UNUM owns home office property consisting of five office buildings and four service buildings located throughout the Portland, Maine, area. UNUM also owns an office building in the United Kingdom, which is the home office of UNUM Limited. The home office of the Colonial Companies is located in Columbia, South Carolina, and is also owned by UNUM. In addition, UNUM leases, on periods principally from three to six years, office and warehouse space for use by its home office, affiliates, and sales forces.
This management's discussion and analysis reviews the consolidated financial condition of UNUM at December 31, 1995, the consolidated results of operations for the past three years and, where appropriate, factors that may affect future financial performance are identified and discussed. Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the Consolidated Financial Statements, Notes to Consolidated Financial Statements and Selected Consolidated Financial Data.
To more clearly reflect UNUM's management of its businesses and to more appropriately group its product portfolios, UNUM began reporting its operations, effective January 1, 1995, principally in four business segments. The following chart provides a summary of the changes in reporting segments.
During second quarter 1995, UNUM sold virtually all of the common stock portfolio of its United States subsidiaries, primarily due to consideration of statutory capital requirements associated with investment in common stocks and to increase future investment income. The sale of the common stock portfolio contributed to significantly higher realized investment gains than in 1994. UNUM reinvested the proceeds from the sale of the common stock portfolio primarily in investment grade fixed income assets, which has decreased the required amount of statutory capital for regulatory purposes and increased investment income. Dependent on capital considerations and market conditions, UNUM may invest in equity securities in the future.
Reserves for certain disability products are discounted using an interest rate which is a composite yield of assets matched with each product. As a result of the sale of the common stock portfolio, which had partially supported these disability reserves, and the subsequent reinvestment of the proceeds primarily in investment grade fixed income assets at yields below the average portfolio yield, certain reserve discount rates were lowered during second quarter 1995. The effect of lowering these discount rates was an increase to the reserve liabilities and benefits to policyholders reported in the Disability Insurance segment of $128.6 million and a decrease in net income of $83.6 million, or $1.15 per share, for the year ended December 31, 1995. The discount rate used to determine the group LTD reserves was reduced to 8.00% at June 30, 1995, as compared with 9.18% at December 31, 1994. At December 31, 1995, the group LTD discount rate was 7.94%. Management expects the reserve discount rate for certain disability products will further decline, since current cash flows are invested in high quality assets at current yields, which are below the composite yield of the existing assets purchased in prior years. UNUM periodically adjusts prices on both existing and new business in an effort to mitigate the impact of the current interest rate environment.
On February 7, 1996, UNUM announced plans to merge its Commercial Life Insurance Company affiliate into UNUM America to accelerate growth of its special risk business, increase its commitment to the association group business and to improve operating and capital efficiencies. The merger will be effective December 31, 1996, subject to regulatory approvals. During 1996, UNUM expects to incur costs of approximately $7 million related to the merger and anticipates annual savings of a similar amount following the merger due to reductions in operating costs.
Effective January 1, 1995, UNUM adopted FAS No. 114, "Accounting by Creditors for Impairment of a Loan," and FAS No. 118, "Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures," which defined the principles to measure and record a loan when it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. The adoption of FAS 114 and FAS 118 did not have a material effect on UNUM's results of operations or financial position.
Effective January 1, 1994, UNUM adopted FAS No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which specified the accounting and reporting for certain investments in equity securities and for all investments in debt securities. Upon the adoption of FAS 115, UNUM increased unrealized gains on available for sale securities included in stockholders' equity on January 1, 1994, by $41.8 million (net of deferred taxes of $22.5 million) to reflect the unrealized holding gains on fixed maturities classified as available for sale that were previously carried at amortized cost. In accordance with FAS 115, prior year consolidated financial statements have not been restated to reflect the change in accounting principle. The adoption of FAS 115 did not affect 1994 net income.
Effective January 1, 1993, UNUM adopted FAS 106, which changed the method for recognition of the cost of postretirement benefits other than pensions from a cash basis to an accrual basis over the years in which employees render the related services. UNUM elected to recognize the FAS 106 liability at January 1, 1993, of $48.8 million as a cumulative effect of an accounting change, which decreased net income by $32.1 million, or $0.40 per share, in 1993.
Effective tax rates, which reflect income tax expense as a percentage of pretax income, were 26.4%, 22.1% and 32.2% for 1995, 1994 and 1993, respectively. The increase in the effective tax rate for 1995 was primarily due to increased pretax earnings, as compared with 1994. Reported income tax expense was below the federal statutory tax rate of 35% for 1995, 1994 and 1993, primarily due to tax savings from investments in tax-exempt securities. Management anticipates the effective tax rate for 1996 will be higher than 1995, primarily related to reduced levels of tax-exempt income. Although investments in tax-exempt securities result in increased consolidated net income, these investments reduce UNUM's business segments' income before income taxes.
On August 10, 1993, legislation was enacted to increase the federal corporate income tax rate of 34% to 35%, retroactive to January 1, 1993. The change in tax rates resulted in a $7.8 million, or $0.10 per share, charge related to the adjustment of deferred tax liabilities. Excluding the adjustment to deferred income tax expense of $7.8 million for the enacted tax rate change, the 1993 effective tax rate would have been 30.5%.
The Disability Insurance segment includes disability products offered through: UNUM America, First UNUM Life Insurance Company ("First UNUM") and Commercial Life Insurance Company ("Commercial Life") in North America; UNUM Limited in the United Kingdom; and UNUM Japan Accident Insurance Company Limited in Japan. The products included in this segment are group LTD, individual disability, group short term disability ("group STD"), association group disability, disability reinsurance and long term care insurance.
The Disability Insurance segment reported slightly decreased income before income taxes in 1995, as compared with 1994, when the following items, as described below, are excluded: the increased realized investment gains resulting primarily from the sale of the common stock portfolio, the increased reserves resulting from the lowering of certain disability product reserve discount rates, the increased group LTD reserves for IBNR claims, and the increased reserves for unpaid claims related to the association group disability business, all of which took place in 1995; and the individual disability reserve strengthening and the related restructuring charge, recorded in 1994. This decrease was primarily attributable to a higher benefit ratio at UNUM Limited and in group LTD, and the inclusion of the results of UNUM
Japan's operations in the Disability Insurance segment effective January 1, 1995. Partially offsetting these decreases were increased investment income, a lower benefit ratio in the individual disability business, and continued expense management.
