the facilities described above. The Company also owns 72,000 square feet of office space in Hillsboro, Oregon, which is used by StanCorp Mortgage Investors, LLC and will be used by our Employee Benefits claims operations later in 2006. In addition, Standard leases 160,000 square feet of office space located in downtown Portland, Oregon, and 60,000 square feet of offsite storage. The Company also leases 64 offices under commitments of varying terms to support its sales and regional processing offices throughout the United States. Management believes that the capacity and types of facilities are suitable and adequate. Management may evaluate additional square footage in 2006 to accommodate its increasing workforce. See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements.”
Includes operating expenses, commissions and bonuses, premium taxes, and the net increase in deferred acquisition costs and value of business acquired.
Our financial results for 2005 were strong. Net income per diluted share increased 9.0% to $3.76 for 2005, compared to $3.45 for 2004. Net income increased 5.9% to $211.1 million for 2005, compared to $199.4 million for 2004. Factors contributing to the increase in net income for 2005 were comparatively favorable claims experience in the Employee Benefits and Individual insurance segments, and higher revenues in the Retirement Plans segment. In addition, results for 2004 included a reduction in income taxes of approximately $7 million from resolution of prior years’ tax examinations and certain state income tax matters. We do not expect similar reductions in income taxes to recur.
Significant factors that are likely to influence our 2006 financial results when compared to 2005 include:
Strong sales and high customer retention in 2005 will contribute to premium growth in 2006. We expect to achieve our long-term premium growth objective in the range of 10% to 12% for 2006.
For the first three quarters of 2005, benefits to policyholders were reduced by the release of approximately $3 million per quarter as a result of our on-going assessment of claims recovery patterns in the Employee Benefits segment. We do not currently anticipate similar reserve releases for 2006.
We have established a long-term financial objective to grow assets under management by more than 20% per year.
Revenues consist primarily of premiums, administrative fees and net investment income. Total revenues increased 9.0% to $2.34 billion for 2005 compared to 2004 and increased 4.0% to $2.14 billion for 2004 compared to 2003.
Growth in premiums and administrative fees was primarily driven by premium growth in the Employee Benefits segment. Premium growth excluding experience rated refunds (“ERRs”), which are refunds to certain group contract holders in the Employee Benefits segment based on favorable claims experience, was 10.9% for 2005 compared to 2004, and 3.6% for 2004 compared to 2003. ERRs were $20.2 million, $11.7 million and $18.6 million for 2005, 2004 and 2003, respectively. ERRs can vary greatly from quarter to quarter depending on the underlying experience of these contracts. See “Business Segments.”
For most of 2004, our premium growth for the Employee Benefits segment was lower than our targeted range primarily due to lower employment growth and wage growth (factors on which our premiums are based), commensurate with overall economic conditions at the time, and correspondingly slower sales growth. Late in 2004, we saw improvements in employment growth and wage growth. In addition, in the second quarter of 2004, we began actions to reinvigorate sales, including rate adjustments for selected segments and industries and realignment of our compensation plan for field representatives. These actions led to increased sales in the second half of 2004 compared to the first half of 2004.
Net investment income increased 4.5% to $465.2 million for 2005 compared to 2004, and increased 2.3% to $445.3 million for 2004 compared to 2003. Net investment income is primarily affected by changes in levels of invested assets and interest rates. Average invested assets increased 7.0% for 2005 compared to 2004, and 9.5% for 2004 compared to 2003. The portfolio yield
for fixed maturity securities decreased to 5.61% at the end of 2005, from 5.81% at the end of 2004 and 5.94% at the end of 2003. Similarly, the portfolio yield for commercial mortgage loans decreased to 6.46% at the end of 2005, from 6.71% at the end of 2004 and 7.28% at the end of 2003.
Commercial mortgage loan prepayment fees were $13.4 million, $14.9 million and $17.0 million for 2005, 2004 and 2003, respectively. The level of commercial mortgage loan prepayment fees will vary depending primarily on the overall interest rate environment. If interest rates rise, we could see a decrease in prepayment fees. Over 70% of our commercial mortgage loan portfolio has a provision that requires the borrower to pay a prepayment fee that assures that the Company’s expected cash flow from commercial mortgage loan investments will be protected in the event of prepayment. Since 2001, all new commercial mortgage loans originated by the Company contain this prepayment provision. The remainder of our commercial mortgage loans contains fixed prepayment fees that mitigate prepayments, but may not fully protect the Company’s expected cash flow in the event of prepayment.
Net capital gains and losses occur as a result of sale or impairment of the Company’s invested assets, neither of which is likely to occur in regular patterns. While the timing of an impairment is not controllable, management does have discretion over the timing of sales of invested assets. Net capital gains and losses are reported in “Other.” Net capital gains were $2.2 million, $11.5 million and $9.3 million for 2005, 2004 and 2003, respectively.
Three primary factors drive benefits to policyholders: premium growth (reserves are established in part based on premium levels), claims experience, and the assumptions used to establish related reserves. The predominant factors affecting claims experience are incidence (number of claims) and duration (length of time a disability claim is paid). The assumptions used to establish the related reserves reflect incidence and duration, as well as new investment interest rates and overall portfolio yield, both of which affect the discount rate used to establish reserves. See “Critical Accounting Policies and Estimates-Reserves.”
The 7.9% increase in benefits to policyholders for 2005 compared to 2004 resulted primarily from business growth, as evidenced by premium growth, which was partially offset by comparatively favorable claims experience in our Employee Benefits and Individual Insurance segments. We continued to experience favorable and sustained claims recovery patterns for Employee Benefits group long term disability insurance and, as a result of our on-going assessment of those recovery patterns, we released reserves, which decreased benefits to policyholders, totaling $9 million and $12 million for 2005 and 2004, respectively. We do not anticipate similar reserve releases for 2006. In addition, benefits to policyholders for 2004 included a $9.0 million premium deficiency reserve established during the first quarter of 2004 as a result of a pricing miscalculation on long term disability contracts with one large Employee Benefits customer. There was no similar reserve established for 2005 or 2003. See “Business Segments.”
