We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Unum Group and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Unum Group and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
In our opinion, management’s assessment that Unum Group and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Unum Group and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We have audited the accompanying consolidated balance sheets of Unum Group and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Unum Group and subsidiaries at December 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Basis of Presentation: The accompanying consolidated financial statements of Unum Group and its subsidiaries (the Company) have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). Such accounting principles differ from statutory accounting principles (see Note 16). Material intercompany transactions have been eliminated.
Description of Business: We are the largest provider of group and individual income protection products in the United States and the United Kingdom. We also provide a complementary portfolio of other insurance products, including long-term care insurance, life insurance, employer- and employee-paid group benefits, and other related services. We market our products primarily to employers interested in providing benefits to their employees.
Property and Equipment: Property and equipment is reported at cost less accumulated depreciation, which is calculated on the straight-line method over the estimated useful life. The accumulated depreciation for property and equipment was $496.4 million and $443.0 million as of December 31, 2006 and 2005, respectively.
Policy and Contract Benefits: Policy and contract accrued benefits, principally related to accident and health insurance policies, are based on reported losses and estimates of incurred but not reported losses for traditional life and accident and health products. For interest-sensitive products, benefits are the amounts paid and expected to be paid on insured claims in excess of the policyholders’ policy fund balances.
Policy and Contract Benefits Liabilities: Active life reserves for future policy and contract benefits on traditional life and accident and health products have been provided on the net level premium method. The reserves are calculated based upon assumptions as to interest, withdrawal, morbidity, and mortality that were appropriate at the date of issue. Interest assumptions for active life reserves may be graded downward over a period of years. Withdrawal assumptions are based on our actual experience. Morbidity and mortality assumptions are based upon industry standards adjusted as appropriate to reflect our actual experience. The assumptions vary by plan, year of issue, and policy duration and include a provision for adverse deviation.
Reserves for future policy and contract benefits on interest-sensitive products are principally policyholder account values.
Accounting for Participating Individual Life Insurance: Participating policies issued by one of our subsidiaries prior to its 1986 conversion from a mutual to a stock life insurance company will remain participating as long as the policies remain in force. A Participation Fund Account (PFA) was established for the benefit of all such individual participating life and annuity policies and contracts. The assets of the PFA provide for the benefit, dividend, and certain expense obligations of the participating individual life insurance policies and annuity contracts. The PFA was $349.8 million and $353.1 million at December 31, 2006 and 2005, respectively, and represented approximately 0.7 percent of consolidated assets and 0.7 percent of consolidated liabilities at December 31, 2006 and 2005.
FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, an interpretation of Statement of Financial Accounting Standard No. 109 (SFAS 109), was issued in June 2006. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS 109. Unlike SFAS 109, FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We will adopt the provisions of FIN 48 effective January 1, 2007. The cumulative effect of applying the provisions of FIN 48 will be reported in our first quarter of 2007 financial statements as an adjustment to the opening balance of retained earnings for 2007. We estimate that the cumulative effect adjustment will increase retained earnings by up to $25.0 million.
Statement of Financial Accounting Standards No. 157 (SFAS 157), Fair Value Measurements, was issued in September 2006. SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. We will adopt the provisions of SFAS 157 effective January 1, 2008. The adoption of SFAS 157 will not have a material effect on our financial position or results of operations.
As discussed in Note 1, in January 2007, we entered into a definitive agreement for the sale of GENEX and expect to close the transaction during the first quarter of 2007, subject to customary closing conditions. The expected gain on the transaction is not material. We have agreed with the buyer, in an arms-length transaction, to continue to purchase certain disability management services for a period of up to five years from the effective date of the sale. Intercompany amounts paid to GENEX for these types of services for the years ended December 31, 2006, 2005, and 2004 were approximately $15.4 million, $15.7 million, and $18.8 million, respectively. The estimated future purchase of these services from the buyer is not material.
GENEX is accounted for as an asset held for sale at December 31, 2006 and is reported as discontinued operations in the accompanying consolidated financial statements. The results of GENEX, which were previously included in the Other segment, are now reported as discontinued operations and excluded from segment results for all periods.
During 2003, we entered into an agreement to sell our Canadian branch. In the first quarter of 2004, we recognized a loss of $0.6 million before tax and $0.4 million after tax to write down the value of bonds in the Canadian branch investment portfolio to market value. The transaction closed April 30, 2004, and in the second quarter of 2004, we recognized a loss of $113.0 million before tax and $70.9 million after tax on the sale of the branch.