During 1995, UNUM sold virtually all of the common stock portfolio of its United States subsidiaries, primarily due to consideration of statutory capital requirements associated with investment in common stocks and to increase future investment income. The sale of the common stock portfolio contributed to significantly higher realized investment gains in 1995 for the Disability Insurance segment. UNUM reinvested the proceeds from the sale of the common stock portfolio primarily in investment grade fixed income assets, which has decreased the required amount of statutory capital for regulatory purposes and increased investment income. Dependent on capital considerations and market conditions, UNUM may invest in equity securities in the future.
Increased investment income in the Disability Insurance segment for 1995 was primarily a result of the reinvestment of the proceeds from the sale of the common stock portfolio into investment grade fixed income assets. This increase in investment income was partially offset by the effects of lower discount rates for certain disability products. Management expects the reserve discount rate for certain disability products will further decline, since current cash flows are invested in high quality assets at current yields, which are below the composite yield of the existing assets purchased in prior years. UNUM periodically adjusts prices on both existing and new business in an effort to mitigate the impact of the current interest rate environment.
During the fourth quarter of 1995, UNUM increased reserves for unpaid claims related to the association group disability business by $15.0 million, which decreased net income by $9.8 million, or $0.14 per share, for the year ended December 31, 1995. These increased reserves reflect management's expectations of slower than expected claim recoveries. In 1995, the association group line of business has been negatively affected by unfavorable claims experience, which management has attributed to certain geographical and occupational segments, particularly dentists and physicians. Management is taking pricing actions and strengthening underwriting standards to address this claims experience.
Throughout 1994, UNUM's individual disability business experienced a higher incidence of new claims and a disproportionate number of large claims, which management attributed to certain geographic and occupational segments of the business, particularly physicians. During the third quarter of 1994, management concluded that the deterioration of claims experience was not a temporary fluctuation in certain segments of the business, but was indicative of expected claim trends for the future. As a result, in third quarter 1994, UNUM increased reserves for existing claims by $83.3 million and strengthened reserves for estimated future losses by $109.1 million. These increased reserves reflected management's expectations of morbidity trends for the existing non-cancellable individual disability business. It is not possible to predict whether morbidity trends will be consistent with UNUM's assumptions; however, as of December 31, 1995, management believes that the strengthened reserve levels continue to be adequate.
Reserves for unpaid claims are estimates based on UNUM's historical experience and other actuarial assumptions that consider the effects of current developments, anticipated trends, risk management programs and renewal actions. Many factors affect actuarial calculations of claim reserves, including but not limited to interest rates and current and anticipated incidence rates, recovery rates, and economic and societal conditions. Reserve estimates and assumptions are periodically reviewed and updated with any resulting adjustments to reserves reflected in current operating results. Given the complexity of the reserving process, the ultimate liability may be more or less than such estimates indicate.
The ratio of operating expenses to premiums was 22.7%, 24.5% and 25.2% in 1995, 1994 and 1993, respectively. The decreases in 1995 and 1994 were primarily attributable to continued efforts to manage expenses and increased premium from 1995 claim block acquisitions, which do not have proportionally higher expenses. Deferrals of policy acquisition costs decreased in 1995 primarily due to lower levels of individual disability sales. The increase in deferred policy acquisition costs in 1994 was primarily attributable to deferrals of higher marketing costs associated with increased sales and renewal activity.
During 1995 and 1994, management implemented and strengthened various risk management programs to address the unfavorable claims experience in group LTD. In addition to the selected price increases on new and inforce business, more stringent underwriting practices, and the reduction of benefit options for certain segments of the business, management established special claims units for both its group LTD and individual disability businesses to address specific aspects of disability claims, including complex and fraudulent claims. Additionally, management implemented new group LTD contract provisions that provide risk management features and claimant rehabilitation incentives. Management continually reviews the benefits management process to identify and strengthen risk management policies and procedures.
During 1995, group LTD's benefit ratio increased slightly after excluding the effects of lowering the group LTD discount rate as a result of the sale of the common stock portfolio in the second quarter of 1995 and of increasing the group LTD reserves for IBNR claims. This increase was primarily attributable to increased claims severity. However, the effect of the increase in claims severity was partially offset by continued improvements in claim incidence rates and claim recoveries, which management attributes to risk management programs.
Management continues to address the unfavorable claim trends in group LTD by periodically adjusting prices on selected new and inforce business, implementing more stringent underwriting guidelines and strengthening risk management programs. Management believes these actions have strengthened UNUM's ability to deal with these claim trends and the current interest rate environment. The level of earnings of the group LTD product will be a function of various factors, including but not limited to, the effectiveness of these continuing actions over time.
claims, implemented more stringent underwriting standards and strengthened risk management programs. The level of earnings for UNUM Limited will be a function of various factors, including but not limited to, the effectiveness of these actions over time. Due to the relative size of the U.K. block of business, UNUM Limited's operating results can exhibit claims variability.
The individual disability business experienced a lower benefit ratio in 1995, as compared with 1994, after excluding the effects of increased reserves resulting from lowering the individual disability reserve discount rate in second quarter 1995 and the reserve strengthening recorded in 1994. The lower benefit ratio was primarily due to lower new claims incidence rates for physicians in 1995; however, such claims incidence rates can exhibit variability. During 1995, lower expenses, partially offset by reduced deferrals of policy acquisition costs resulting from lower individual disability sales in 1995, also contributed to the improved results of the individual disability business.
Group STD's contribution to the Disability Insurance segment's income before income taxes increased significantly in 1995 and 1994. These increases were primarily attributable to group STD's strong premium growth and continued risk and expense management. The record sales reported in 1995 reflected management's continuing efforts to cross-sell the group STD products with the group LTD business.