Benefits to policyholders, including interest credited, decreased 0.4% to $1,367.7 million for 2004 compared to 2003. The decrease was primarily due to favorable claims experience in the Employee Benefits segment during 2004. Claims experience can fluctuate widely from quarter to quarter. For an additional discussion of factors affecting benefits to policyholders, see “Business Segments.”
Operating expenses increased 14.1% to $340.6 million for 2005 compared to 2004, and 8.4% to $298.5 million for 2004 compared to 2003. The majority of the increases for the comparative periods occurred in our Employee Benefits segment. The increases for that segment resulted from a combination of factors:
In an effort to leverage technology in our expense structure and support our continued focus on customer service and product delivery platforms, we have increased our technology related spending by approximately $9 million in 2005 compared to 2004, and approximately $4 million in 2004 compared to 2003. In 2006, we expect operating expenses, when measured as a percentage of premiums, will continue at these levels in the Employee Benefits segment. See “Business Segments.”
million for 2005 compared to 2004, and 24.5% to $242.0 million for 2004 compared to 2003. The increases resulted from a combination of increased premium growth and comparatively favorable claims experience for 2005 compared to 2004, and comparatively favorable claims experience for 2004 compared to 2003.
Premiums in our Employee Benefits segment, excluding ERRs (which are refunds to certain group contract holders based on favorable claims experience), increased 10.1% to $1,727.2 million for 2005 compared to 2004, and 3.2% to $1,568.2 million for 2004 compared to 2003. ERRs can vary greatly from quarter to quarter depending on the underlying experience of these contracts.
The three primary factors that affected premium growth for the Employee Benefits segment were as follows:
Organic Growth. Organic growth includes wage rate growth and employment growth. Wage rate growth increased 3.1% for 2005 compared to 2004, while employment growth for 2005 remained stable compared to 2004. In 2004, both wage rate growth and employment growth were low, commensurate with economic conditions at that time.
Sales. Sales, reported as annualized new premiums, were $324.9 million for 2005, which was nearly equal to the record sales of $330.3 million for 2004. In the second quarter of 2004, we began actions to reinvigorate sales, including rate adjustments for selected segments and industries and realignment of our compensation plan for field representatives. These actions led to increased sales in the second half of 2004 compared to the first half of 2004 and 2003.
Benefits to policyholders increased 7.4% for 2005 compared to 2004, and decreased 1.2% for 2004 compared to 2003. Beyond premium growth of 10.1% for 2005 compared to 2004, and 3.2% for 2004 compared to 2003, the most significant drivers of benefits to policyholders are claims experience and the assumptions used to establish related reserves. For 2005 and 2004, we have had comparatively favorable claims experience. Claims experience can fluctuate widely from quarter to quarter.
The establishment of reserves includes discounting expected future benefits to their present value. The discount rate used, which is determined quarterly, is based on our average new money investment rate for a quarter less a margin to allow for reinvestment and credit risk. During 2005, we reduced our discount rate from 5.00% to 4.75%. Given that we discount new reserves established in each quarter using our average new money investment rate less a margin, changes in our average new money investment rate may result in a change in the discount rate used to establish new reserves, and therefore may increase or decrease the expense of benefits to policyholders. Based on our current size, a 25 basis point decrease in the discount rate would result in a quarterly increase of approximately $2 million in the expense of benefits to policyholders, and a corresponding decrease to pre-tax earnings, until recovery can be realized through related adjustments to premium rates (generally group long term disability policies offer rate guarantees for periods from one to three years).
Should reinvestment rates ultimately prove to be lower than provided for in the margin between the new money investment rate and the reserve discount rate, we could be required to increase reserves, which could cause the expense of benefits to policyholders to increase. The duration of our invested assets generally is well matched to the duration of our liabilities in total. Our investments are generally not callable or have prepayment penalties. Based on these factors, we believe the current margin of 40 basis points in our overall block of business between invested asset yield and weighted average reserve discount rate is adequate to cover potential reinvestment risk. See “Liquidity and Capital Resources.”
Income before income taxes for the Individual Insurance segment was $38.5 million, $34.0 million and $37.4 million for 2005, 2004 and 2003, respectively.
Following are key indicators that management uses to manage and assess the performance of the Individual Insurance segment at or for the years ended December 31:
Also, premium growth for this segment can fluctuate from year to year due in part to experience rated reinsurance agreements on some disability policies. Under these agreements, reinsurance receivables increased premiums by $5.2 million, $4.9 million and $8.9 million for 2005, 2004 and 2003, respectively, reflecting comparatively more favorable claims experience for the reinsured business in 2005.
Sales of individual disability products increased 13.8% to $21.5 million for 2005 compared to 2004, and 18.1% to $18.9 million for 2004 compared to 2003. Increased sales, and ultimately premiums, resulted from additional penetration of existing distribution channels in recent years and the continuation of a national marketing agreement with Minnesota Life Insurance Company (“Minnesota Life”) for individual disability products.
Standard Insurance Company (“Standard”) has developed a registered group annuity contract to expand its market to 403(b) plans, 457 tax-exempt plans and nonqualified deferred compensation plans of private employers. StanCorp Equities, Inc. is the principal underwriter and distributor of registered contracts for Standard.
Premiums for the Retirement Plans segment are generated from life contingent annuities sold, which can vary significantly from year to year. Premiums for our Retirement Plans segment decreased to $1.3 million for 2005, compared to $2.6 million for 2004 and $3.0 million for 2003.
Interest credited as a percentage of net investment income was 55.0%, 55.5% and 60.6%, for 2005, 2004 and 2003, respectively. The decreases correlated with the decreases in
interest rates on invested assets since 2003 as the investment margin becomes more significant relative to the total return on invested assets.
