fair value measurement while increases in these inputs would result in a higher fair value measurement. Generally, the unobservable inputs are not interrelated and a change in the assumption used for one unobservable input is not accompanied by a change in the other unobservable input. See the preceding discussion regarding the Company's valuation processes and controls.
Guaranteed minimum income benefit contracts. As discussed in Note 7, the Company effectively exited the GMIB business in 2013. Although these GMIB assets and liabilities must continue to be reported as derivatives at fair value, the only assumption that is expected to impact future shareholders' net income is the risk of non-performance. This assumption reflects a market participant's view of (a) the risk of the Company not fulfilling its GMIB obligations (GMIB liabilities) and (b) the credit risk that the reinsurers do not pay their obligations (GMIB assets). As of December 31, 2014, there were three reinsurers for GMIB, with collateral securing 70% of the balance.
The non-performance risk adjustment is incorporated by adding an additional spread to the discount rate in the calculation of both (a) the GMIB liabilities to reflect a market participant's view of the risk of the Company not fulfilling its GMIB obligations, and (b) the GMIB assets to reflect a market participant's view of the credit risk of the reinsurers, after considering collateral.
Other assumptions that affect GMIB assets and liabilities include capital market assumptions (including market returns, interest rates and market volatilities of the underlying equity and bond mutual fund investments) and future annuitant behavior (including mortality, lapse, and annuity election rates). As certain assumptions used to estimate fair values for these contracts are largely unobservable (primarily related to future annuitant behavior), the Company classifies GMIB assets and liabilities in Level 3.
As noted in the tables above, total gains and losses included in shareholders' net income are reflected in the following captions in the Consolidated Statements of Income:
Some financial assets and liabilities are not carried at fair value each reporting period, but may be measured using fair value only under certain conditions, such as investments in real estate entities and commercial mortgage loans when they become impaired. Impaired real estate entities and commercial mortgage loans representing less than 1% of total investments were written down to their fair values, resulting in realized investment losses of $10 million, after-tax in 2014 and $12 million, after-tax in 2013.
The following table includes the Company's financial instruments not recorded at fair value that are subject to fair value disclosure requirements at December 31, 2014 and 2013. Financial instruments that are carried in the Company's Consolidated Financial Statements at amounts that approximate fair value are excluded from the following table.
Actual maturities of these securities could differ from their contractual maturities used in the table above. This could occur because issuers may have the right to call or prepay obligations, with or without penalties, or because in certain cases the Company may have the option to unilaterally extend the contractual maturity date.
The above table includes investments with a fair value of $3.1 billion supporting liabilities of the Company's run-off settlement annuity business, with gross unrealized appreciation of $758 million and gross unrealized depreciation of $2 million at December 31, 2014. Such unrealized amounts are reported in future policy benefit liabilities rather than accumulated other comprehensive income. At December 31, 2013, investments supporting this business had a fair value of $2.6 billion, gross unrealized appreciation of $478 million and gross unrealized depreciation of $20 million.
• financial health and specific near term prospects of the issuer;
• the Company's intent to sell or the likelihood of a required sale prior to recovery. The table below summarizes fixed maturities with a decline in fair value from amortized cost as of December 31, 2014. These fixed maturities are primarily corporate securities with a decline in fair value that reflects an increase in market yields since purchase.
There were no available for sale equity securities with a significant unrealized loss reflected in accumulated other comprehensive income at December 31, 2014. Equity securities also include hybrid investments consisting of preferred stock with call features that are carried at fair value with changes in fair value reported in other realized investment gains (losses) and dividends reported in net investment income. As of December 31, 2014, fair values of these securities were $57 million and amortized cost was $69 million. As of December 31, 2013, fair values of these securities were $56 million and amortized cost was $68 million.