- ------------ nm = not meaningful or in excess of 100%
The decrease in income before income taxes for 1995, as compared with 1994, was primarily attributable to increased claims in the group life and special risk accident insurance businesses, combined with reduced fee income from the reinsurance underwriting management operations. Partially offsetting these decreases were continued premium growth, increased realized investment gains from the sale of the common stock portfolio and favorable claims experience in certain reinsurance pools. Due to the nature of the risks underwritten and the relative size of the blocks of businesses, several of the Special Risk Insurance segment's products can exhibit claims variability.
Investment income increased during 1995, primarily because of increased cash flows and additional income realized from the reinvestment of the proceeds from the second quarter 1995 sale of Colonial's equity portfolio into investment grade fixed income assets. The sale of the equity portfolio also contributed to the higher level of realized investment gains during the year. Realized investment gains for 1993 include gains associated with Colonial's sales of higher yielding but callable investments to realign its investment portfolio with UNUM's investment philosophy.
Colonial's benefit ratio improved again in 1995 to 49.7%, as compared with 50.4% in 1994 and 51.4% in 1993. The lower benefit ratio was driven by continued favorable claims experience and improved incidence rates across most product lines. The expense ratio remained virtually unchanged for 1995 reflecting management's continued investment in the sales organization, offset by continued efforts to control expenditures and improved operating effectiveness. During 1994, the expense ratio increased because of higher than expected costs associated with sales organization realignment and litigation expenses, which were partially offset by continued expense control efforts.
As previously discussed in the Consolidated Overview, UNUM America entered into an agreement for the sale of its group TSA business to Lincoln Life, a part of Lincoln National Corporation, and to a new New York insurance subsidiary of Lincoln Life. The agreement also contemplates that First UNUM will enter into a similar agreement with Lincoln Life's New York insurance subsidiary. The group TSA business of UNUM America and First UNUM accounted for approximately $34 million of the Retirement Products segment's income before income taxes in 1995, 1994 and 1993.
During 1994, UNUM implemented an investment strategy to increase investments in tax-exempt securities. Although investments in tax-exempt securities resulted in increased consolidated net income, these investments reduced the Retirement Products segment's income before income taxes by $7.6 million and $6.7 million in 1995 and 1994, respectively. During 1995, primarily due to market conditions, UNUM ceased the purchase of tax-exempt securities and sold the majority of tax-exempt securities held by the TSA business.
Since 1993, UNUM has offered the holders of certain types of TSA contracts the opportunity to modify their contracts. The proposed contract amendments provide for UNUM to increase the minimum guaranteed credited interest rates in return for contractholders relinquishing the right to make lump-sum withdrawals without an associated fee. As expected, certain contract holders elected to withdraw their funds rather than convert to the modified contract provisions, which has affected the overall growth of invested assets under management.
decline. As a result, the TSA business experienced unusually favorable interest spread margins during those years. Management expects the lower interest spread margins in 1995 on TSAs to continue, which may reduce future earnings of the Retirement Products segment.
The reduced asset base under management for GICs, DAs and 401(k) plans has also resulted in lower revenues from investment income and reduced amounts of interest credited. Management expects continued decreases in the amounts of investment income and interest credited as the related GICs, DAs and 401(k) contracts mature or terminate. Management expects future earnings for these closed blocks of businesses to decline, reflecting their run-off nature.
UNUM's investment portfolio is concentrated in investment grade bonds. UNUM evaluates total expected return after consideration of all associated expenses and losses, within criteria established for each product line. Product line investment strategies are developed to complement business risks by meeting the liquidity and solvency requirements of each product. UNUM purchases assets with maturities, expected cash flows and prepayment conditions that are consistent with these strategies. The nature and quality of the types of investments comply with policies established by management, which are more stringent overall than the statutes and regulations imposed by the jurisdictions in which UNUM's insurance subsidiaries are licensed.
During the second quarter of 1995, UNUM sold virtually all of the common stock portfolio of its United States subsidiaries, primarily due to consideration of statutory capital requirements associated with investment in common stocks and to increase future investment income. UNUM has reinvested the proceeds from the sale of the common stock portfolio primarily in investment grade fixed income assets. Dependent on capital considerations and market conditions, UNUM may invest in equity securities in the future.
Effective January 1, 1994, UNUM adopted Financial Accounting Standard ("FAS") No. 115, "Accounting for Certain Investments in Debt and Equity Securities," which specified the accounting and reporting for certain investments in equity securities and for all investments in debt securities. UNUM adopted the provisions for FAS 115 for these investments held or acquired after January 1, 1994. Upon the adoption of FAS 115, UNUM increased unrealized gains on available for sale securities included in stockholders' equity on January 1, 1994, by $41.8 million (net of deferred taxes of $22.5 million) to reflect the unrealized holding gains on fixed maturities classified as available for sale which were previously carried at amortized cost. In addition, UNUM reclassified certain fixed maturities from held to maturity to available for sale on January 1, 1994, in connection with the adoption of FAS 115.
In November 1995, the FASB issued "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities," which provided a one-time opportunity to reassess the appropriateness of the classifications of securities described in FAS 115, and to reclassify fixed maturities from the held to maturity category without calling into question the intent to hold other debt securities to maturity in the future. On December 31, 1995, UNUM reassessed its fixed maturity portfolio and as allowed under the implementation guidance, reclassified fixed maturities with an amortized cost of $6,082.8 million and a related net unrealized gain of $393.0 million from the held to maturity category to available for sale. In connection with the reclassification of the held to maturity fixed maturities to available for sale, on December 31, 1995, UNUM adjusted its unpaid claims by $261.2 million to reflect the changes that would have been necessary if the unrealized gains and losses related to fixed maturities classified as available for sale had been realized.