Prior to 2006, Other included financial service businesses that are generally non-insurance related. These included StanCorp Mortgage Investors, LLC (“StanCorp Mortgage Investors”), our commercial mortgage lending business, and StanCorp Investment Advisers, Inc., our registered investment adviser. This category also included net capital gains and losses on investments, return on capital not allocated to the product segments, holding company expenses, interest on senior notes and adjustments made in consolidation.
It is management’s objective generally to align the cash flow characteristics of assets and liabilities to ensure that the Company’s financial obligations can be met under a wide variety of economic conditions. From time to time, management may choose to liquidate certain investments and reinvest in alternate investments to better match the cash flow characteristics of assets to liabilities. See “-Investing Cash Flows.”
The Company manages interest rate risk, in part, through asset/liability duration analyses. As part of this strategy, detailed actuarial models of the cash flows associated with each type of insurance liability and the financial assets related to the liability are generated under various interest rate scenarios. Both interest rate risk and investment strategies are examined. The actuarial models include those used to support the statutory Statement of Actuarial Opinion required annually by insurance regulators. According to presently accepted actuarial standards of practice, statutory reserves of Standard and related items at December 31, 2005, made adequate provision for the anticipated cash flows required to meet contractual obligations and related expenses, in light of the assets held.
Generally, duration is a measure of the price sensitivity of assets or liabilities to changes in interest rates. For example, duration of 5 indicates that a 1% change in interest rates would result in a change of approximately 5% in the economic value of the asset or liability. The duration of our invested assets was generally well matched to the duration of our liabilities in total, approximating 4.8 and 6.2, respectively, at December 31, 2005. As a percentage of our fixed maturity investments, callable bonds were 2% at December 31, 2005. Over 70% of our commercial mortgage loan portfolio has a provision that requires the borrower to pay a prepayment fee that assures that the Company’s expected cash flow from commercial mortgage loan investments will be protected in the event of prepayment. Since 2001, all new commercial mortgage loans originated by the Company contain this prepayment provision. The remainder of our commercial mortgage loans contains fixed prepayment fees that mitigate prepayments, but may not fully protect the Company’s expected cash flow in the event of prepayment.
The Company launched an equity-indexed annuity product in January 2006 and plans to use over the counter call-spread options to hedge the index performance of the policies.
Net cash used in investing activities was $664.9 million, $594.7 million and $743.6 million for 2005, 2004 and 2003, respectively. Our target investment portfolio allocation is approximately 60% fixed maturity securities and 40% commercial mortgage loans. At December 31, 2005, our portfolio consisted of 58% fixed maturity securities and 41% commercial mortgage loans, with the remainder in real estate. We anticipate that commercial mortgage loans will continue to represent approximately 40% of our investment portfolio in the future.
Net cash used in investing activities for 2003 included investments in fixed maturity securities related to proceeds from the TIAA business and approximately $200 million in proceeds received from the issuance of long-term debt (see “-Financing Cash Flows”).
At December 31, 2005, our fixed maturity securities portfolio had gross unrealized capital gains of $135.0 million and gross unrealized capital losses of $40.0 million. Unrealized gains and losses primarily result from holding fixed maturity securities with interest rates higher or lower, respectively, than those currently available at the reporting date.
At December 31, 2005, commercial mortgage loans in our investment portfolio totaled $3.24 billion. We currently have a portfolio of over 3,900 commercial mortgage loans. The average loan to value ratio in the overall portfolio was 61% at December 31, 2005, and the average loan size was approximately $0.8 million. The Company receives personal recourse on most of our loans.
At December 31, 2005, there was one loan in our portfolio totaling $0.3 million that was more than sixty days delinquent and in the process of foreclosure. We had a net balance of restructured loans of $10.1 million at December 31, 2005, and a commercial mortgage loan loss reserve of $2.5 million. The delinquency rate and loss performance of our commercial mortgage loan portfolio have generally been better than industry averages as reported by the American Council of Life Insurers. The performance of our commercial mortgage loan portfolio may fluctuate in the future. Should the delinquency rate or loss performance of our commercial mortgage loan portfolio increase, the increase could have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
At December 31, 2005, our commercial mortgage loan portfolio was diversified regionally as follows:
In the normal course of business, we commit to fund commercial mortgage loans generally up to 90 days in advance. At December 31, 2005, the Company had outstanding commitments to fund commercial mortgage loans totaling $118.6 million with fixed interest rates ranging from 5.50% to 6.50%. These commitments generally have fixed expiration dates. A small percentage of commitments expire due to the borrower’s failure to deliver the requirements of the commitment by the expiration date. In these cases, we will retain the commitment fee and good faith deposit. Alternatively, if we terminate a commitment due to the disapproval of a commitment requirement, the commitment fee and deposit will be refunded to the borrower, less an administrative fee.
line of credit, borrowings and repayments on long-term debt, repurchase of common stock, and dividends paid on common stock. Net cash provided by financing activities was $265.7 million, $200.7 million and $233.9 million for 2005, 2004 and 2003, respectively. The increase for 2005 primarily resulted from a third party interest in a limited liability company created for the purpose of holding commercial mortgage loans originated by StanCorp Mortgage Investors. The minority third party investment totaled $143.2 million for 2005. The increase in policyholder fund deposits net of withdrawals for 2004 compared to 2003, primarily reflected higher individual annuity sales in the Individual Insurance segment, and higher deposits into the Retirement Plans segment general account assets, both of which reflected related distribution system penetration and growth.
We currently have two unsecured lines of credit for $75 million each, with credit availability totaling $150 million, with expiration dates in June 2006. Under the credit agreements, we are subject to customary covenants that take into consideration the impact of material transactions, changes to the business, compliance with legal requirements and financial performance. The financial covenants include limitations on the following: indebtedness, financial liquidity and risk-based capital. We are not required to maintain compensating balances, but pay commitment fees. Interest charged for use of the facilities is based on the federal funds rate, the bank’s prime rate or the London Interbank Offered Rate at the time of borrowing plus an incremental basis point charge that varies by agreement, type of borrowing and the amount outstanding on the lines. At December 31, 2005, we were in compliance with all covenants under the credit agreements and had no outstanding balance on the lines of credit. We currently have no commitments for standby letters of credit, standby repurchase obligations or other related commercial commitments under the credit agreements.