The following tables summarize the credit risk profile of the Company's commercial mortgage loan portfolio based on loan-to-value and debt service coverage ratios, as of December 31, 2014 and 2013:
The Company's annual in-depth review of its commercial mortgage loan investments is the primary mechanism for identifying emerging risks in the portfolio. The most recent review was completed by the Company's investment professionals in the second quarter of 2014 and included an analysis of each underlying property's most recent annual financial statements, rent rolls, operating plans, budgets, a physical inspection of the property and other pertinent factors. Based on historical results, current leases, lease expirations and rental conditions in each market, the Company estimates the current year and future stabilized property income and fair value, and categorizes the investments as loans in good standing, potential problem loans or problem loans. Based on property valuations and cash flows estimated as part of this review, and considering updates for loans where material changes were subsequently identified, the portfolio's average loan-to-value ratio improved slightly to 63% at December 31, 2014 from 64% at December 31, 2013. The portfolio's average debt service coverage ratio was estimated to be 1.66 at December 31, 2014, a modest improvement from 1.62 at December 31, 2013.
Certain other loans were modified during 2014 and 2013. However, these were not considered troubled debt restructures and the impact of such modifications was not material to the Company's results of operations, financial condition or liquidity.
Problem and potential problem mortgage loans, net of valuation reserves, totaled $208 million at December 31, 2014 and $158 million at December 31, 2013. At December 31, 2014 and December 31, 2013, industrial loans located in the South Atlantic region represented the most significant component of problem and potential problem mortgage loans.
As of December 31, 2014, the Company had commitments to contribute:
•$476 million to entities that hold securities diversified by issuer and maturity date. The Company expects to disburse approximately 40% of the committed amounts in 2015.
Short-term investments and cash equivalents included corporate securities of $509 million, federal government securities of $274 million and money market funds of $33 million as of
December 31, 2014. The Company's short-term investments and cash equivalents as of December 31, 2013 included corporate securities of $2.2 billion, federal government securities of $323 million and money market funds of $35 million.
The Company uses derivative financial instruments to manage the characteristics of investment assets (such as duration, yield, currency and liquidity) to meet the varying demands of the related insurance and contractholder liabilities (such as paying claims, investment returns and withdrawals) and to hedge interest rate risk of its long-term debt. The Company has written and purchased Guaranteed Minimum Income Benefit (GMIB) reinsurance contracts in its run-off reinsurance business that are accounted for as freestanding derivatives. The Company also used derivative financial instruments to manage the equity, foreign currency, and certain interest rate risk exposures of its run-off reinsurance business until the time of the Berkshire reinsurance transaction in 2013. For information on the Company's accounting policy for derivative financial instruments, see Note 2. Derivatives in the Company's separate accounts are excluded from the following discussion because associated gains and losses generally accrue directly to separate account policyholders.
Collateral and termination features. The Company routinely monitors exposure to credit risk associated with derivatives and diversifies the portfolio among approved dealers of high credit quality to minimize this risk. As of December 31, 2014, the Company had $21 million in cash on deposit representing the upfront margin required for the Company's centrally-cleared derivative instruments. Certain of the Company's over-the-counter derivative instruments contain provisions requiring either the Company or the counterparty to post collateral or demand immediate payment depending on the amount of the net liability position and predefined financial strength or credit rating thresholds. Collateral posting requirements vary by counterparty. The net liability positions of these derivatives were not material as of December 31, 2014 or 2013.
Accounting policy. Using cash flow hedge accounting, fair values are reported in other long-term investments or other liabilities. Changes in fair value are reported in accumulated other comprehensive income and amortized into net investment income or reported in other realized investment gains and losses as interest or principal payments are received.
(1)Other comprehensive income for foreign currency swaps excludes amounts required to adjust future policy benefits for the run-off settlement annuity business.
(2)There were no amounts offset in the Consolidated Balance Sheets at December 31, 2014 or 2013.
For the years ended December 31, 2014 and 2013, the amounts of gains (losses) reclassified from accumulated other comprehensive income into shareholders' net income were not material. No amounts were excluded from the assessment of hedge effectiveness and no gains (losses) were recognized due to hedge ineffectiveness.
Purpose. Beginning in 2014, the Company entered into centrally-cleared interest rate swap contracts to convert a portion of the interest rate exposure on its long-term debt from fixed to variable rates to more closely align interest expense with interest income received on its cash equivalent and short-term investment balances. The variable rates are benchmarked to LIBOR.