At December 31, 1995, the fixed maturity portfolio included $139.4 million of below investment grade bonds (below "Baa") recorded at fair value, which represented 1.5% of the fixed maturity portfolio, and had an associated amortized cost of $133.8 million. At December 31, 1994, the carrying value of below investment grade bonds included in the fixed maturity portfolio was $193.8 million, which represented 2.5% of the fixed maturity portfolio, and had an associated market value of $193.4 million. Virtually all of the nonconvertible, below investment grade bonds were purchased at investment grade, but were subsequently downgraded. UNUM's investment policy is to invest primarily in fixed maturities of investment grade quality. Selected purchases of convertible subordinated debentures, which UNUM considered to be part of its investment strategy for equity securities, have contributed to the amount of below investment grade bonds. Fixed maturity ratings are obtained from external rating agencies, and if not externally rated, are rated by UNUM internally using similar methods. Management does not expect any risks or uncertainties associated with below investment grade bonds to have a significant affect on UNUM's consolidated financial position or results of operations. UNUM had no fixed maturities delinquent 60 days or more at December 31, 1995. The percentage of fixed maturities delinquent 60 days or more, compared to total fixed maturities, was 0.25% at December 31, 1994.
During 1995, UNUM sold fixed maturities of two issuers classified as held to maturity with an amortized cost of $4.0 million, and realized a net loss of $1.2 million on the sales. The bonds were sold due to significant deterioration of the issuers' creditworthiness, as evidenced by bankruptcy filings. During 1994, UNUM sold fixed maturities of five issuers classified as held to maturity with an amortized cost of $49.8 million due to evidence of significant deterioration of the issuers' creditworthiness. These sales resulted in a net realized loss of $3.0 million.
Effective January 1, 1995, UNUM adopted Financial Accounting Standard ("FAS") No. 114, "Accounting by Creditors for Impairment of a Loan," and FAS No. 118, "Accounting by Creditors for Impairment of a Loan -- Income Recognition and Disclosures," which defined the principles to measure and record a loan when it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. The adoption of FAS 114 and FAS 118 did not have a material affect on UNUM's results of operations or financial position.
Mortgage loans that were restructured prior to the adoption of FAS 114, are defined by UNUM as loans whose terms have been modified to interest rates less than market at the time of restructure and are currently expected to perform pursuant to such modified terms. UNUM modifies loans to protect its investment and only when it is anticipated that the borrower will be able to meet the modified terms. As of December 31, 1995, restructured mortgage loans totaled $59.9 million, as compared with $73.6 million at December 31, 1994. Interest lost on restructured loans was not material in 1995, 1994 or 1993.
At December 31, 1995, investment real estate amounted to $222.2 million compared with $190.8 million at December 31, 1994. UNUM purchases investment real estate in selected markets when certain investment criteria are met. Investment real estate is intended to be held long-term and is carried at cost less accumulated depreciation. Occasionally, investment real estate is reclassified and revalued as real estate held for sale when it no longer meets UNUM's investment criteria.
At December 31, 1995, real estate held for sale amounted to $35.5 million compared with $31.0 million at December 31, 1994. Real estate acquired through foreclosure is valued at fair value at the date of foreclosure. Real estate held for sale is included in other assets in the Consolidated Balance Sheets and is valued net of an allowance which reduces the carrying value to the lower of fair value less estimated costs to sell, or cost. Additions to the allowance for probable losses related to real estate held for sale resulted in realized investment losses of $6.3 million, $0.8 million and $18.8 million for the years ended December 31, 1995, 1994 and 1993, respectively. Additions to the allowance represent charges to net realized investment gains less recoveries.
UNUM's businesses produce positive cash flows, which are invested primarily in intermediate, fixed maturity investments intended to reflect the nature of anticipated cash obligations of insurance benefit payments and insurance contract maturities and to optimize investment returns at appropriate risk levels. Unexpected cash requirements and liquidity needs
In 1995, UNUM America's statutory net income increased to $226.4 million, as compared with $39.2 million in 1994, which was primarily due to significant improvements in the income of certain disability products, and significantly higher realized investment gains as a result of the sale of the common stock portfolio. As described in the Disability Insurance segment, in 1994 UNUM America strengthened reserves for existing claims related to the traditional non-cancellable individual disability products, which resulted in a statutory after-tax charge of $69.6 million in third quarter 1994. This charge combined with unfavorable claims experience in certain disability businesses contributed to the decline in UNUM America's statutory income in 1994.
As a result of the increase in UNUM America's statutory earnings in 1995, the amount available under current law for payment of dividends during 1996 to UNUM Corporation from all U.S. domiciled insurance subsidiaries without state insurance regulatory approval, increased to approximately $135 million, as compared with approximately $81 million for 1995. UNUM Corporation also has the ability to draw a dividend of approximately $19 million from its United Kingdom- based affiliate, UNUM Limited, subject to certain U.S. tax consequences.
Cash flow requirements are also supported by a committed revolving credit facility totaling $500 million, which expires October 1, 1999. UNUM Corporation's commercial paper program is supported by the revolving credit facility, and is available for general liquidity needs, capital expansion, acquisitions and stock repurchase. The committed revolving credit facility contains certain covenants which, among other provisions, require maintenance of certain levels of stockholders' equity and limits on level of debt.
In September 1993, UNUM filed an omnibus shelf registration statement with the Securities and Exchange Commission which became effective on October 8, 1993, relating to $450 million of securities (including debt securities, preferred stock, common stock and other securities). On October 8, 1993, UNUM filed a prospectus supplement to establish a $250 million medium-term note ("MTN") program under the shelf registration. On May 11, 1995, UNUM Corporation issued $172.5 million of 8.80% Monthly Income Debt Securities ("MIDS") (Junior Subordinated Deferrable Interest Debentures, Series A) under the shelf registration, which mature in 2025.
During 1995, 1994 and 1993, withdrawals of 401(k), GIC and DA contracts reported in the Retirement Products segment, including contract terminations, payments to participants and transfers to other carriers, were approximately $46 million, $130 million and $309 million, respectively. Withdrawals during 1995, 1994 and 1993, were at levels expected by management and reflect the run-off nature of these closed blocks of businesses. UNUM manages liquidity objectives by including certain conditions in pension contracts which prohibit or restrict availability of funds.