Selected results for the Canadian branch for the period January 1, 2004 through April 30, 2004 are as follows (in millions of dollars, except share data):
Mortgage Loans: Fair values are estimated using discounted cash flow analyses and interest rates currently being offered for similar mortgage loans to borrowers with similar credit ratings and maturities. Mortgage loans with similar characteristics are aggregated for purposes of the calculations.
Policy Loans and Other Long-term Investments: Carrying amounts approximate fair value.
The gross unrealized loss on below-investment-grade fixed maturity securities was $60.6 million at December 31, 2006, or 9.3 percent, of the total gross unrealized loss on fixed maturity securities. Generally, below-investment-grade fixed maturity securities are more likely to develop credit concerns.
As of December 31, 2006, we held 466 individual investment-grade fixed maturity securities and 51 individual below-investment-grade fixed maturity securities that were in an unrealized loss position, of which 181 investment-grade fixed maturity securities and 27 below-investment-grade fixed maturity securities had been in an unrealized loss position continuously for over one year.
As of December 31, 2006, we held three securities with a gross unrealized loss of $10.0 million or greater, as follows:
The second fixed maturity bond of the U.S. government sponsored mortgage funding company was issued by the Federal Home Loan Mortgage Corporation. The bond was rated AAA by S&P as of December 31, 2006, with no negative outlook by rating agencies or in analysts’ reports. The change in the market value of this security relates to changes in interest rates after the purchase of the bond. We believe that the decline in fair value of this security is temporary. The market value of this security will increase if interest rates decline to levels similar to when the bonds were purchased. We believe this is likely to occur over the life of the security. We have the ability to hold this security to the earlier of recovery or maturity.
Whether the security is current as to principal and interest payments.
We have four special purpose entities which support our investment objectives and which are consolidated under the provisions of Interpretation No. 46 (FIN 46(R)), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51. These entities are securitized asset trusts and contain specific financial instruments that do not include our common stock or debt. Three of these entities are trusts holding forward contracts to purchase unrelated equity securities. Each of these trusts also holds a defeasance swap contract for highly rated bonds to provide principal protection for the investments. The fair values of the underlying forward and swap contracts equaled $177.3 million as of December 31, 2006, and are reported as fixed maturity securities in the consolidated balance sheets. The fourth entity is a trust containing a highly rated bond for principal protection, unrelated equity securities, and several partnership equity investments. We contributed the bond and partnership investments into the trust at the time it was established. The purpose of this trust was to allow us to maintain our investment in the partnerships while at the same time protecting the principal of the investment. The fair values of the bond, equity securities, and partnerships were $81.0 million, $11.5 million, and $40.3 million, respectively, as of December 31, 2006.
We have a significant investment in, but are not the primary beneficiary of, a special purpose entity which is a collateralized bond obligation asset trust (CBO) in which we hold interests in several of the tranches and for which we act as investment manager of the underlying securities. This special purpose entity does not meet the consolidation requirements of FIN 46(R). We issued the CBO in 1998, and its purpose is to securitize high yield bonds and earn a spread over the cost of the funds from the different tranches issued. The outstanding balance of all tranches at December 31, 2006 was $143.7 million, $91.8 million of which is held by third parties. These third parties have no recourse against us. The total value of the CBO assets was $82.2 million at December 31, 2006. Our maximum exposure to loss for the fixed maturity securities is $18.8 million at December 31, 2006.
At December 31, 2006, we had capital commitments of approximately $13.2 million to fund certain of our private placement fixed maturity securities. The funds are due upon satisfaction of contractual notice from the issuer. These amounts may or may not be funded during the term of the security.
In the normal course of business, we receive collateral from unaffiliated third parties through transactions which include both securities lending and also short-term agreements to purchase securities with the agreement to resell them at a later, specified date. For both types of transactions, we require that a minimum of 102 percent of the fair value of the securities loaned or securities purchased under repurchase agreements be maintained as collateral. Generally, cash is received as collateral under these agreements. In the event that securities are received as collateral, we are not permitted to sell or repledge them. We also pledge our fixed maturity securities as collateral to unaffiliated third parties through transactions including both securities lending and also short-term agreements to sell securities with the agreements to repurchase them at a later, specified date. At December 31, 2006, the carrying value of fixed maturity securities pledged as collateral to third parties was $1,005.7 million.
At December 31, 2006, we had capital commitments of approximately $66.6 million for commercial mortgage loan originations. The funds will be due at closing of the mortgage loans.
The following table summarizes the timing of anticipated settlements of interest rate swaps outstanding at December 31, 2006, whereby we receive a fixed rate and pay a variable rate. The weighted average interest rates assume current market conditions.