Cash flows. Under the terms of these contracts, the Company provides upfront margin and settles fair value changes and net interest between variable and fixed interest rates daily with the clearinghouse. Net interest cash flows are reported in operating activities.
Volume of activity. As of December 31, 2014, the notional value of these derivative instruments was $750 million. As of December 31, 2014, the effects of these derivative instruments on the Consolidated Financial Statements were not material.
The fair value effects of GMIB contracts on the financial statements are included in Note 10 and their volume of activity is included in Note 23. Further information on these contracts is also presented in Note 7. Cash flows on these contracts are reported in operating activities.
When the Company becomes involved with a variable interest entity and when the nature of the Company's involvement with the entity changes, to determine if the Company is the primary beneficiary and must consolidate the entity, it evaluates:
To provide certain services to its Medicare Advantage customers, the Company contracts with independent physician associations ("IPAs") that are variable interest entities. Physicians provide health care services to the Medicare Advantage customers and the Company provides medical management and administrative services to the IPAs.
The following realized gains and losses on investments for the years ended December 31 exclude amounts required to adjust future policy benefits for the run-off settlement annuity business.
In 2014 and 2013, realized investment gains in other investments, including derivatives, primarily represented gains on sale of real estate properties held in joint ventures.
Realized investment gains that are excluded from the Company's revenues for the years ended December 31 were as follows:
(1) In 2014, the Company entered into interest rate swap contracts hedging a portion of these fixed-rate debt instruments. See Note 12 for further information about the Company's interest rate risk management and these derivative instruments.
In December 2014, the Company entered into an updated revolving credit and letter of credit agreement for $1.5 billion, that permits up to $500 million to be used for letters of credit. This agreement extends through December 2019 and is diversified among 16 banks, with three banks each having 12% of the commitment and the remainder spread among 13 banks. The credit agreement includes options, subject to consent by the administrative agent and the committing banks, to increase the commitment amount to $2 billion and to extend the term past December 2019. The credit agreement is available for general corporate purposes, including for the issuance of letters of credit. This agreement has certain covenants, including a financial covenant requiring the Company to maintain a leverage ratio of total consolidated debt-to-consolidated capitalization (each as defined in the credit agreement) at or below 0.50. As of December 31, 2014, the Company had $6.5 billion of borrowing capacity within the maximum debt coverage covenant in the agreement, in addition to the $5.2 billion of debt outstanding. Letters of credit outstanding as of December 31, 2014 totaled $23 million. The Company was in compliance with its debt covenants as of December 31, 2014.
The Company maintains a share repurchase program, authorized by its Board of Directors. Under this program, we may repurchase shares from time to time, depending on market conditions and alternate uses of capital. We may suspend activity under our share repurchase program from time to time and may also remove such suspensions, generally without public announcement. We may also repurchase shares at times when we otherwise might be precluded from doing so under insider trading laws or because of self-imposed trading black-out periods by using a Rule 10b5-1 trading plan.
In 2014, the Company retired 70 million shares of treasury stock. This transaction had no effect on total shareholders' equity.
State insurance departments and foreign jurisdictions that regulate certain of the Company's subsidiaries prescribe accounting practices (differing in some respects from GAAP) to determine statutory net income and surplus. The Company's life insurance and HMO company subsidiaries are
regulated by such statutory requirements. The statutory net income of the Company's life insurance and HMO subsidiaries for the years ended, and their statutory surplus as of December 31, were as follows:
The minimum statutory surplus required by regulators for the Company's life insurance and HMO company subsidiaries was approximately $2.5 billion as of December 31, 2014. As of December 31, 2014, statutory surplus for each of the Company's life insurance and HMO subsidiaries is sufficient to meet the minimum required by regulators. For one of the Company's foreign insurance subsidiaries, the regulatory authority has permitted deferral of certain policy acquisition costs that increased statutory capital and surplus by approximately $0.2 billion as of December 31, 2014. There were no other permitted practices for the Company's insurance subsidiaries that significantly differed from prescribed regulatory accounting practices. As of December 31, 2014, the Company's life insurance and HMO subsidiaries had investments on deposit with state departments of insurance and other regulatory bodies with statutory carrying values of approximately $0.4 billion. The Company's life insurance and HMO subsidiaries are also subject to regulatory restrictions that limit the amount of annual dividends or other distributions (such as loans or cash advances) insurance companies may extend to the parent company without prior approval of regulatory authorities. The maximum dividend distribution that the Company's life insurance and HMO subsidiaries may make during 2015 without prior approval is approximately $1.0 billion. Restricted net assets of the Company as of December 31, 2014, were approximately $8.8 billion. Certain life insurance subsidiaries of the Company are permitted to loan up to approximately $1.0 billion to the parent company without prior approval.