Standard & Poor's Corporation ("Standard & Poor's"), Moody's Investors Service ("Moody's") and A.M. Best Company ("A.M. Best") are among the third parties that provide UNUM independent assessments of its overall financial position. Ratings from these agencies for financial strength and claims paying ability are available for the individual United States domiciled insurance company subsidiaries rather than on a consolidated basis, since the financial information used to develop the ratings is based on statutory accounting practices in the United States. Debt ratings for UNUM Corporation are based on consolidated financial information under generally accepted accounting principles.
At March 8, 1996, the unsold portion of the shelf registration related to preferred stock carried a rating of "(P)"a1"" (Upper-Medium Quality) from Moody's Investors Service.
The Risk-Based Capital standards for life insurance companies, as prescribed by the National Association of Insurance Commissioners, are based on a formula that establishes capital requirements relating to existing asset default risk, insurance risk, interest rate (asset/liability mismatch) risk and business risk. A company's Total Adjusted Capital (statutory capital, surplus and Asset Valuation Reserve plus certain other adjustments) is compared to the Authorized Control Level ("ACL") of Risk-Based Capital produced by the formula. Subject to certain trend tests to determine the change in the ACL ratio from year to year, companies with Total Adjusted Capital above 200% of ACL are assumed to be adequately capitalized. Companies below 200% of ACL are identified as requiring various levels of regulatory action ranging from increased information requirements for companies between 150% and 200% of ACL, to mandatory control by the domiciliary insurance department for companies below 70% of ACL.
UNUM periodically uses common derivative financial instruments such as options, futures and forward exchange contracts to hedge certain risks associated with future investments and certain payments denominated in foreign currencies, primarily British pound sterling, Canadian dollar and Japanese yen. These derivative financial instruments are used to protect UNUM from the effect of market fluctuations in interest and exchange rates between the contract date and the
date on which the hedged transaction occurs. In using these instruments, UNUM is subject to the off-balance-sheet risk that the counterparties of the transactions will fail to completely perform as contracted. UNUM manages this risk by only entering into contracts with highly rated institutions and listed exchanges. UNUM does not intend to hold derivative financial instruments for the purpose of trading. At December 31, 1995 and 1994, UNUM had no open derivative financial instruments.
Changing interest rates, which are traditionally linked to changes in inflation, affect UNUM's level of discounted reserves. While rising interest rates are beneficial when investing current cash flows, they can also reduce the fair value of existing fixed rate long-term investments. In addition, lower interest rates can lead to early payoffs and refinancing of some of UNUM's fixed rate investments. Management generally invests in fixed rate instruments that are structured to limit the exposure to such reinvestment risk.
Certain 1994 and 1993 amounts have been reclassified in 1995 for comparative purposes.
- Fixed maturities available for sale (certain bonds and redeemable preferred stocks) -- at fair value.
- Fixed maturities held to maturity (certain bonds and redeemable preferred stocks) -- principally at amortized cost.
- Equity securities available for sale (common stocks and non-redeemable preferred stocks) -- at fair value.
- Other long-term investments -- at cost plus UNUM's equity in undistributed net earnings since acquisition.
Realized investment gains and losses, which are determined on the basis of specific identification and include adjustments for allowances for probable losses, are reported separately in the Consolidated Statements of Income.
If a decline in fair value of an invested asset is considered to be other than temporary, the investment is reduced to its net realizable value and the reduction is accounted for as a realized investment loss.
For retirement and universal life products, premium and other policy fee revenue consist of charges for the cost of insurance, policy administration and surrenders assessed during the period. Charges related to services to be performed in the future are deferred until earned. The amounts received in excess of premium and fees are recorded as deposits and included in other policyholder funds in the Consolidated Balance Sheets. Benefits and expenses include benefit claims in excess of related account balances, interest credited at various rates and amortization of deferred policy acquisition costs.
The costs of acquiring new business that vary with and that are related primarily to the production of new business have been deferred to the extent such costs are deemed recoverable from future profits. Such costs include commissions, certain costs of policy issue and underwriting, and certain variable field office expenses.
For individual disability, group disability, and group life and health business, the costs are amortized in proportion to expected future premiums. For universal life and certain retirement products, the costs are amortized in proportion to estimated gross profits from interest margins, mortality and other elements of performance under the contracts. Amortization is adjusted periodically to reflect differences between actual experience and original assumptions, with any resulting changes reflected in current operating results. The amounts deferred and amortized were as follows:
The interest rate used to discount the disability reserves is a composite of the yields on assets specifically matched with each block of business. Management expects the reserve discount rate for certain disability products will further decline, since current cash flows are invested in high quality assets at current yields, which are below the composite yield of the existing assets purchased in prior years. UNUM periodically adjusts prices on both existing and new business in an effort to mitigate the impact of the current interest rate environment.
The increase in incurrals related to prior years was $507.0 million, $436.0 million, and $238.0 million (net of reinsurance), for 1995, 1994 and 1993, respectively. These increases were primarily the result of interest accrued on reserves, changes in reserve estimates and assumptions of interest rates, morbidity, mortality and expense costs, and changes in foreign exchange rates, primarily related to the disability reserves of UNUM's United Kingdom-based affiliate, UNUM Limited. Due to the long-term claims payment pattern of some of UNUM's businesses, certain reserves, particularly disability, are discounted for interest. Changes in reserve estimates and assumptions were primarily a result of increased reserves from lower discount rates for certain disability products following the sale of the common stock portfolio in 1995, and adjustments to strengthen certain disability reserves in 1995 and 1994.
In connection with the transfer of all fixed maturities previously classified as held to maturity to available for sale, explained in Note 2, unpaid claims were adjusted by $261.2 million on December 31, 1995. Unpaid claims are adjusted to reflect changes that would have been necessary if the unrealized gains and losses related to fixed maturities classified as available for sale had been realized. Where applicable, UNUM has reflected those adjustments in the liability balances with corresponding credits or charges, net of related deferred taxes, reported as a component of unrealized gains on available for sale securities in stockholders' equity.