We have executed a series of cash flow hedges for certain of our long-term product portfolios using forward starting interest rate swaps and forward contracts. The purpose of these hedges is to lock in the reinvestment rates on future anticipated cash flows through the year 2013 and protect us from the potential adverse impact of declining interest rates on the associated policy reserves. We plan on terminating these forward interest rate swaps and forward contracts at the time the projected cash flows are used to purchase fixed income securities. As of December 31, 2006 and 2005, we had $2,125.0 million and $2,700.0 million, respectively, notional amount of the forward starting interest rate swaps outstanding under this program. We did not have any forward contracts outstanding under this program as of December 31, 2006 or 2005.
As of December 31, 2006 and 2005, we had $367.8 million and $400.0 million, respectively, notional amount of currency swaps and $216.3 million notional amount of forward currency contracts to hedge the foreign currency risk associated with the U.S. dollar denominated debt issued by one of our U.K. subsidiaries.
We have entered into an interest rate swap with a notional amount of $60.0 million as of December 31, 2006 and 2005 whereby we receive a fixed rate of interest and pay a variable rate of interest. The purpose of this swap is to hedge the variable cash flows associated with a floating rate security we own. The variable rate we pay on the swap is offset by the amount we receive on the variable rate security.
As of December 31, 2005, we had $15.2 million notional amount of a foreign currency forward contract to hedge the variability of functional currency cash flows associated with the anticipated receipt of foreign currency proceeds from the settlement of a bankruptcy claim related to a fixed maturity security we owned. We terminated this derivative in 2006, for cash, at the time the bankruptcy claim proceeds were received.
During the years ended December 31, 2006, 2005, and 2004, we recognized net gains of $183.6 million, $120.7 million, and $29.1 million, respectively, on the termination of cash flow hedges and reported $183.6 million, $121.0 million, and $29.2 million, respectively, in other comprehensive income. During the years ended December 31, 2005 and 2004 we reported net losses of $0.3 million and $0.1 million, respectively, as a component of realized investment gains and losses. We amortized $30.0 million, $21.8 million, and $20.7 million of net deferred gains into net investment income during 2006, 2005, and 2004, respectively. The estimated amount of net deferred gains to be amortized into operating earnings during 2007 is $27.2 million.
During 2005 and 2004 GENEX acquired Independent Review Services, Inc., a provider of medical diagnostic networks and independent medical examinations, at a price of $3.5 million and Integrated Benefits Management, a provider of case management services, at a price of $0.7 million, respectively. These companies will be included with the disposition of GENEX.
During 2004, we became responsible for the ongoing administration and management of the United Kingdom portion of the group income protection claims portfolio of Swiss Life (UK) plc (Swiss Life), and Swiss Life reinsured this portfolio to us. We also became a multi-national pooling partner for Swiss Life Insurance & Pension Company with respect to business written in the United Kingdom. The amount attributable to value of business acquired in conjunction with this transaction was $15.4 million.
During 2004, we recognized an impairment of $367.1 million for the remaining balance of the individual income protection - closed block value of business acquired. The impairment related to the restructuring of this business and the resulting modification of our reporting segments. See Note 14 for further discussion.
In 2004, we completed an analysis of the assumptions related to our individual income protection - closed block claim reserves. The analysis was initiated based on the restructuring effective January 1, 2004, which reflected the individual income protection - closed block as a stand-alone segment. Previously these reserves were analyzed for the individual income protection line of business on a combined basis. Included in the analysis was a review of morbidity assumptions, primarily claim resolution rates, and claim reserve discount rate assumptions. Based upon this analysis, we lowered the claim reserve discount rate to reflect the segmentation of the investment portfolio between the individual income protection - recently issued business and the individual income protection - closed block business, the duration of the assets and the related policy liabilities. Based on the analysis, in 2004 we increased our individual income protection - closed block claim reserves by $110.6 million to reflect our current estimate of future benefit obligations. “Incurred Related to Prior Years - Incurred” includes $237.4 million in 2004 for the reserve strengthening, reinsurance, and other related adjustments associated with the restructuring.
A reconciliation of policy and contract benefits and reserves for future policy and contract benefits as reported in the consolidated balance sheets to the liability for unpaid claims and claim adjustment expenses is as follows:
Our consolidated statements of operations include the following amounts of income subject to foreign taxation, including the results of the Canadian branch discontinued operations, and the related foreign income tax expense (benefit):
During the first quarter of 2005, the Internal Revenue Service (IRS) completed its examination of tax years 1999 through 2001 and issued its revenue agent’s report (RAR) in April 2005. Income tax liabilities of approximately $32.0 million that related primarily to interest on the timing of expense deductions were released in the first quarter of 2005, all of which was reflected as a reduction to income tax expense. We are contesting several issues raised in the 1999 through 2001 tax years and expect to resolve these through the IRS appeals process.