The consolidated effective tax rate of 36.6% in 2014 has increased from historical levels due to the health insurance industry tax that took effect in 2014 and that is not deductible for federal income tax
purposes. Other matters having a significant impact on the effective tax rate included:
Unrecognized tax benefits increased $9 million in 2014 of which $6 million impacted shareholders' net income. The prior year decrease was primarily attributable to completion of an IRS examination.
In connection with the HealthSpring acquisition on January 31, 2012, HealthSpring employees' awards of options and restricted shares of HealthSpring stock were rolled over to Cigna stock options and restricted stock. Unless otherwise indicated, information in this footnote includes the effect of the HealthSpring rollover awards.
Stock options. The Company awards options to purchase the Company's common stock at the market price of the stock on the grant date. Options vest over periods ranging from one to five years and expire no later than 10 years from grant date.
Compensation expense of $32 million related to unvested stock options at December 31, 2014 will be recognized over the next two years (weighted average period).
The following table summarizes information for outstanding common stock options at December 31, 2014:
Restricted stock. The Company awards restricted stock to its employees or directors with vesting periods ranging from two to five years. These awards are generally in one of two forms: restricted stock grants or restricted stock units. Restricted stock grants are the most widely used form of restricted stock award and are used for substantially all U.S.-based employees receiving such awards. Recipients of restricted stock grants accumulate dividends and can vote during the vesting period, but forfeit their awards and accumulated dividends if their employment terminates before the vesting date. Awards of restricted stock units are generally limited to overseas employees. A restricted stock unit represents a right to receive a common share of stock when the unit vests. Recipients of restricted stock units are entitled to accumulate hypothetical dividends, but cannot vote during the vesting period. They forfeit their units and accumulated dividends if their employment terminates before the vesting date.
The table below shows the status of, and changes in, restricted stock grants and units during the last three years:
The fair value of vested restricted stock was: $85 million in 2014, $94 million in 2013 and $66 million in 2012.
At the end of 2014, approximately 1,200 employees held 1.5 million strategic performance shares and $32 million of related compensation expense is expected to be recognized over the next two years. For strategic performance shares subject to a performance condition, the amount of expense may vary based on actual performance in 2015 and 2016.
Beginning in the first quarter of 2014, the Company combined the results of its run-off reinsurance business with other immaterial operating segments in Other Operations. Prior year segment information has been conformed to the current presentation.
Group Disability and Life provides group long-term and short-term disability, group life, accident and specialty insurance products and related services.
The Company measures the financial results of its segments using "segment earnings (loss)", defined as shareholders' net income (loss) before after-tax realized investment results. The Company determines segment earnings (loss) consistent with accounting policies used in preparing the consolidated financial statements, except that amounts included in Corporate are not allocated to segments. The Company allocates certain other operating expenses, such as systems and other key corporate overhead expenses, on systematic bases. Income taxes are generally computed as if each segment were filing a separate income tax return. The Company does not report total assets by segment because this is not a metric used to allocate resources or evaluate segment performance.
The Company guarantees that separate account assets will be sufficient to pay certain life insurance or retiree benefits. The sponsoring employers are primarily responsible for ensuring that assets are sufficient to pay these benefits and are required to maintain assets that exceed a certain percentage of benefit obligations. This percentage varies depending on the asset class within a sponsoring employer's portfolio (for example, a bond fund would require a lower percentage than a riskier equity fund) and thus will vary as the composition of the portfolio changes. If employers do not maintain the required levels of separate account assets, the Company or an affiliate of the buyer of the retirement benefits business (see Note 7 for additional information) has the right to redirect the management of the related assets to provide for benefit payments. As of December 31, 2014, employers maintained assets that exceeded the benefit obligations. Benefit obligations under these arrangements were $496 million as of December 31, 2014 and approximately 13% of these are reinsured by an affiliate of the buyer of the retirement benefits business. The remaining guarantees are provided by the Company with minimal reinsurance from third parties. There were no additional liabilities required for these guarantees as of December 31, 2014. Separate account assets supporting these guarantees are classified in Levels 1 and 2 of the GAAP fair value hierarchy. See Note 10 for further information on the fair value hierarchy.