StanCorp filed a $1.0 billion shelf registration statement with the Securities and Exchange Commission (“SEC”), which became effective on July 23, 2002 and expires on December 1, 2008, registering common stock, preferred stock, debt securities and warrants. On September 25, 2002, we completed an initial public debt offering of $250 million of 6.875%, 10 year senior notes, pursuant to the shelf registration statement. The principal amount of the senior notes is payable at maturity and interest is payable semi-annually in April and October.
In addition, we seek to maintain approximately 5% of consolidated equity excluding accumulated other comprehensive income, or approximately $70 million, as well as amounts sufficient to fund holding company operating expenses, interest on our debt and our annual dividend to shareholders, totaling approximately $60 million annually. Maintaining capital above targeted levels provides timing flexibility should we wish to access capital markets to finance growth or acquisitions.
In August 2003, Standard distributed to StanCorp an extraordinary distribution of $200 million from its paid-in capital and contributed surplus. Concurrently, Standard borrowed the same amount from StanCorp and issued a $200 million subordinated surplus note.
From time to time, the board of directors has authorized share repurchase programs. Share repurchases are to be effected in the open market or in negotiated transactions in compliance with the safe harbor provisions of Rule 10b-18 under regulations of the Securities Exchange Act of 1934 (the “Exchange Act”). Execution of the share repurchase program is based upon management’s assessment of market conditions for its common stock and other potential growth opportunities. On November 14, 2005, the board of directors authorized a new share repurchase program of up to 3.0 million shares of StanCorp common stock. The new share repurchase program will be affected in the open market or in negotiated transactions through December 31, 2007, and replaced the Company’s previous share repurchase program.
During 2005, we repurchased approximately 2.7 million shares of common stock at a total cost of $106.4 million for a volume weighted-average price of $39.90 per common share. At December 31, 2005, there were 2,968,000 shares remaining under the Company’s current share repurchase program. Also during 2005, the Company acquired 17,558 shares of common stock from an executive officer and from a director to cover tax liabilities resulting from the release of restricted shares at a total cost of $0.7 million for a volume weighted-average price of $42.44 per common share.
During 2004, the Company repurchased approximately 2.4 million shares of common stock at a total cost of $74.7 million for a volume weighted-average price of $31.69 per common share. Also during 2004, the Company acquired 53,498 shares of common stock from executive officers to cover tax liabilities resulting from the release of performance-based shares at a total cost of $1.8 million for a volume weighted-average price of $33.70 per common share.
Financial strength ratings, which rate claims paying ability, are an important factor in establishing the competitive position of insurance companies. Ratings are important in maintaining public confidence in our company and in our ability to market our products. Rating organizations continually review the financial performance and condition of insurance companies, including ours. In addition, debt ratings on our senior notes are tied to our financial strength ratings. A ratings downgrade could increase surrender levels for our annuity products, could adversely affect our ability to market our products, and also could increase costs of future debt issuances. Standard & Poor’s, Moody’s Investors Service, Inc., A.M. Best Company and Fitch, Inc. provide financial strength and credit ratings.
The Company’s financing obligations generally include debts, lease payment obligations and commitments to fund commercial mortgage loans. The remaining obligations reflect the long-term portion of other liabilities and the Company’s obligations under our insurance and annuity product contracts. The following table summarizes the Company’s contractual obligations as of December 31, 2005:
Other long-term liabilities reflected in the Company’s balance sheet at December 31, 2005, consisted of a $14.7 million tax reimbursement liability related to the block of life insurance business sold to Protective Life Insurance Company in 2001, $13.3 million in capital commitments related to our low income housing investments, $20.5 million in unfunded liabilities for non-qualified deferred compensation and supplemental retirement plans, an accrued liability of $11.1 million for postretirement benefits, and $0.8 million of accrued guarantee association payments.
Statutory accounting practices differ in some respects from GAAP. The principal statutory practices which differ from GAAP are: a) bonds and commercial mortgage loans are reported principally at amortized cost; b) asset valuation and IMR are provided as prescribed by the NAIC; c) certain assets designated as non-admitted, principally deferred tax assets, furniture, equipment, and unsecured receivables, are not recognized as assets, resulting in a charge to statutory surplus; d) annuity considerations with life contingencies, or purchase rate guarantees, are recognized as revenue when received; e) reserves for life and disability policies and contracts are reported net of ceded reinsurance and calculated based on statutory requirements, including required discount rates; f) commissions, including initial commissions and expense allowance paid for reinsurance assumed, and other policy acquisition expenses are expensed as incurred; g) initial commissions and expense allowance received for a block of reinsurance ceded net of taxes are
On December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued Financial Accounting Standard (“FAS”) No.123(R), Share Based Payment, which amends FAS No.123 and FAS No.95, Statement of Cash Flows, effective for fiscal years beginning after June 15, 2005. The FASB also issued FASB Staff Position (“FSP”) No. FAS 123(R)-1, Classification and Measurements of Freestanding Financial Instruments Originally Issued In Exchange for Employee Services under FASB Statement No. 123(R) on August 31, 2005, FSP No. FAS 123(R)-2, Practical Exception to the Application of Grant Date as Defined in FASB Statement No. 123(R) on October 18, 2005, and FSP No. FAS 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards on November 10, 2005, which are all effective upon the adoption of FAS No. 123(R) or the effective date of the FSP, whichever is later. The statement and related FSP’s require compensation costs related to share-based payment transactions be recognized in operating expense, including grants prior to 2003 when the Company began to expense option grants (the “modified prospective” method). The use of the modified prospective method will result in projected additional pre-tax expense of approximately $0.2 million in 2006. The Company adopted FAS No. 123(R) effective January 1, 2006.