Effective January 1, 1993, UNUM adopted Financial Accounting Standard ("FAS") No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts," which eliminated the practice by insurance
During 1995, UNUM sold virtually all of the common stock portfolio of its United States subsidiaries. The sale of the common stock portfolio, which partially supported certain disability reserves, and the reinvestment of the proceeds primarily in investment grade fixed income assets at yields below the average portfolio yield, resulted in lower reserve discount rates for certain disability products reported in the Disability Insurance segment. This change in accounting estimate to lower certain discount rates resulted in an increase of $128.6 million to benefits to policyholders in the Consolidated Statement of Income, and a decrease to net income of $83.6 million, or $1.15 per share.
During 1995, UNUM increased reserves for unpaid claims related to the association group disability business by $15.0 million to reflect management's expectations of slower than expected claim recoveries. This change in accounting estimate, which was reflected in the Disability Insurance segment, decreased net income by $9.8 million, or $0.14 per share.
During 1994, UNUM increased reserves for existing claims by $83.3 million and strengthened reserves for estimated future losses by $109.1 million. These increased reserves reflected management's expectations of morbidity trends for the non-cancellable individual disability business, as reported in the Disability Insurance Segment. This change in accounting estimate resulted in an increase to benefits to policyholders in the Consolidated Statement of Income of $192.4 million, and a decrease to net income of $125.1 million, or $1.69 per share.
Liabilities for restructuring activities are recorded when management, prior to the balance sheet date, commits to execute an exit plan that will result in the incurral of costs that have no future economic benefit, or approves a plan of termination and communicates sufficient detail of the plan to employees.
Certain assets of UNUM's defined benefit plans and tax sheltered annuity contracts are in separate accounts that are pooled investment funds of securities. Investment income and realized gains and losses on these accounts accrue directly to the contractholders. Assets, carried at market value, and liabilities of the separate accounts are shown separately in the Consolidated Balance Sheets. The assets of the separate accounts are legally segregated and are not subject to claims that arise out of any other business of UNUM.
The provision for income taxes includes amounts currently payable and deferred income taxes, which result from differences between financial reporting and tax bases of assets and liabilities, and are measured using enacted tax rates and laws. Deferred U.S. income taxes have not been provided on accumulated earnings of UNUM's foreign subsidiaries. These earnings could generate additional U.S. tax if remitted to UNUM Corporation.
The weighted average number of shares outstanding used to calculate earnings per share was approximately 72,677,000, 74,158,000 and 78,779,000 in 1995, 1994 and 1993, respectively. The assumed exercise of outstanding stock options does not result in a material dilution of earnings per share.
In March 1995, the Financial Accounting Standards Board ("FASB") issued Financial Accounting Standard ("FAS") No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of," which establishes accounting standards for the impairment of long-lived assets, certain identifiable intangibles, and goodwill related to those assets to be held and used and for long-lived assets and certain identifiable intangibles to be disposed of. UNUM will adopt FAS 121 effective January 1, 1996. The adoption of FAS 121 is not expected to have a material effect on UNUM's results of operations or financial position.
In October 1995, the FASB issued FAS No. 123, "Accounting for Stock-Based Compensation," which establishes financial accounting and reporting standards for stock-based employee compensation plans. FAS 123 defines a new method of accounting for employee stock compensation plans using a fair value based method, under which compensation cost is measured and recognized in results of operations. Alternatively, FAS 123 allows an entity to retain the accounting method for employee stock compensation plans defined under Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees." If an entity retains the accounting defined under APB 25, certain pro forma disclosures of net income and earnings per share must be made as if the fair value based method defined under FAS 123 had been applied. UNUM is required to adopt FAS 123 effective January 1, 1996. UNUM has determined that it will retain the accounting methodology prescribed in APB 25 and will disclose the pro forma effects of such stock-based compensation as required in 1996.
NOTE 2. INVESTMENTS Effective January 1, 1994, UNUM adopted FAS 115, "Accounting for Certain Investments in Debt and Equity Securities," which specified the accounting and reporting for certain investments in equity securities and for all investments in debt securities. UNUM adopted the provisions of FAS 115 for these investments held or acquired after January 1, 1994. Upon the adoption of FAS 115, UNUM increased unrealized gains on available for sale securities included in stockholders' equity on January 1, 1994, by $41.8 million (net of deferred taxes of $22.5 million) to reflect the unrealized holding gains on fixed maturities classified as available for sale that were previously carried at amortized cost. In addition, UNUM reclassified certain fixed maturities from held to maturity to available for sale on January 1, 1994, in connection with the adoption of FAS 115.
In November 1995, the FASB issued "A Guide to Implementation of Statement 115 on Accounting for Certain Investments in Debt and Equity Securities," which provided a one-time opportunity to reassess the appropriateness of the
NOTE 2. INVESTMENTS (CONTINUED) classifications of securities described in FAS 115, and to reclassify fixed maturities from the held to maturity category without calling into question the intent to hold other debt securities to maturity in the future. On December 31, 1995, UNUM reassessed its fixed maturity portfolio and as allowed under the implementation guidance, reclassified fixed maturities with an amortized cost of $6,082.8 million and a related net unrealized gain of $393.0 million from the held to maturity category to available for sale. In connection with the reclassification of the held to maturity fixed maturities to available for sale, on December 31, 1995, UNUM adjusted its unpaid claims by $261.2 million to reflect the changes that would have been necessary if the unrealized gains and losses related to fixed maturities classified as available for sale had been realized.
NOTE 2. INVESTMENTS (CONTINUED) The amortized cost and fair values of fixed maturities at December 31, 1994, were as follows:
During 1995, UNUM sold fixed maturities of two issuers classified as held to maturity with an amortized cost of $4.0 million due to evidence of significant deterioration of the issuers' creditworthiness, as evidenced by bankruptcy filings. These sales resulted in a net realized loss of $1.2 million.
Gross unrealized investment gains on equity securities available for sale totaled $5.5 million and $158.7 million and losses totaled $1.4 million and $23.0 million, at December 31, 1995, and 1994, respectively.