Also during 2004, we recognized tax benefits from settlements of IRS examinations of tax years 1996 through 1998. Under the settlements, we resolved issues raised by the IRS pertaining to the calculation of insurance tax reserves and the deductibility of losses on notional principal contracts. Tax benefits of $33.1 million are included in 2004 results from operations attributable to the effect of prior year tax settlements.
The 7.25% notes due 2032 are redeemable at Unum Group’s option on or after June 25, 2007. The adjustable conversion-rate equity security units, the 5.997% notes due 2008, and the junior subordinated debt securities due 2038 are callable under limited, specified circumstances. The remaining callable debt may be redeemed, in whole or in part, at any time. Collateralized debt, which consists of the senior secured notes, ranks highest in priority, followed by unsecured notes, which consists of adjustable conversion-rate equity security units, notes, and medium-term notes, followed by junior subordinated debt securities. The aggregate contractual principal maturities are $175.0 million in 2008, $300.0 million in 2009, $325.0 million in 2011, and $1,860.0 million in 2012 and thereafter.
Tailwind Re has reinsured a quota share portion of Unum Life Insurance Company of America’s (Unum America) liability with respect to certain specified long-term disability claims incurred between January 1, 1999 and December 31, 2001 that were in payment status on January 1, 2006 (reinsured claims). Assets held in the funding sub account will not be available to fund payments of principal or interest on the notes, but will be held solely to satisfy any obligations of Tailwind Re to Unum America under the Reinsurance Agreement.
Tailwind Holdings is required to repay a portion of the outstanding principal under the notes at par on the scheduled payment dates of each year in an amount equal to the lesser of (i) a specified targeted amortization amount as defined in the indenture and (ii) the amount of the remaining available funds in the DSCA minus an amount equal to the minimum balance that is required to be maintained in the DSCA under the indenture, provided that Tailwind Holdings has sufficient funds available to pay its other expenses, including the payment of interest on the notes, and to retain the required balance in the DSCA.
In November 2005, UnumProvident Finance Company plc, a wholly-owned subsidiary of Unum Group, issued $400.0 million of 6.85% senior debentures due November 15, 2015 in a private offering and received net proceeds of $399.6 million. These debentures are fully and unconditionally guaranteed by Unum Group. In December 2006, $32.0 million of these debentures were redeemed. The cost related to this redemption decreased 2006 income by $2.7 million before tax, or $1.9 million after tax.
In May 2004, Unum Group issued 12.0 million 8.25% adjustable conversion-rate equity security units (units) in a private offering for $300.0 million. We subsequently registered the privately placed securities for resale by the private investors. Each unit has a stated amount of $25 and will initially consist of (a) a contract pursuant to which the holder agrees to purchase, for $25, shares of Unum Group’s common stock on May 15, 2007 and which entitles
Interest paid on short-term and long-term debt and related securities during 2006, 2005, and 2004 was $200.7 million, $210.7 million, and $205.2 million, respectively.
We sponsor several defined benefit pension and postretirement plans for our employees, including non-qualified pension plans. The U.S. plans comprise the majority of our total benefit obligation and benefit cost. We maintain a separate defined benefit plan for eligible employees in our U.K. operation. We previously maintained separate defined benefit plans for the employees of our Canadian branch operation. As a result of the sale of the Canadian
branch, we froze the Canadian defined benefit pension plans during 2004 and are currently in the process of terminating these plans.
The following tables provide the changes in the benefit obligation and fair value of plan assets and statements of the funded status of the plans. We use a December 31 measurement date for each plan.
The weighted average assumptions used to determine net periodic benefit cost for years ended December 31 are as follows:
We currently set the discount rate assumption annually for each of our pension-related benefit plans at the measurement date to reflect the yield of a portfolio of high quality long-term fixed income securities matched against the projected cash flows for future benefits.
A one percent increase or decrease in the assumed health care cost trend rate at December 31, 2006 would have increased (decreased) the service cost and interest cost by $0.7 million and $(0.6) million, respectively, and the postretirement benefit obligation by $7.6 million and $(6.8) million, respectively.
Our funded pension plans’ weighted average asset allocations, by asset category, are as follows:
To determine the net periodic pension cost for our U.S. qualified defined benefit pension plan for the year 2006, an 8.0 percent long-term expected rate of return assumption was used. The long-term rate of return assumption is an estimate, based on statistical analysis, of the average annual assumed return that will be produced from the pension trust assets until current benefits are paid. The investment portfolio during 2006 contained a diversified blend of large cap, mid cap, and small cap domestic equity securities, international equity securities, convertible securities, and investment-grade and below-investment-grade fixed income securities. Our expectations for the future investment returns of these asset categories were based on a combination of historical market performance and evaluations of investment forecasts obtained from external consultants and economists. The methodology underlying the return assumption included the various elements of the expected return for each asset class such as long-term rates of return, volatility of returns, and the correlation of returns between various asset classes. The expected return for the total portfolio was calculated based on the plan’s strategic asset allocation. Investment risk is measured and monitored on an ongoing basis through annual liability measurements, periodic asset/liability studies, and quarterly investment portfolio reviews. Risk tolerance is established through consideration of plan liabilities, plan funded status, and corporate financial condition. The plan prohibits the use of derivative instruments.
Our U.K. operation maintains a separate defined benefit plan (Scheme) for eligible employees. The Scheme assets are invested in pooled funds, with a 54 percent global equity securities allocation. The remainder of the assets is predominantly invested in fixed interest bonds and index linked bonds. The long-term rate of return assumption is the best estimate of the average annual assumed return that will be produced from the Scheme assets until current benefits are paid. We are required to contribute to the Scheme at the rate of at least 18.20 percent of eligible salaries sufficient to meet the minimum funding requirement under U.K. legislation. We made contributions of $53.3 million and $8.8 million in 2006 and 2005, respectively. We expect to make contributions of $9.5 million during 2007.
We also maintain a reserve for life insurance benefits payable to certain former retirees covered under the postretirement welfare plan. The expected return assumption for this reserve was 5.75 percent, which was based on full investment in fixed income securities with an average book yield of 6.39 percent and 6.56 percent for 2006 and 2005, respectively.
During 2006, we settled the purchase contract element of the adjustable conversion-rate equity security units issued in 2003 by issuing 43.3 million shares of Unum Group common stock. See Note 9 for further discussion.
We use the treasury stock method to account for the effect of the purchase contract element of the units, outstanding stock options, and other dilutive securities on the number of weighted average common shares, assuming dilution. Under this method, the purchase contract element of the units, as described in Note 9, and outstanding stock options, as described in Note 12, will have a dilutive effect only when the average market price of Unum Group’s common
Note 11 - Stockholders’ Equity and Earnings Per Common Share - Continued
stock during the period exceeds the threshold appreciation price of the purchase contract element of the units or the exercise price of the stock options. The purchase contract elements of the units issued in 2004 have a threshold appreciation price of $16.95 per share. The units issued in 2003 had a threshold appreciation price of $13.27. The outstanding stock options have exercise prices ranging from $12.23 to $58.56.
Options to purchase approximately 8.2 million, 12.1 million, and 14.4 million shares of common stock for the years ended December 31, 2006, 2005, and 2004, respectively, were outstanding but were not included in the computation of earnings per common share, assuming dilution, because the exercise prices of the options were greater than the average market price of Unum Group’s common stock. The purchase contract elements of the units issued in 2004 were also excluded from the computation for the year ended December 31, 2004 because the threshold appreciation price was greater than the average market price of Unum Group’s common stock.
We previously had a broad-based stock plan of 2002 under which there were up to 2,390,000 shares of common stock available for stock option awards to our employees, officers, consultants, and brokers, excluding certain senior officers and directors. Prior to terminating the plan in February 2004 for purposes of any further grants, we granted 2,007,375 shares in the form of stock options with a maximum term of ten years after the date of grant and generally with a three year vesting period.
Under the broad-based stock plan of 2001, up to 2,000,000 shares of common stock are available for stock option awards to our employees, officers, consultants, and brokers, excluding certain senior officers and directors. The stock options have a maximum term of ten years after the date of grant and generally vest after three years. At December 31, 2006, 550,990 shares were available for future grants.
Under the stock plan of 1999, up to 17,500,000 shares of common stock are available for awards to our employees, officers, brokers, and directors. Awards may be in the form of stock options, stock appreciation rights, stock awards, dividend equivalent awards, or any other right or interest relating to stock. Stock options have a maximum term of ten years after the date of grant and generally vest after three years. The number of shares available to be issued as stock awards under the stock plan of 1999 is limited to 6,125,000 shares. At December 31, 2006, 6,366,710 shares were available for future grants under the stock plan of 1999.
For the stock plan of 1999, the broad-based stock plan of 2001, and the broad-based stock plan of 2002, the exercise price for stock options issued cannot be less than the fair market value of the underlying common stock as of the grant date.
We issue new shares of common stock for nonvested stock grants, exercise of stock options, and purchase of employee stock purchase plan (ESPP) shares.
Expense for the stock plans described above, included in compensation expense in the consolidated statements of operations, is as follows:
Cash received under all share-based payment arrangements for the years ended December 31, 2006, 2005, and 2004 was $5.0 million, $18.1 million, and $5.7 million, respectively.