Exchanges of Insurance Contracts, effective for internal replacements occurring in fiscal years beginning after December 15, 2006. The SOP defines an internal replacement as modifications in product benefits, features, rights or coverages that occur by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by election of a feature or coverage within an existing contract. Accounting treatment for such replacements depends on whether the replacement contract is considered substantially changed from the original. A substantial change requires treating the new contract as an extinguishment of the original, with all DAC, unearned revenue liabilities and deferred sales inducement assets from the replaced contract no longer deferred. The Company currently eliminates any unamortized DAC for all replaced business, and is evaluating the remaining potential financial statement effect of SOP 05-1, if any.
On November 3, 2005, the FASB issued FSP No. FAS 115-1 and 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which amends FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. The FSP, effective for reporting periods beginning after December 15, 2005, outlines a three-step model for identifying and accounting for investment impairments. (1) Determine whether an investment is impaired by comparing its cost at the individual security level to its fair market value. (2) Evaluate whether the impairment is other than temporary by applying existing guidance such as SEC Staff Accounting Bulletin Topic 5M, Other than Temporary Impairments of Certain Investments in Debt and Equity Securities. Then, (3) if the impairment is other than temporary, recognize an impairment loss equal to the difference between the investment’s cost and its fair value at the period end date. In periods after recognition of an impairment loss on a debt security, the security should be accounted for as if it had been purchased on the impairment measurement date with the discount or reduced premium, based on the new cost basis, amortized over the remaining life of the security. The FSP carries forward the disclosure requirements of the Emerging Issue Task Force (“EITF”) 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which have been included in the Notes to Consolidated Financial Statements since December 31, 2003, using the rules of the approved portions of the EITF 03-1 at that time. No additional financial statement impact is expected upon adoption of the FSP in 2006.
Reserves represent amounts set aside today to pay future benefits and claims. Developing the estimates for reserves (and therefore the resulting impact on earnings) requires varying degrees of subjectivity and judgment, depending upon the nature of the reserve. For most of our reserves, the calculation methodology is prescribed by various accounting and actuarial standards, although judgment is required in the determination of assumptions to use in the calculation. At December 31, 2005, these reserves represented approximately 87% of total reserves held. We also hold reserves that lack a prescribed methodology but instead are determined by a formula that we have developed based on our own experience. Because this type of reserve requires a higher level of subjective judgment, we closely monitor its adequacy. These reserves, which are primarily incurred but not reported reserves associated with our disability products represented approximately 12% of total reserves held at December 31, 2005. Finally, a small amount of reserves is held based entirely upon subjective judgment. These reserves are generally set up as a result of unique circumstances
that are not expected to continue far into the future and are released according to pre-established conditions and timelines. Currently, these reserves represent less than 1% of total reserves held.
Certain costs related to obtaining new business and acquiring business through reinsurance agreements have been deferred and will be amortized to accomplish matching against related future premiums or gross profits, as appropriate. We normally defer certain acquisition related commissions and incentive payments, certain costs of policy issuance and underwriting, and certain printing costs. Assumptions used in developing DAC and amortization amounts each period include the amount of business in force, expected future persistency, withdrawals, interest rates and profitability. These assumptions are modified to reflect actual experience when appropriate. The amortization of DAC is charged to current earnings to the extent it is determined that future premiums or gross profits are not adequate to cover the remaining amounts deferred. DAC totaled $165.8 million and $132.5 million at December 31, 2005 and 2004, respectively.
profits. VOBA totaled $79.5 million and $86.3 million at December 31, 2005 and 2004, respectively.
The provision for income taxes includes amounts currently payable and deferred amounts that result from temporary differences between financial reporting and tax bases of assets and liabilities as measured by current tax rates. Income taxes for 2004 were reduced approximately $7 million related to the favorable resolution of uncertainties related to the Internal Revenue Service examination of the Company’s tax years through 2001, and favorable outcomes on state tax return matters. At December 31, 2005, years open for audit by the Internal Revenue Service were 2002 through 2005.
Some of the statements contained in this Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, including those relating to our strategy and other statements that are predictive in nature, that depend on or refer to future events or conditions or that include words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates” and similar expressions, are forward-looking statements within the meaning of Section 21E of the Exchange Act, as amended. These statements are not historical facts but instead represent only management’s expectations, estimates and projections regarding future events. Similarly, these statements are not guarantees of future performance and involve uncertainties that are difficult to predict, which may include, but are not limited to, the factors discussed below. As a provider of financial products and services, our results of operations may vary significantly in response to economic trends, interest rate changes, investment performance and claims experience. Caution should be used when extrapolating historical results or conditions to future periods.
Our actual results and financial condition may differ, perhaps materially, from the anticipated results and financial condition in any such forward-looking statements and, given these uncertainties or circumstances, readers are cautioned not to place undue reliance on such statements. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
growth in assets under management including performance of equity investments in the separate account;
availability of capital required to support business growth and the effective utilization of excess capital;
experience in delinquency rates or loss experience in our commercial mortgage loan portfolio;
Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 2005, 2004 and 2003
We have audited the accompanying consolidated balance sheets of StanCorp Financial Group, Inc. and subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of income and comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of StanCorp Financial Group, Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.
We were incorporated under the laws of Oregon in 1998. We conduct business through our subsidiaries, Standard Insurance Company (“Standard”); The Standard Life Insurance Company of New York; StanCorp Mortgage Investors, LLC (“StanCorp Mortgage Investors”); StanCorp Investment Advisers, Inc. (“StanCorp Investment Advisers”); and StanCorp Equities, Inc. (“StanCorp Equities”). We are headquartered in Portland, Oregon.
Standard, our largest subsidiary, underwrites group and individual disability insurance and annuity products, group life, AD&D, and dental insurance and provides retirement plan products and services. Founded in 1906, Standard is domiciled in Oregon and licensed in 49 states, the District of Columbia, and the U.S. Territories of Guam and the Virgin Islands.
The Standard Life Insurance Company of New York was organized in 2000, and provides group long term and short term disability, life, AD&D, and dental insurance in New York.