• all underlying mutual fund investment values remained at the December 31, 2014 value of $1.1 billion with no future returns. Using these hypothetical assumptions, GMIB exposure is $754 million. The recorded liability for GMIB is calculated using fair value assumptions. The Company has retrocessional coverage in place that covers the exposures on these contracts. See Notes 7, 10 and 12 for further information on GMIB contracts.
The Company had indemnification obligations to lenders of up to $208 million as of December 31, 2014, related to borrowings by certain real estate joint ventures that the Company either records as an investment or consolidates. These borrowings, that are nonrecourse to the Company, are secured by the joint ventures' real estate properties with fair values in excess of the loan amounts and mature at various dates beginning in 2015 through 2021. The Company's indemnification obligations would require payment to lenders for any actual damages resulting from certain acts such as unauthorized ownership transfers, misappropriation of rental payments by others or environmental damages. Based on initial and ongoing reviews of property management and operations, the Company does not expect that payments will be required under these indemnification obligations. Any payments that might be required could be recovered through a refinancing or sale of the assets. In some cases, the Company also has recourse to partners for their proportionate share of amounts paid. There were no liabilities required for these indemnification obligations as of December 31, 2014.
The Company operates in a regulatory environment that may require the Company to participate in assessments under state insurance guaranty association laws. The Company's exposure to assessments for certain obligations of insolvent insurance companies to policyholders and claimants is based on its share of business written in the relevant jurisdictions. For the year ended December 31, 2014 and 2013, charges related to guaranty fund assessments were immaterial to the Company's results of operations.
The business of administering and insuring health services programs, particularly health care and group insurance programs, is heavily regulated by federal and state laws and administrative agencies, such as state departments of insurance and the U.S. Departments of Health and Human Services, Treasury, Labor and Justice, as well as the courts. Health care regulation and legislation in its various forms, including the implementation of Health Care Reform, other regulatory reform initiatives, such as those relating to Medicare programs, or additional changes in existing laws or regulations or their interpretations, could have a material adverse effect on the Company's business, results of operations and financial condition.
that the legal actions, regulatory matters, proceedings and investigations currently pending against it should not have a material adverse effect on the Company's results of operation, financial condition or liquidity based upon current knowledge and taking into consideration current accruals. The Company had pre-tax reserves as of December 31, 2014 of $189 million ($123 million after-tax) for the matters discussed below. Due to numerous uncertain factors presented in these cases, it is not possible to estimate an aggregate range of loss (if any) for these matters at this time. In light of the uncertainties involved in these matters, there is no assurance that their ultimate resolution will not exceed the amounts currently accrued by the Company. An adverse outcome in one or more of these matters could be material to the Company's results of operations, financial condition or liquidity for any particular period.
Disability claims regulatory matter. During the second quarter of 2013, the Company finalized an agreement with the Departments of Insurance for Maine, Massachusetts, Pennsylvania, Connecticut and California (together, the "monitoring states") related to an examination of the Company's long-term disability claims handling practices. The agreement requires, among other things: (1) enhanced claims handling procedures related to documentation and disposition; (2) monitoring the Company's implementation of these procedures during a two-year period following the execution date of the agreement; and (3) a reassessment of claims denied or closed during a two-year prior period, except California for which the reassessment period is three years.
The following unaudited quarterly financial data is presented on a consolidated basis for each of the years ended December 31, 2014 and December 31, 2013. Quarterly financial results necessarily rely heavily on estimates. This and certain other factors, such as the seasonal nature of portions of the insurance business, suggest the need to exercise caution in drawing specific conclusions from quarterly consolidated results.