Stock awards vest over a two to five year service period, beginning at the date of grant, and the compensation cost is recognized ratably during the vesting period. Compensation cost for stock awards subject to accelerated vesting upon retirement is recognized over the implicit service period for awards issued subsequent to 2005 and over the explicit service period (subject to acceleration upon actual retirement) for awards issued prior to 2006. We pay cash dividend equivalents on outstanding nonvested stock awards. Dividend equivalents paid on nonvested stock awards are charged to expense when paid. At December 31, 2006, we had $12.7 million of unrecognized compensation cost related to nonvested stock awards that will be recognized over a weighted average period of 1.0 year. Prior to adoption of SFAS 123(R), this amount was reported as additional paid-in capital and deferred compensation, a contra equity account. The value of this contra equity account at the adoption of SFAS 123(R) was $13.8 million. The weighted average grant date fair values per share for nonvested stock awards granted during 2006, 2005, and 2004 were $20.95, $17.43, and $15.14, respectively.
During the third quarter of 2005, we recaptured a closed block of individual income protection business, with approximately $1.6 billion in invested assets and $185.0 million of annual premium. Before the recapture, the underlying operating results of the reinsurance contract were reflected in other income. The recapture did not have a material effect on operating results for the Individual Income Protection - Closed Block segment.
During 2004, we restructured our individual income protection - closed block business wherein three of our insurance subsidiaries entered into reinsurance agreements to reinsure approximately 66.7 percent of potential future losses that occur above a specified retention limit. The reinsurance agreements effectively provide approximately 60 percent reinsurance coverage for our overall consolidated risk above a specified retention limit, which equaled approximately $8.0 billion in existing statutory reserves at the date of the transaction. The maximum risk limit for the reinsurer was approximately $783.0 million initially and is now estimated to grow to approximately $2.4 billion over time, after which any further losses will revert to us. These reinsurance transactions were effective as of April 1, 2004. We transferred cash equal to $521.6 million of ceded reserves plus an additional $185.8 million in cash for a before-tax prepaid cost of insurance which was deferred and is being amortized into earnings over the expected claim payment period covered under our retention limit.
Our reporting segments are comprised of the following: Unum US, Unum UK, Colonial, Individual Income Protection - Closed Block, Other, and Corporate.
The Colonial segment includes insurance for income protection products, life products, and cancer and critical illness products issued and marketed primarily to employees at the workplace through an agency sales force and brokers.
The Other segment, includes results from Unum US insured products not actively marketed (with the exception of the individual income protection products in the Individual Income Protection - Closed Block segment), including individual life and corporate-owned life insurance, reinsurance pools and management operations, group pension, health insurance, and individual annuities.
A reconciliation of total operating revenue and operating income (loss) by segment to revenue and net income (loss) as reported in the consolidated statements of operations follows:
We report goodwill in our Unum US segment and in our Unum UK segment, which are the segments expected to benefit from the originating business combinations. Stockholders’ equity is allocated to the operating segments on the basis of an internal allocation formula that reflects the volume and risk components of each operating segment’s business and aligns allocated equity with our target capital levels for regulatory and rating agency purposes. We modify this formula periodically to recognize changes in the views of capital requirements.
We have noncancelable lease obligations on certain office space and equipment. As of December 31, 2006, the aggregate net minimum lease payments were $106.8 million payable as follows: $32.1 million in 2007, $23.1 million in 2008, $16.1 million in 2009, $10.1 million in 2010, $6.9 million in 2011, and $18.5 million thereafter. Rental expense for the years ended December 31, 2006, 2005, and 2004 was $35.8 million, $33.9 million, and $37.9 million, respectively.
On February 12, 2003, the first of six virtually identical putative securities class actions was filed in the U.S. District Court for the Eastern District of Tennessee. In two orders dated May 21, 2003, and January 22, 2004, the district court consolidated these actions under the caption In re UnumProvident Corp. Securities Litigation.
A motion to dismiss was filed, and the court ultimately issued a Memorandum and Order denying in part, and granting in part, the motion. The court granted the motion with respect to Lead Plaintiff’s claims concerning our investments and denied the motion challenging the other alleged misstatements. Discovery, which had been stayed in this action pursuant to the Private Securities Litigation Reform Act of 1995, has now begun.
On July 15, 2002, Rombeiro v. Unum Life Insurance Company of America, et al., was filed in the Superior Court of California and subsequently was removed to federal court, alleging that the plaintiff was wrongfully denied disability benefits under a group long-term disability plan. On January 21, 2003, an Amended Complaint was filed
Court ordered mediation has concluded with the settlement of all individual claims brought by six of the fifteen named plaintiffs in the ERISA Benefit Denial Actions. A seventh plaintiff has subsequently resolved her claims through the process established under the regulatory settlement agreements.
On January 9, 2004, plaintiffs filed a consolidated amended complaint against us, several of our officers and directors, and several alleged Plan fiduciaries on behalf of a putative class of individuals that held our Company’s stock in their 401(k) retirement accounts subsequent to November 17, 1999. Plaintiffs allege that the defendants violated ERISA by making misrepresentations and omissions regarding investment in our Company’s stock and by acting imprudently in failing to take action to protect participants from losses sustained from investments in the Plan’s UnumProvident Stock Fund.
The parties are currently engaged in settlement discussions supervised by a Court appointed mediator. The parties have reached an agreement in principle for resolution of the matter, the net cost of which is immaterial to the Company. The agreement is subject to further negotiations on a number of points, including attorneys’ fees, the preparation of a definitive written agreement, and Court approval of any final agreement.
The agreements will remain in place until the later of January 1, 2007, or the completion of an examination of claims handling practices and an examination of the reassessment process, both of which will be conducted by the lead state regulators. The settlement agreements also provide for a contingent fine of up to $145.0 million on our U.S. insurance subsidiaries in the event that we fail to satisfactorily meet the performance standards in the settlement agreements relating to the examinations referred to above. The parties to the agreements have subsequently agreed to extend the reassessment process until December 31, 2007, and we expect to conclude the claim reassessment process by that time. The examinations will commence before or after that date. We believe that due to the changes we have made to our claims operations to enhance our oversight functions, it is not probable that we will fail to meet the performance standards in the agreements when these examinations are concluded.
In October 2005, certain of our insurance subsidiaries entered into a settlement agreement with the California DOI, concluding a market conduct examination and investigation of the subsidiaries’ disability claims handling practices. The California DOI had chosen not to join the 2004 multistate settlement agreements. As part of the settlement with the California DOI, we agreed to change certain practices and policy provisions related to our California business. The settlement also incorporates claims handling practices previously covered by the multistate settlement agreements and includes certain additional claim handling changes. Under the terms of the settlement, we changed certain provisions specific to California disability policies, and we received approval from the California DOI for the use of new individual and group disability policy forms. Following the California settlement, we also amended the multistate settlement agreements to include mailing a notice of eligibility to participate in the claim reassessment process to approximately 29,500 individuals whose claims were denied or terminated between January 1, 1997 and December 31, 1999. Under the original multistate settlement agreements, claimants during this period could request participation in the reassessment process, but they were not sent a notice.
Separately, we are proceeding with a plan to offer to reassess private label, acquired, and reinsured block claims, as well as claims administered on behalf of certain employers.
As of the end of 2006, we had completed our review of approximately 55 percent of the total claims expected to be reassessed under the multistate and California settlement agreements and had information on an additional 15 percent for which we had not yet finalized our review. Based on current information, we believe that our ultimate claim reassessment costs could be lower or higher by approximately $90.0 million relative to the best estimate upon which our accruals are currently based. The estimate of the lower and upper end of the range of reasonably possible
additional costs is much less certain than our best estimate and uses assumptions, among the range of reasonably possible outcomes, which are more favorable to us at the lower end of the cost range and less favorable to us at the upper end of the range. We continue to monitor our claim reassessment experience and review the adequacy of the associated reserves on a quarterly basis. Unfavorable experience relative to our revised assumptions could result in additional claim reassessment costs above our current accrual and in excess of our reasonably possible range.
On March 29, 2006 we received a subpoena from the Securities and Exchange Commission (SEC) seeking information regarding certain reinsurance transactions and transactions regarding “Non Traditional Products” entered into after January 1, 2002. We are cooperating fully with the SEC in its investigation.
These and other regulatory examinations or investigations could result in, among other things, changes in business practices, including changes in broker compensation and related disclosure practices, changes in the use and oversight of reinsurance, changes in governance and other oversight procedures, fines, and other administrative action.
Such results, singly or in combination, could injure our reputation, cause negative publicity, adversely affect our debt and financial strength ratings, or impair our ability to sell or retain insurance policies, thereby adversely affecting our business, and potentially materially adversely affecting our consolidated results of operations in a period, depending on the results of operations for the particular period. Determination by regulatory authorities that the Company or its insurance subsidiaries have engaged in improper conduct could also adversely affect our defense of various lawsuits described herein.
In June 2004, we received a subpoena from the NYAG requesting documents and information relating to compensation arrangements between insurance brokers or intermediaries and us and our subsidiaries.