Effective January 1, 1995, UNUM adopted Financial Accounting Standard ("FAS") No. 114, "Accounting by Creditors for Impairment of a Loan," and FAS No. 118, "Accounting by Creditors for Impairment of a Loan -- Income Recognition and Disclosures," which defined the principles to measure and record an impaired loan. When it is probable that UNUM will be unable to collect all amounts of principal and interest due according to the contractual terms of a loan agreement, the loan is deemed impaired. Once a loan is determined to be impaired, an allowance for probable losses is established for the difference between the carrying amount of the loan and its estimated value. The estimated value is based on either the present value of expected future cash flows discounted using the loan's effective interest rate, the loan's observable market price or the fair value of the collateral. The adoption of FAS 114 and FAS 118 did not have a material effect on UNUM's results of operations or financial position.
At December 31, 1995, the recorded investment in impaired loans amounted to $50.1 million. Included in the $50.1 million was $38.4 million of loans which had a related allowance for probable losses of $7.1 million, and $11.7 million of loans which had no related allowance for probable losses. Mortgage loans that were restructured prior to the adoption of FAS 114 amounted to $59.9 million and $73.6 million at December 31, 1995, and 1994, respectively. Troubled debt restructurings represent loans that are refinanced with terms more favorable to the borrower. Interest foregone on these loans was not material for the years ended December 31, 1995, 1994 or 1993.
Real estate acquired in satisfaction of debt cumulatively amounts to $107.6 million at December 31, 1995. Real estate held for sale amounted to $35.5 million at December 31, 1995, and $31.0 million at December 31, 1994.
UNUM was committed at December 31, 1995, to purchase fixed maturities and other invested assets in the amount of $91.2 million.
NOTE 3. ALLOWANCE FOR PROBABLE LOSSES ON INVESTED ASSETS AND REAL ESTATE HELD FOR SALE Changes in the allowance for probable losses on invested assets and real estate held for sale were as follows:
NOTE 4. DERIVATIVE FINANCIAL INSTRUMENTS UNUM periodically uses common derivative financial instruments such as options, futures and forward exchange contracts to hedge certain risks associated with future investments and certain payments denominated in foreign currencies, primarily British pound sterling, Canadian dollar and Japanese yen. These derivative financial instruments are used to protect UNUM from the effect of market fluctuations in interest and exchange rates between the contract date and the date on which the hedged transaction occurs. In using these instruments, UNUM is subject to the off-balance-sheet risk that the counterparties to the transactions will fail to completely perform as contracted. UNUM manages this risk by only entering into contracts with highly rated institutions and listed exchanges. UNUM does not intend to hold derivative financial instruments for the purpose of trading. At December 31, 1995, and 1994, UNUM had no open derivative financial instruments.
NOTE 5. REINSURANCE UNUM, through its life insurance subsidiaries, is involved in both the cession and assumption of reinsurance with other companies. Risks are reinsured with other companies to reduce UNUM's exposure to large losses and permit recovery of a portion of direct losses. UNUM remains liable to the insured for the payment of policy benefits if the reinsurers cannot meet their obligations under the reinsurance agreements. Deferred policy acquisition costs, premiums and expenses are stated net of reinsurance ceded to other companies.
The effect of reinsurance on premiums earned and written for the years ended December 31, 1995, 1994 and 1993 was as follows:
NOTE 6. BUSINESS RESTRUCTURING AND OTHER CHARGES Charges of $8.4 million and $14.4 million were recorded in 1995 and 1994, respectively, related to the acceleration of organizational changes within UNUM Life Insurance Company of America and the decision to discontinue the individual disability non-cancellable product. Partially offsetting the charge recorded in 1995 was a $3.4 million curtailment gain, related to workforce reductions in UNUM Corporation's noncontributory defined benefit pension plan.
The weighted average discount rate and rate of increase in future compensation levels used in determining the actuarial present value of the projected benefit obligation were 7.25% and 4.70%, respectively, at December 31, 1995, and 8.25% and 5.20%, respectively, at December 31, 1994. The expected long-term rate of return on plan assets was 9.0% in 1995 and 1994, and 8.25% in 1993. Prior year service costs are being amortized on a straight-line basis over expected employment periods for active employees.
UNUM also administers certain supplemental retirement plans for eligible employees and officers and certain other pension plans. The cost of these plans was not significant for the years ended December 31, 1995, 1994 and 1993.
At December 31, 1995, a 1% increase in the trend rate for health care costs would increase the accumulated postretirement benefits obligation by $17.3 million and postretirement benefits expense by $2.7 million.
The 1990 Long-Term Stock Incentive Plan ("Incentive Plan") provides for granting of restricted shares of UNUM Corporation common stock to key officers. The Incentive Plan also provides for granting of options to officers, non- employee directors of UNUM Corporation and key employees, to purchase UNUM Corporation common stock over ten years at a price not less than 100% of the fair market value on the date of grant. The maximum number of shares reserved for issuance under the Incentive Plan was 6,800,000 in 1995, 1994 and 1993. At December 31, 1995, 1994 and 1993, 1,680,235 shares, 2,511,145 shares, and 3,316,734 shares, respectively, were available for grant under the Incentive Plan.
The restriction period for each restricted stock award under the Incentive Plan is in excess of three years, with the restrictions lapsing as a result of the achievement of prescribed financial performance objectives during each three year period, with the exception of 20,200 shares granted in 1995 and 10,000 shares granted in 1994, on which restrictions will lapse upon the grantee remaining in the employ of UNUM for a prescribed period of time. Plan participants are entitled to cash dividends and voting rights on their respective shares. All other restricted stock shares issued remained subject to restrictions.
NOTE 8. STOCK BASED COMPENSATION AND INCENTIVE PLANS (CONTINUED) The following is a summary of stock options and restricted stock information:
The number of exercisable shares as of December 31, 1995, 1994 and 1993, was 2,108,060 shares, 1,975,219 shares, and 1,396,182 shares, respectively.
Deferred income taxes relating to cumulative net unrealized gains on available for sale fixed maturity and equity securities were $174.0 million, $27.1 million and $79.4 million at December 31, 1995, 1994 and 1993, respectively.