StanCorp Mortgage Investors originates and services small fixed-rate commercial mortgage loans for the investment portfolios of our insurance subsidiaries. It also generates additional fee income from the origination and servicing of commercial mortgage loans sold to institutional investors.
For all investments, capital gains and losses are recognized using the specific identification method. Net investment income and capital gains and losses related to separate account assets and liabilities are included in the separate account assets and liabilities. For all investments, we record impairments when it is determined that the decline in fair value of an investment below its amortized cost basis is other than temporary. We reflect impairment charges in net capital gains or losses and permanently adjust the cost basis of the investment to reflect the impairment. In our quarterly impairment analysis, we evaluate whether a decline in value of fixed maturity securities is other than temporary. Factors considered in this analysis include the length of time and the extent to which the fair value has been below amortized cost, the financial condition and near-term prospects of the issuer, our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in market value, and the value of any security interest we may have collateralized in the investment. See “Note 5, Investment Securities.” For securities expected to be sold, an other than temporary impairment charge is recorded if we do not expect the realizable market value of a security to recover to amortized cost prior to the expected date of sale. Once an impairment charge has been recorded, we continue to review the other than temporarily impaired securities for further potential impairment on an on-going basis.
A permanent impairment is generally recognized on a security if its market value falls below 80% of its book value for six months or longer, or it is determined that the value
Real estate held for investment is stated at cost less accumulated depreciation. Depreciation generally is provided on the straight-line method, with property lives varying from 30 to 40 years. Accumulated depreciation for real estate totaled $31.9 million and $29.8 million at December 31, 2005 and 2004, respectively. Real estate acquired in satisfaction of debt is recorded at the lower of cost or fair value less estimated costs to sell and is depreciated consistently with real estate held for investment.
Cash equivalents include investments purchased with original maturities, at the time of acquisition, of three months or less.
Certain costs related to obtaining new business and acquiring business through reinsurance agreements have been deferred and will be amortized to accomplish matching against related future premiums or gross profits, as appropriate. We normally defer certain acquisition-related commissions and incentive payments, certain costs of policy issuance and underwriting, and certain printing costs. Assumptions used in developing DAC and amortization amounts each period include the amount of business in force, expected future persistency, withdrawals, interest rates and profitability. These assumptions are modified to reflect actual experience when appropriate. The amortization of DAC is charged to current earnings to the extent it is determined that future premiums or gross profits are not adequate to cover the remaining amounts deferred. DAC totaled $165.8 million and $132.5 million at December 31, 2005 and 2004, respectively.
VOBA primarily represents the discounted future profits of business assumed through reinsurance agreements. VOBA is amortized in proportion to future premiums or expected future profitability as appropriate. If actual premiums or future profitability is inconsistent with our assumptions, we could be required to make adjustments to VOBA and related amortization. For the VOBA associated with the Minnesota Life Insurance Company (“Minnesota Life”) block of business reinsured, the amortization period is up to 30 years. Accompanying the transaction was a national marketing agreement that provides access to Minnesota Life agents, some of whom now market Standard’s individual disability insurance products. The amortization period of the intangible asset for the marketing agreement with Minnesota Life is 23 years. The VOBA associated with the Teachers Insurance and Annuity Association of America (“TIAA”) is comprised of two parts with differing amortization methods. The amortization periods are up to 10 years for VOBA that is amortized in proportion to premiums and up to 20 years for VOBA that is amortized in proportion to expected gross profits.
The following table reconciles VOBA and intangible assets, including the intangible asset for the marketing agreement with Minnesota Life, for the years ended December 31:
Property and equipment are stated at cost less accumulated depreciation. The Company provides for depreciation of property and equipment using the half-year straight-line method over the estimated useful lives, which are generally 40 years for properties, and from three to ten years for equipment. Leasehold improvements are amortized over the estimated useful life of the asset, not to exceed the life of the lease. Depreciation expense for 2005, 2004 and 2003 was $12.7 million, $12.5 million and $12.1 million, respectively. The Company reviews property and equipment for impairment when circumstances or events indicate the carrying amount of the asset may not be recoverable and recognizes a charge to earnings if an asset is impaired.
Separate account assets and liabilities represent segregated funds held for the exclusive benefit of contract holders. The activities of the account primarily relate to contract holder-directed 401(k) contracts. Standard charges the separate account asset management and plan administration fees associated with the contracts. Separate account assets and liabilities are carried at fair value.
Benefits and expenses are matched with recognized premiums to result in recognition of profits over the life of the contracts. The match is accomplished by recording a provision for future policy benefits and unpaid claims and claim adjustment expenses. For most of our product lines, we establish and carry as a liability actuarially determined reserves that are calculated to meet our obligations for future
policy benefits and claims. These reserves do not represent an exact calculation of our future benefit liabilities, but are instead estimates based on assumptions and considerations concerning a number of factors, including:
Other comprehensive income includes changes in unrealized capital gains and losses on investment securities available-for-sale, net of the related tax effects, and the increase in the unfunded liability of the non-qualified supplemental retirement plan. The following table sets forth unrealized capital gains and losses, and adjustments for realized capital gains and losses for the years ended December 31:
The 2004 change in unrealized capital gains on securities available-for-sale, net of tax included $1.1 million for the increase in the unfunded liability of the non-qualified supplemental retirement plan. There was no material change in the unfunded liability for 2005.
The Company has in effect three stock-based employee compensation plans. See “Note 12, Stock-Based Compensation.” Effective January 1, 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, prospectively to all employee awards granted, modified or settled after January 1, 2003. Awards under the Company’s plans vest over periods ranging from one to four years. Therefore, the cost related to stock-based employee compensation included in the determination of
net income for 2005 and prior years is less than that which would have been recognized if the fair value based method had been applied to all awards since the first options were granted in 1999. The following table sets forth the effect on net income and earnings per share if the fair value based method had been applied to all outstanding and unvested awards for the years ended December 31:
of the modified prospective method will result in projected additional pre-tax expense of approximately $0.2 million in 2006. The Company adopted FAS No. 123(R) effective January 1, 2006.
On November 3, 2005, the FASB issued FSP No. FAS 115-1 and 124-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which amends FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. The FSP, effective for reporting periods beginning after December 15, 2005, outlines a three-step model for identifying and accounting for investment impairments. (1) Determine whether an investment is impaired by comparing its cost at the individual security level to its fair market value. (2) Evaluate whether the impairment is other than temporary by applying existing guidance such as SEC Staff Accounting Bulletin Topic 5M, Other than Temporary Impairments of Certain Investments in Debt and Equity Securities. Then, (3) if the impairment is other than temporary, recognize an impairment loss equal to the difference between the investment’s cost and its fair value at the period end date. In periods after recognition of an impairment loss on a debt security, the security should be accounted for as if it had been purchased on the impairment measurement date with the discount or reduced premium, based on the new cost basis, amortized over the remaining life of the security. The FSP carries forward the disclosure requirements of the Emerging Issue Task Force (“EITF”) 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which have been included in the Notes to
Basic net income per common share was calculated based on the weighted-average number of common shares outstanding. Net income per diluted common share reflects the potential effects of restricted stock grants and exercises of outstanding options. The weighted-average common share and share equivalents outstanding used to compute the dilutive effect of common stock options outstanding were computed using the treasury stock method. The computation of dilutive weighted-average earnings per share does not include options with an option exercise price greater than the average market price because they are antidilutive (i.e., would increase earnings per share). Net income per diluted common share was calculated as follows, for the years ended December 31:
money purchase pension, and profit sharing plan products and services to small and medium sized employers. In 2005, this segment began offering 403(b) and non-qualified deferred compensation products through an affiliated broker-dealer.
StanCorp Mortgage Investors serviced $3.10 billion and $2.95 billion in commercial mortgage loans for subsidiaries of StanCorp at December 31, 2005 and 2004, respectively. Commercial mortgage loans serviced for other institutional investors totaled $1.14 billion and $747.9 million at December 31, 2005 and 2004, respectively, and associated capitalized mortgage servicing rights totaled $3.3 million and $2.1 million at December 31, 2005 and 2004, respectively.
The fair values of investment securities were based on quoted market prices, where available, or on values obtained from independent pricing services. The fair values of commercial mortgage loans were estimated using option adjusted valuation discount rates. The carrying values of
policy loans approximate fair values. While potentially financial instruments, policy loans are an integral component of the insurance contract and have no maturity date.
The Company underwrites mortgage loans on commercial property and in addition to real estate collateral, requires either partial or full recourse on most loans. Although the Company underwrites commercial mortgage loans throughout the United States, commercial mortgage loans in California represent a concentration of credit risk. The following table sets forth the geographic concentration of commercial mortgage loans at December 31:
Historically, the delinquency rate of our California-based commercial mortgage loans has been substantially below the industry average and consistent with our experience in other states. However, if economic conditions in California decline, we could experience a higher delinquency rate on the portion of our commercial mortgage loan portfolio located in California, which could have a material adverse effect on
The liability for unpaid claims, claims adjustment expenses and other policyholder funds includes liabilities for insurance offered on products such as group long term and short term disability, individual disability, group dental, and group AD&D. The liability for unpaid claims and claim adjustment expenses is included in future policy benefits and claims in the consolidated balance sheets. The following table sets forth the change in the liabilities for unpaid claims and claim adjustment expenses for the years ended December 31:
Other policyholder funds at December 31, 2005, 2004 and 2003 included $1,142.6 million, $954.9 million and $818.1 million, respectively, of employer-sponsored defined contribution and benefit plans funds, and $986.7 million, $938.4 million and $776.5 million, respectively, of individual fixed-rate annuity funds.
The Company has two non-contributory defined benefit pension plans: the employee pension plan and the agent pension plan. The employee pension plan is for all eligible employees of StanCorp and its subsidiaries. The agent pension plan, which is frozen, is for former field employees and agents. Both plans are sponsored and administered by Standard. The defined benefit pension plans provide benefits based on years of service and final average pay.
Prepaid benefit costs of $26.5 million, $9.1 million and $15.1 million were recognized in the balance sheets at December 31, 2005, 2004 and 2003, respectively.
The long run rate of return for the employee pension plan portfolio is derived by calculating the average return for the portfolio monthly, from 1971 to the present, using the average mutual fund manager returns in each asset category, weighted by the target allocation to each category. Because the average equity market value returns over the last 30 years generally have been higher than the long run expected rate
of return, the historical average return used to determine the expected return on plan assets was reduced by 20%.
Amounts recognized in the balance sheets at December 31 consisted of accrued benefit cost of $11.0 million, $12.8 million and $11.8 million for 2005, 2004 and 2003, respectively.
The projected discounted cash flow obligation for the postretirement plan was $33.4 million and $47.9 million at December 31, 2005 and 2004, respectively.
Net periodic benefit cost and obligation assumptions used in the measurement of the postretirement benefit obligations were as follows for the years ended December 31:
performance stock options, restricted and foreign stock awards, and stock appreciation and cash bonus rights related
The weighted-average grant date fair value of option awards for 2005, 2004 and 2003 was $10.73, $9.98 and $9.14, respectively.
The grant date fair value of the performance shares granted was $33.76 and $32.69 per share for the shares granted in 2005 and 2004, respectively.
The Company’s Employee Share Purchase Plan allows eligible employees to purchase common stock at 85% of the lesser of the fair market value of the stock on either the commencement date of each six-month offering period or the end-of-the-period purchase date. Under the terms of the plan, each eligible employee may elect to have up to 10% of the employee’s gross total cash compensation for the period withheld to purchase common stock. No employee may purchase common stock having a fair market value in excess of $25,000 in any calendar year.
We manage risk through sound product design and underwriting, effective claims management, disciplined pricing, distribution expertise, broad diversification of risk by customer geography, industry, size and occupation,
In order to limit our losses from large exposures, we enter into reinsurance agreements with other insurance companies. During 2004, we reviewed our retention limits and, based on our current size and recent experience, increased our maximum retention limits for our group and individual disability and group life and AD&D contracts. Effective October 1, 2004, we increased our maximum retention limits per individual for group life and AD&D combined from $500,000 to $750,000. Our maximum retention for group disability insurance increased from $10,000 to $15,000 monthly benefit per individual. Our maximum retention increased generally from $3,500 to $5,000 monthly benefit per individual for individual disability policies with effective dates on or after October 1, 2004. On certain Minnesota Life business, we have a maximum retention of $6,000 monthly benefit per individual.
During 2002, Standard formed a strategic marketing alliance with Ameritas Life Insurance Corp. (“Ameritas”) that offers Standard’s policyholders new and more flexible dental coverage options and access to Ameritas’ nationwide preferred provider organization panel of dentists. As part of this alliance, Standard and Ameritas entered into a reinsurance agreement that provides for approximately 15% of the net dental premiums written by Standard and the risk associated with this premium, to be ceded to Ameritas.
force relative to the total group life and AD&D in force for all pool participants. The reinsurance pool does not exclude war or nuclear, biological and chemical acts of terrorism.
Recoveries recognized under reinsurance agreements were $52.8 million, $50.6 million and $50.3 million for 2005, 2004 and 2003, respectively. Amounts recoverable from reinsurers were $897.7 million and $887.9 million at December 31, 2005 and 2004, respectively. Of these amounts, $781.1 million and $778.5 million were from the reinsurance transaction with Protective Life Insurance Company (“Protective Life”) effective January 1, 2001. See “Note 14, Reinsurance of Blocks of Business.”
Effective October 1, 2000, Standard assumed through a reinsurance agreement, the individual disability insurance business of Minnesota Life. Standard paid a ceding commission of approximately $55 million and received
approximately $500 million in assets and corresponding statutory liabilities. If Standard were to become unable to meet its obligations, Minnesota Life would retain the reinsured liabilities. Therefore, in accordance with the agreement with Minnesota Life, Standard established a trust for the benefit of Minnesota Life with the market value of assets in the trust equal to Minnesota Life’s reinsurance receivable from Standard. The market value of assets required to be maintained in the trust is determined quarterly. The market value of assets required to be maintained in the trust at December 31, 2005, was $605.3 million. Accompanying the transaction was a national marketing agreement that provides access to Minnesota Life agents, some of whom now market Standard’s individual disability insurance products. We have signed an extension of the national marketing agreement through 2007.
Standard and The Standard Life Insurance Company of New York are subject to statutory restrictions that limit the maximum amount of dividends and distributions that they
could declare and pay to StanCorp without prior approval of the states in which the subsidiaries are domiciled. In August 2003, Standard made an extraordinary distribution of $200 million to StanCorp from Standard’s paid-in capital and contributed surplus. Concurrently, Standard borrowed the distributed amount from StanCorp and issued a $200 million subordinated surplus note.
On March 2, 2005, Standard made a distribution of $0.8 million to StanCorp to pay accrued interest due on the surplus note. On November 30, 2005, Standard made an extraordinary distribution of $150 million to StanCorp. The $150 million extraordinary distribution was applied to the $75 million outstanding balance on the surplus note and $3.6 million to accrued interest. The remaining $71.4 million was recorded as a dividend paid to StanCorp. During 2004, Standard distributed a total of approximately $140 million to StanCorp related to the surplus note.
State insurance departments require insurance enterprises to adhere to minimum Risk-Based Capital (“RBC”) requirements promulgated by the NAIC. At December 31, 2005 and 2004, the insurance subsidiaries’ capital levels were significantly in excess of that which would require corrective action by the insurance subsidiaries or regulatory agencies. The authorized control level RBC was $164.6 million and $153.6 million at December 31, 2005 and 2004, respectively. The current amount of distributions approved by the board of directors for 2006, based on excess capital at December 31, 2005, is $179 million. We anticipate seeking approval of a distribution from the Oregon Department of Consumer and Business Services-Insurance Division during 2006.
The Company leases certain buildings and equipment under non-cancelable operating leases that expire in various years through 2013, with renewal options for periods ranging from one to nine years. Future minimum payments under the leases are 2006, $11.9 million; 2007, $9.9 million; 2008, $8.8 million; 2009, $7.5 million and thereafter, $2.8 million. Total rent expense was $12.5 million, $14.1 million and $12.2 million for the years ended December 31, 2005, 2004 and 2003, respectively.
In the normal course of business, the Company commits to fund commercial mortgage loans generally up to 90 days in advance. At December 31, 2005, the Company had outstanding commitments to fund commercial mortgage loans totaling $118.6 million, with fixed interest rates ranging from 5.50% to 6.50%. These commitments generally have fixed expiration dates. A small percentage of commitments expire due to the borrower’s failure to deliver the requirements of the commitment by the expiration date. In these cases, the Company will retain the commitment fee and good faith deposit. Alternatively, if we terminate a commitment due to our disapproval, the commitment fee and deposit will be refunded to the borrower, less an administrative fee.
future policy benefits and claims. These estimates do not represent an exact calculation of our future benefit liabilities, but are instead based on assumptions, which involve a number of factors, including mortality, morbidity, recovery, the consumer price index, reinsurance arrangements and other sources of income for people on claim. Assumptions may vary by age and gender and, for individual policies, occupation class of the claimant; time elapsed since disablement; and contract provisions and limitations. Certain of these factors could be materially affected by changes in social perceptions about work ethics, emerging medical perceptions and legal interpretations regarding physiological or psychological causes of disability, emerging or changing health issues and changes in industry regulation. Changes in one or more of these factors or if actual claims experience is materially inconsistent with our assumptions, could cause actual results to be materially different from the information presented in the table. Not included in the table is approximately $837.4 million in other reserve liabilities where the amount and timing of related payouts cannot be reasonably determined.
negotiated transactions through December 31, 2007, and replaced the Company’s previous share repurchase program.