On November 1, 2006, we entered into a settlement agreement with the NYAG in the form of an assurance of discontinuance that provides for a national restitution fund of $15.5 million and a fine of $1.9 million, the costs of which were recorded in the third quarter of 2006. That restitution fund should be fully distributed by year end 2007.
Since October 2004, we and/or our insurance subsidiaries have received subpoenas or information requests from the NYAG, a Federal Grand Jury in San Diego, the District Attorney for the County of San Diego, insurance departments, and/or other state regulatory or investigatory agencies of at least seven additional states including Connecticut, Florida, Maine, Massachusetts, North Carolina, South Carolina, and Tennessee.
With respect to the states listed, other than Florida and other than those with whom settlements have been reached, we have not received any further inquiries in the past 12 months and consider those investigations to be dormant.
We have also had discussions with the DOL regarding compliance with ERISA, relating to our interactions with insurance brokers and to regulations concerning insurance information provided by us to plan administrators of ERISA plans, including specifically the reporting of fees and commissions paid to agents, brokers, and others in accordance with the requirements of Schedule A of Form 5500. The DOL is pursuing an investigation of us concerning these issues, both generally and specifically in connection with certain brokers, including Universal Life Resources, Inc. We are cooperating fully with the DOL’s investigation.
We and certain of our subsidiaries, along with many other insurance brokers and insurers, have been named as defendants in a series of putative class actions that have been transferred to the U.S. District Court for the District of New Jersey for coordinated or consolidated pre-trial proceedings as part of multidistrict litigation (MDL) No. 1663, In re Insurance Brokerage Antitrust Litigation. The plaintiffs in MDL No. 1663 filed a consolidated amended complaint in August 2005, which alleges, among other things, that the defendants violated federal and state antitrust laws, RICO, ERISA, and various state common law requirements by engaging in alleged bid rigging and customer allocation and by paying undisclosed compensation to insurance brokers to steer business to defendant insurers. Defendants filed a motion to dismiss the complaint on November 29, 2005. Various motions remain pending before the court. Rulings on these motions may be delayed pending a motion related to the potential recusal of the district court judge hearing the case.
On December 21, 2004, a putative derivative action styled Leonard v. UnumProvident Corporation, et al., was filed in Tennessee Chancery Court against us and various members of our board of directors alleging claims on behalf of us against the director defendants for breach of duty, mismanagement, and corporate waste, challenging certain compensation paid to insurance brokers and alleging insider trading against certain director defendants. A motion to dismiss the complaint remains pending. The defendants strongly deny the allegations in the complaint and will vigorously defend both the substantive and procedural aspects of the litigation.
In September 2003, United States of America ex. rel. Patrick J. Loughren v. UnumProvident Corporation and GENEX Services, Inc., was filed in the United States District Court for the District of Massachusetts. This is a qui tam action to recover damages and civil penalties on behalf of the United States of America alleging violations of the False Claims Act by us and our GENEX subsidiary. In accordance with the False Claims Act, the action was originally filed under seal to provide the government the opportunity to investigate the allegations and prosecute the action if they believed that the case had merit and warranted their attention. The government declined to prosecute the case and the case became a matter of public record on December 23, 2004. The complaint alleges that we defrauded the government by inducing and or assisting disability claimants to apply for disability benefits from the Social Security Administration (SSA) when we allegedly knew that the claimants were not disabled under SSA criteria. A motion to dismiss the complaint was unsuccessful. We intend to vigorously defend the action.
Statutory net income for U.S. life insurance companies is reported in conformity with statutory accounting principles prescribed by the National Association of Insurance Commissioners (NAIC) and adopted by applicable domiciliary state laws. For the years ended December 31, 2006, 2005, and 2004, our U.S. insurance subsidiaries’ statutory combined net income, excluding Tailwind Re, was $307.4 million, $641.8 million, and $607.6 million, respectively, and statutory combined net gain from operations was $371.5 million, $650.0 million, and $662.1 million, respectively. Statutory capital and surplus, excluding Tailwind Re, was $4,232.0 million and $4,270.2 million at December 31, 2006 and 2005, respectively. Tailwind Re, our South Carolina domiciled special purpose financial captive insurance subsidiary, had statutory net income and statutory net gain from operations of $14.1 million for the year ended December 31, 2006. Statutory capital and surplus for Tailwind Re at December 31, 2006 was $136.2 million.
The third and first quarters of 2006 include claim reassessment charges of $325.4 million and $86.0 million before tax, respectively, and $211.5 million and $55.9 million after tax, respectively.
The third quarter of 2005 includes claim reassessment charges of $75.0 million before tax and $51.6 million after tax.
The third and first quarters of 2005 include income tax benefits of $10.8 million and $32.0 million, respectively, related to the reduction of income tax liabilities.