NOTE 9. INCOME TAXES (CONTINUED) A valuation allowance is established when it is more likely than not that deferred tax assets will not be realized. UNUM established a valuation allowance of $6.0 million in 1995 to reflect the estimated amount of deferred tax assets which may not be realized related to certain reported foreign subsidiaries' losses.
As of December 31, 1995, deferred U.S. income taxes have not been provided on the accumulated earnings of UNUM's foreign subsidiaries. These earnings could generate additional U.S. tax if remitted to UNUM Corporation.
Prior to the Tax Reform Act of 1984 ("1984 Act"), half the excess of the tax basis gain from operations of a life insurance company over its taxable investment income was currently taxable. The other half was set aside in a Policyholders Surplus Account, together with certain special life insurance company deductions. The cumulative amount in the Policyholders Surplus Account as of December 31, 1983, was frozen by the 1984 Act and amounted to $31.8 million at December 31, 1995. Any direct or indirect distributions from this account would be taxed at current tax rates; however, no provision has been made for related taxes. If the amount set aside in this account were taxed at the current rate at December 31, 1995, for all life insurance subsidiaries, the tax would have amounted to $11.1 million.
NOTE 10. NOTES PAYABLE (CONTINUED) At December 31, 1995, UNUM Corporation had a $500 million committed revolving credit facility that expires on October 1, 1999. UNUM's commercial paper program is supported by the revolving credit facility and is available for general liquidity needs, capital expansion, acquisitions or stock repurchase. The committed revolving credit facility contains certain covenants which, among other provisions, require maintenance of certain levels of stockholders' equity and limits on debt levels. The commercial paper outstanding at December 31, 1995, and 1994, had a weighted average interest rate of 5.88% and 6.34%, respectively.
UNUM Corporation also has the ability to draw a dividend of approximately $19 million from its United Kingdom based affiliate, UNUM Limited, subject to certain U.S. tax consequences.
On December 29, 1993, UNUM filed a suit in the United States District Court for the District of Maine, seeking a federal income tax refund. The suit is based on a claim for a deduction in certain prior tax years, for $652 million in cash
NOTE 13. LITIGATION (CONTINUED) and stock distributed to policyholders in connection with the 1986 conversion of Union Mutual Life Insurance Company to a stock company. Although UNUM believes its claims are meritorious, the United States is aggressively resisting the claims and the ultimate recovery, if any, cannot be determined at this time.
NOTE 14. SUBSEQUENT EVENT On January 24, 1996, UNUM America entered into an agreement for the sale of its group tax-sheltered annuity ("TSA") business to The Lincoln National Life Insurance Company ("Lincoln Life"), a part of Lincoln National Corporation, and to a new New York insurance subsidiary of Lincoln Life. The agreement also contemplates that First UNUM will enter into a similar agreement with Lincoln Life's New York insurance subsidiary. The sale, which is subject to regulatory approvals, involves approximately 1,700 group contractholders and assets under management of approximately $3 billion. The agreement initially contemplates the reinsurance of these contracts under an indemnity reinsurance arrangement. These contracts will then be reinsured pursuant to an assumption reinsurance arrangement upon consent of the TSA contractholders and/or participants. The purchase price (ceding commission) at closing is expected to be approximately $70 million. It is anticipated that it will take several months (perhaps six to nine months) to obtain the necessary approvals and otherwise close the sale. There is no guarantee that the sale will close.
Historical results of the TSA business included in UNUM's Consolidated Statements of Income were as follows:
The following table summarizes the carrying amounts and fair values of UNUM's financial instruments at December 31, 1995, and 1994:
POLICY LOANS, SHORT-TERM INVESTMENTS, CASH AND ACCRUED INVESTMENT INCOME: Fair values for these instruments approximate the carrying amounts reported in the Consolidated Balance Sheets.
INVESTMENT-TYPE INSURANCE CONTRACTS: Fair values for liabilities under investment-type insurance contracts with defined maturities are estimated using discounted cash flow calculations based on interest rates that would be offered currently for similar contracts with maturities consistent with those remaining for the contracts being valued. Fair values for liabilities under investment-type insurance contracts with no defined maturities are the amounts payable on demand after surrender charges at the balance sheet date.
NOTE 16. SEGMENT INFORMATION UNUM's markets for its insurance, special risk and retirement income products are the United States, its principal market, Canada, the United Kingdom and the Pacific Rim. Through its affiliates, UNUM is the leading provider of group long term disability insurance, its principal product, in the United States and the United Kingdom. Products are marketed through sales personnel, independent contractors and brokers, and specialty agents. UNUM targets sales of its disability products to executive, administrative and management personnel, and other professionals such as doctors, attorneys, accountants and engineers.
To more clearly reflect UNUM's management of its businesses and to more appropriately group its product portfolios, UNUM began reporting its operations, effective January 1, 1995, principally in four business segments: Disability Insurance, Special Risk Insurance, Colonial Products and Retirement Products. For comparative purposes, prior period information has been restated to reflect reporting in these segments.
The Disability Insurance segment includes disability products offered in North America, the United Kingdom and Japan including: group long term disability, individual disability, group short term disability, association group disability, disability reinsurance and long term care insurance. The Special Risk Insurance segment includes group life, special risk accident insurance, non-disability reinsurance operations, reinsurance underwriting management operations and other special risk insurance products. The Colonial Products segment includes Colonial Companies, Inc. and subsidiaries, which offer payroll-deducted, voluntary employee benefits including personal accident and sickness, cancer and life insurance products to employees at their worksites. The Retirements Products segment includes tax sheltered annuities and products which are no longer actively marketed by UNUM including guaranteed investment contracts, deposit administration accounts and 401(k) plans. Corporate includes transactions that are generally non-insurance related.
Investment income and net realized investment gains are allocated to the segments based on designation of ownership of assets identified to the segments. Operating expenses are allocated to the segments based on direct association with a product whenever possible. If, however, the expense cannot be readily associated with a particular product, the costs are allocated based on ratios of the relative time spent, extent of usage or varying volume of work performed for each segment.
NOTE 17. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED) The following is a summary of unaudited quarterly results of operations for 1995 and 1994: