The following selected consolidated financial data as of and for each of the five years in the period ended December 31, 2008 has been derived from the audited consolidated financial statements of the Company. The following data should be read in conjunction with the consolidated financial statements and the notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included herein.
Additionally, the Company may also disclose financial information on a non-GAAP basis when management uses this information and believes this information will be valuable to investors in measuring the quality of our
financial performance, identifying trends in our results and providing more meaningful period-to-period comparisons.
The Company operates three business segments, the Insurance segment, Corporate and Disposed Operations. The Insurance segment includes the Company’s Self-Employed Agency Division (“SEA”), the Medicare Division and the Other Insurance Division. Corporate includes investment income not allocated to the Insurance segment, realized gains or losses, interest expense on corporate debt, general expenses relating to corporate operations, variable non-cash stock-based compensation and operations that do not constitute reportable operating segments. Disposed Operations includes the former Life Insurance Division, former Star HRG Division and former Student Insurance Division.
In 2007, we initiated efforts to expand into the Medicare market. In the fourth quarter of 2007, we began offering a new portfolio of Medicare Advantage Private-Fee-for-Service Plans (“PFFS”) - called HealthMarkets Care Assured PlansSM (“HMCA Plans”) - in selected markets in 29 states with calendar year coverage effective for January 1, 2008. Policies were issued by our Chesapeake subsidiary, under a contract with the Centers for Medicare and Medicaid Services (“CMS”). The HMCA Plans were offered to Medicare eligible beneficiaries as a replacement for original Medicare and Medigap (Supplement) policies. They provided enrollees with the actuarial benefit equivalence they would receive under original Medicare, as well as certain additional benefits or benefit options, such as preventive care, pharmacy benefits, and vision, dental and hearing services. In July 2008, the Company determined it would not continue to participate in the Medicare business after the 2008 plan year.
Our Other Insurance Division consists of ZON Re-USA, LLC (“ZON Re”), an 82.5%-owned subsidiary, which underwrites, administers and issues accidental death, accidental death and dismemberment (“AD&D”), accident medical, and accident disability insurance products, both on a primary and on a reinsurance basis. We distribute these products through professional reinsurance intermediaries and a network of independent commercial insurance agents, brokers and third party administrators. We expect to exit this line of business in 2009, with the existing reinsurance business managed to final termination of substantially all liabilities.
On September 30, 2008 (the “Closing Date”), HealthMarkets, LLC, a subsidiary of the Company, completed the transactions contemplated by the Agreement for Reinsurance and Purchase and Sale of Assets dated June 12, 2008 (the “Master Agreement”). Pursuant to the Master Agreement, Wilton Reassurance Company or its affiliates (“Wilton”) acquired substantially all of the business of the Company’s Life Insurance Division, which operated through The Chesapeake Life Insurance Company (“Chesapeake”), Mid-West National Life Insurance Company of Tennessee (“Mid-West”) and The MEGA Life and Health Insurance Company (“MEGA”) (collectively the “Ceding Companies”), and all of the Company’s 79% equity interest in each of U.S. Managers Life Insurance Company, Ltd. and Financial Services Reinsurance, Ltd. As part of the transaction, under the terms of the Coinsurance Agreements (the “Coinsurance Agreements”) entered into with each of the Ceding Companies on the Closing Date, Wilton has agreed, effective July 1, 2008 (the “Coinsurance Effective Date”), to reinsure on a 100% coinsurance basis substantially all of the insurance policies associated with the Company’s Life Insurance Division (the “Coinsured Policies”).
Under the terms of the Coinsurance Agreements, Wilton has assumed responsibility for all insurance liabilities associated with the Coinsured Policies. The Ceding Companies have transferred to Wilton cash in an amount equal
to the net statutory reserves and liabilities corresponding to the Coinsured Policies, which amount was approximately $344.5 million. Wilton has agreed to be responsible for administration of the Coinsured Policies, subject to certain transition services to be provided by the Ceding Companies to Wilton. The Ceding Companies remain primarily liable to the policyholders on those policies with Wilton assuming the risk from the Ceding Companies pursuant to the terms of the Coinsurance Agreements. As a result, in accordance with guidance provided in Financial Accounting Standard No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, the Company reported and will continue to report the policy liabilities ceded to Wilton under “Policy liabilities” and record a corresponding asset as “Reinsurance recoverable - ceded policy liabilities” on its consolidated balance sheet.
The Company and the Ceding Companies received total consideration of approximately $139.2 million, including $134.5 million in aggregate ceding allowances with respect to the reinsurance of the Coinsured Policies. Under certain circumstances, the Master Agreement also provides for the payment of additional consideration to the Company following the closing based on the five year financial performance of the Coinsured Policies. The reinsurance transaction resulted in a pre-tax loss of $21.5 million, of which $13.0 million was recorded as an impairment to the Life Insurance Division’s deferred acquisition costs (“DAC”) with the remainder of $8.5 million recorded in “Realized gains (losses)” in the Company’s consolidated statement of income (loss).
In connection with these transactions the Company incurred $6.5 million in investment banker fees and legal fees recorded as “Other expense” on the Company’s consolidated statement of income (loss) for the year ended December 31, 2008. The Company also incurred $6.4 million of employee and lease termination costs and other costs recorded in “Underwriting, acquisition and insurance expenses,” on its consolidated statement of income (loss) during 2008. In addition, the Company incurred interest expense of $3.1 million during 2008 associated with the use of the cash transferred to Wilton during the period from the Coinsurance Effective Date to the Closing Date. The Ceding Companies also wrote-off DAC of $101.1 million, representing all of the deferred acquisition costs associated with the Coinsured Policies subject to the transaction, which is included in the realized loss on the transaction. This write-off of DAC correspondingly reduced the related deferred tax assets by $36.7 million. See Note 2 of Notes to Consolidated Financial Statements for additional information.
pre-tax gain in 2006 of $201.7 million, of which $101.5 million was attributable to the Star HRG transaction and $100.2 million was attributable to the Student Insurance transaction.
As more fully discussed above, the Company entered into Coinsurance Agreements in connection with its exit from the Life Insurance Division business during 2008 and sold the assets comprising our former Star HRG Division and our former Student Insurance Division in 2006. HealthMarkets management believes that comparisons between years are most meaningful after the reclassification and netting of the operating revenues and expenses attributable to these divisions to the line item “Income (loss) from disposed operations, net of income tax,” which is a non-GAAP measure:
The Company’s expenses consist primarily of insurance claims expense and expenses associated with the underwriting and acquisition of insurance policies. Claims expenses consist primarily of payments to physicians, hospitals and other healthcare providers under health policies and include an estimated amount for incurred but not reported and unpaid claims. Underwriting, acquisition and insurance expenses consist of direct expenses incurred across all insurance lines in connection with issuance, maintenance and administration of in-force insurance policies, including amortization of deferred policy acquisition costs, commissions paid to agents, administrative expenses and premium taxes. The Company also incurs other direct expenses in connection with generating income derived by the SEA Division from ancillary services and membership marketing and administrative services provided to the membership associations that make available to their members the Company’s health insurance products.
Set forth below is certain summary financial and operating data for the Company’s Insurance segment for each of the three most recent fiscal years:
The increase in the loss ratio reflects an ongoing gradual shift in product mix to the Company’s CareOne product suite and other PPO products which are designed to provide a higher proportion of premium dollars as benefits. For the last two years the Company’s sales efforts have been focused on new PPO type products, which, by design, have a higher loss ratio than the Company’s previous products that were largely per occurrence or scheduled benefit products. In addition, as previously disclosed, during 2007, the Company made various refinements to the claim liability estimates.
Underwriting, acquisition and insurance expenses decreased to $420.5 million in 2008 from $478.1 million in 2007, a decrease of $57.6 million or 12.0%. The decrease partially reflects the variable nature of certain expenses, including commission expenses and premium taxes, which are included in these amounts. Commission expenses and premium taxes generally vary in proportion to earned premium revenue. This decrease from 2007 also resulted from a $20.0 million expense associated with the settlement of the multi-state market conduct examination recognized in 2007 and an $8.0 million asset impairment charge in 2007 associated with two technology assets that we determined were no longer of value to the Company.
Other income and other expenses both decreased in the current period compared to the prior year period. Other income largely consists of fee and other income received for sales of association memberships by our dedicated agency sales force. Sales of association memberships by our dedicated agency sales force tend to move in tandem with sales of health insurance policies; consequently, this decrease in other income is consistent with the decline in earned premiums and new sales. Other expenses consist of amounts incurred for bonuses and other compensation provided to the agents, which are based on policy sales during the current year.
For 2007, the SEA Division reported operating income of $150.4 million compared to $236.5 million in 2006, a decrease of $86.1 million or 36.4%. Operating margin in 2007 was 11.7% compared to 17.8% in 2006. Operating income for the SEA Division in 2007 was negatively impacted by a decrease in earned premium revenue, an increase in the loss ratio, and an increase in underwriting, acquisition and insurance expenses.
Loss ratio. The loss ratio represents total benefit expenses as a percentage of earned premium revenue.
Earned premium revenues were $27.1 million in 2008 as compared with $30.0 million in 2007, a decrease of $2.9 million or 9.7%. In 2008, our principal insurance subsidiaries experienced downgrades in their financial strength ratings which had a negative effect on the growth of this business and our ability to maintain ZON Re’s current level of operating income. As such, we expect to exit this line of business in 2009, with the existing reinsurance business managed to final termination of substantially all liabilities.
Set forth below is a summary of the components of operating income (loss) at the Company’s Corporate segment for each of the three most recent fiscal years:
Investment income not allocated to the Insurance segment (investment income on equity) decreased $20.7 million, from $39.5 million in 2007 to $18.8 million in 2008. The decrease is primarily related to a decrease in income on our equity investments, a decrease in the average fixed maturities balance and a decrease in the short-term rates from prior year.
performance of the fair value of the Company’s common stock. The Company recorded a variable stock-based compensation benefit of $6.8 million for 2008 as compared with a $482,000 benefit in 2007. The 2008 benefit is primarily a reflection of a 46% decrease in the value of the Company’s share price on December 31, 2008 as compared to December 31, 2007.
Investment income not allocated to the Insurance segment (investment income on equity) increased $5.4 million, from $34.1 million in 2006 to $39.5 million in 2007. The increase primarily reflects particularly favorable earnings on an international fund investment which is not anticipated to recur based on the most recent activity in that market and a reduction in the size of our commitment to that investment vehicle.
Interest expense on corporate debt of $43.6 million in 2007 represents an $8.8 million or 25.3% increase over the $34.8 million incurred in 2006. This increase in interest expense is a function of a greater average outstanding debt balance in 2007 associated with the additional borrowings undertaken in connection with the Merger transaction in 2006. See Note 8 of Notes to Consolidated Financial Statements.
The Company’s Life Insurance Division reported an operating loss in 2008 of $23.4 million compared to operating income of $2.6 million in 2007. The decrease in operating income for 2008 reflects a $13.0 million impairment charge to underwriting, acquisition and insurance expenses as a result of the decision to exit this business. Based upon the consideration expected to be received in connection with the coinsurance arrangement, the Company recorded an impairment charge to DAC during 2008. See Note 2 of Notes to Consolidated Financial Statements. In addition, the Company incurred expenses in 2008 related to employee severance of $4.1 million and facility lease termination costs of $2.3 million. Also contributing to the decrease in operating income for 2008 was a strengthening of the future policy and contract benefit reserves of $3.9 million incurred in the first half of 2008 for certain interest sensitive whole life products.
The Life Insurance Division reported operating income in 2007 of $2.6 million compared to operating income of $5.3 million in 2006, a decrease of $2.7 million. This decrease was largely attributable to a $9.6 million increase in benefits expenses partially offset by a $4.2 million increase in premium and a $2.6 million decrease in underwriting, acquisition and insurance expenses.
Earned premium revenue at the Life Insurance Division increased to $69.9 million in 2007 compared to $65.7 million in 2006, an increase of $4.2 million or 6.4%. This increase reflects a greater level of renewal premiums from sales that originated in 2006 and prior years through our relationships with two independent marketing companies. The number of policies in force grew during 2007 as new sales exceeded the deterioration in existing blocks of business of older products.
Benefits expenses increased substantially in 2007 to $54.0 million from $44.5 million in 2006. This $9.5 million or 21.3% increase resulted from unusually adverse mortality experience. Underwriting, acquisition and insurance expenses decreased in 2007 to $35.4 million from $38.1 million in 2006, a decrease of $2.7 million or 7.1%. This reduction in expenses reflects a decrease in new sales and a decrease in the amortization of DAC based on more current actuarial assumptions.
The following table sets forth additional information with respect to the Company’s debt:
In connection with the Merger, the Company borrowed $500.0 million under a term loan credit facility and issued $100.0 million of Floating Rate Junior Subordinated Notes during 2006.
Domestic insurance companies require prior approval by insurance regulatory authorities for the payment of dividends that exceed certain limitations based on statutory surplus and net income. During 2009, the Company’s domestic insurance companies are eligible to pay, without prior approval of the regulatory authorities, aggregate dividends in the ordinary course of business to HealthMarkets, LLC of approximately $69.9 million. However, as it has done in the past, the Company will continue to assess the results of operations of the regulated domestic insurance companies to determine the prudent dividend capability of the subsidiaries, consistent with HealthMarkets’ practice of maintaining risk-based capital ratios at each of the Company’s domestic insurance subsidiaries significantly in excess of minimum requirements.
In 2008 and 2007, the holding company received $18.3 million and $54.2 million, respectively, in proceeds from other financing activities largely consisting of $14.8 and $50.4 million, respectively, in proceeds from subsidiaries to acquire shares in the agent stock plans. The corresponding amount in 2006 was $20.4 million. The 2007 activity was unusually greater than 2006 and 2008 in large part due to a $27.9 million reinvestment of the extraordinary cash dividend in May 2007.
In 2008, 2007 and 2006, the holding company paid $30.3 million, $36.9 million and $23.8 million, respectively in interest on outstanding debt, of which $17.8 million, $25.5 million and $22.0 million, respectively, related to the $362.5 million term loan facility.
In connection with the sales of the Company’s former Life Insurance Division and Student Insurance Division, insurance subsidiaries of the Company entered into 100% coinsurance arrangements with each of the purchasers, pursuant to which the purchasers agreed to assume liability for future benefits associated with the Life Insurance and Student Insurance businesses. See Note 7 of Notes to Consolidated Financial Statements for additional information with respect to these coinsurance arrangements.
In accordance with the terms of the Coinsurance Policies, Wilton will fund student loans; provided, however, that Wilton will not be required to fund any student loan that would cause the aggregate par value of all such loans funded by Wilton, following the Coinsurance Effective Date, to exceed $10.0 million. See Note 16 of Notes to Consolidated Financial Statements for additional information with respect to student loan commitments.
The Company believes the following critical accounting policies affect its more significant judgments and estimates used in the preparation of its consolidated financial statements, which are discussed in more detail below:
valuations of assets and liabilities requiring fair value estimates, including but not limited to:
other matters that affect the reported amounts and disclosure of contingencies in the financial statements.
assets including the CIGNA Note. The net proceeds from the senior secured notes were distributed to HealthMarkets, LLC.
The Company measures the fair value of its residual interest in Grapevine using a present value model incorporating the following two key economic assumptions: (1) the timing of the collections of interest on the CIGNA Note, payments of interest expense on the senior secured notes and payment of other administrative expenses and (2) an assumed yield observed on a comparable CIGNA bond.
As discussed in Notes 1 and 3 of Notes to Consolidated Financial Statements, the Company adopted SFAS No. 157 effective January 1, 2008. SFAS No. 157 establishes a framework for measuring fair value that includes a hierarchy used to classify the inputs used in measuring fair value. The hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three levels. The level in the fair value hierarchy within which the fair value measurement falls is determined based on the lowest level input that is significant to the fair value measurement. The levels of the fair value hierarchy are as follows:
Level 1 - Unadjusted quoted market prices for identical assets or liabilities in active markets which are accessible by the Company.
Level 2 - Observable prices in active markets for similar assets or liabilities. Prices for identical or similar assets or liabilities in markets that are not active. Directly observable market inputs for substantially the full term of the asset or liability, such as interest rates and yield curves at commonly quoted intervals, volatilities, prepayment speeds, default rates, and credit spreads. Market inputs that are not directly observable but are derived from or corroborated by observable market data.
If quoted market prices and independent third party valuation information are unavailable, the Company produces an estimate of fair value based on internally developed valuation techniques, which, depending on the level of observable market inputs, will render the fair value estimate as Level 2 or Level 3. On occasions when pricing service data is unavailable, the Company may rely on bid/ask spreads from dealers in determining fair values. When dealer quotations are used to assist in establishing the fair value, the Company obtains one quote per instrument. The quotes obtained from dealers or brokers are generally non-binding. When dealer quotations are used, the Company uses the mid-mark as fair value. When broker or dealer quotations are used for valuation or price verification, greater priority is given to executable quotes. As part of the price verification process, valuations based on quotes are corroborated by comparison both to other quotes and to recent trading activity in the same or similar instruments.
Historically, the Company had not experienced a circumstance where it had determined that an adjustment to a quote or price received from an independent third party valuation source was required. To the extent the Company determines that a price or quote is inconsistent with actual trading activity observed in that investment or similar investments, or if the Company does not think the quote is reflective of the market value for the investment, the Company will internally develop a fair value using this observable market information and disclose the occurrence of this circumstance. During the year ended December 31, 2008, the Company determined that the non-binding quote received from an independent third party broker for a particular collateralized debt obligation investment did not reflect fair value. In accordance with guidance provided in FSP 157-3, the Company determined the fair value of this security based on other internally developed approaches, which are discussed in Note 3 of Notes to Consolidated Financial Statements.
The Company establishes liabilities for benefit claims that have been reported but not paid and claims that have been incurred but not reported under health and life insurance contracts. The claim liability estimate, as determined, is expected to be adequate under reasonably likely circumstances. The estimate is developed using actuarial principles and assumptions that consider a number of items, including, but not limited to, historical and current claim payment patterns, product variations, the timely implementation of rate increases and seasonality. The Company does not develop ranges in the setting of the claims liability reported in the financial statements.
In estimating the ultimate level of claims for the most recent incurral months, the Company uses what it believes are prudent estimates that reflect the uncertainty involved in these incurral months. An extensive degree of judgment is used in this estimation process. For healthcare costs payable, the claim liability balances and the related benefit expenses are highly sensitive to changes in the assumptions used in the claims liability calculations. With respect to health claims, the items that have the greatest impact on the Company’s financial results are the medical cost trend, which is the rate of increase in healthcare costs, and the unpredictable variability in actual experience. Any adjustments to prior period claim liabilities are included in the benefit expense of the period in which adjustments are identified. Due to the considerable variability of healthcare costs and actual experience, adjustments to health claim liabilities usually occur each quarter and may be significant.
For products introduced in 2008, claim payments are considered incurred on the date the service is rendered, regardless of whether the sickness or accident is distinct or the same. This is consistent with the assumptions used in the pricing of these products, which represent less than 10% of the total claim liability of the SEA Division at December 31, 2008.
The SEA Division also makes various refinements to the claim liabilities as appropriate. These refinements estimate liabilities for circumstances such as inventories of pending claims in excess of historical levels and disputed claims. When the level of pending claims appears to be in excess of normal levels, the Company typically establishes a liability for excess pending claims. The Company believes that such an excess pending claims liability is appropriate under such circumstances because of the operation of the developmental method used to calculate the principal claim liability, which method “develops” or “completes” paid claims to estimate the claim liability. When the pending claims inventory is higher than would ordinarily be expected, the level of paid claims is correspondingly lower than would ordinarily be expected. This lower level of paid claims, in turn, results in the developmental method yielding a smaller claim liability than would have been yielded with a normal level of paid claims, resulting in the need for augmented claim liabilities.
With respect to Disposed Operations, the Company primarily assigns incurred dates based on the date of service, which estimates the liability for all medical services received by the insured prior to the end of the applicable financial period. Adjustments are made in the completion factors to account for pending claim inventory changes and contractual continuation of coverage beyond the end of the financial period. However, for the workers’ compensation business that was part of the Life Insurance Division operations, for which the Company still retains some risk, the Company assigns incurred dates based on the date of loss.
The completion factors and loss ratio estimates in the most recent incurral months are the most significant factors affecting the estimate of the claim liability. The Company believes that the greatest potential for variability from estimated results is likely to occur at its SEA Division. The following table illustrates the sensitivity of these factors and the estimated impact to the December 31, 2008 unpaid claim liability for the SEA Division. We believe that the scenarios selected are reasonable based on the Company’s past experience, however, future results may differ.
Impact due to change in estimated loss ratio for the most recent five months.
Reflects liability related to unpaid losses recoverable. The amount associated with Disposed Operations in 2008, 2007 and 2006 is $26.6 million, $33.3 million, and $69.3 million, respectively.
Set forth in the table below is a summary of the claims liability development experience (favorable) unfavorable by business unit in the Company’s Insurance segment for each of the years ended December 31, 2008, 2007 and 2006:
The total favorable claims liability development experience for 2008, 2007 and 2006 in the amount of $20.3 million, $75.6 million and $85.8 million, respectively, represented 5.5%, 18.1% and 19.5% of total claim liabilities established for the SEA Division as of December 31, 2007, 2006 and 2005, respectively.
As indicated in the table above, considerable favorable development ($12.2 million, $35.5 million and $36.6 million for the year ended December 31, 2008, 2007 and 2006, respectively) is associated with the estimate of claim liabilities for the most recent incurral months and development of completion factors. In estimating the ultimate level of claims for the most recent incurral months, the Company uses what it believes are prudent estimates that reflect the uncertainty involved in these incurral months. An extensive degree of judgment is used in this estimation process. For healthcare costs payable, the claim liability and the related benefit expenses are highly sensitive to changes in the assumptions used in the claims liability calculations. With respect to health claims, the items that have the greatest impact on the Company’s financial results are the medical cost trend, which is the rate of increase in healthcare costs, and the unpredictable variability in actual experience. Over time, the developmental method replaces anticipated experience with actual experience, resulting in an ongoing re-estimation of the claims liability. Since the greatest degree of estimation is used for more recent periods, the most recent prior year is subject to the greatest change. Recent actual experience has produced lower levels of claims payment experience than originally expected. See discussion below regarding Changes in SEA Claim Liability Estimates.
The Company experienced favorable development for each of the three years presented in the table above associated with its reserves for regulatory and legal matters due to settlements of certain matters on terms more favorable than originally anticipated.
The favorable claim liability development experience at the Student Insurance Division in 2006 was $478,000. This favorable development was due to claims in the current year developing more favorably than indicated by the loss trends used to determine the claim liability at December 31 of the preceding year.
The favorable claims liability development experience at Star HRG Division of $1.4 million in 2006 included the effects of claims in 2006 developing more favorably than indicated by the loss trends in 2005 used to determine the claim liability at December 31, 2005.
In prior reporting periods the Company made the following changes in estimate, by year, as described below:
The claim liability was reduced by $12.3 million resulting from a refinement to the estimate of unpaid claim liability specifically for the most recent incurral months. In particular, the Company reassessed its claim liability estimates among product lines between the more mature scheduled benefit products that have more historical data and are more predictable, and the newer products that are less mature, have less historical data and are more susceptible to adverse deviation.
The Company incurs various costs in connection with the origination and initial issuance of its health insurance policies, including underwriting and policy issuance costs, costs associated with lead generation activities and distribution costs (i.e., sales commissions paid to agents). The Company defers those costs that vary with production. The Company generally defers commissions paid to agents and premium taxes with respect to the portion of health premium collected but not yet earned and the Company amortizes the deferred expense over the period as premium is earned. Costs associated with generating sales leads with respect to the health business issued through the SEA Division are capitalized and amortized over the average life of a policy, which approximates a two-year period. Other underwriting and policy issuance costs (which the Company estimates are more fixed than variable) are expensed as incurred.
The Company formerly capitalized commissions and premium taxes associated with its SEA Division business, classified as DAC, and amortized all of these costs over the period (and in proportion to the amount) that the associated unearned premium was earned. The Company utilized this accounting methodology in preparing its reported 2006 interim financial statements.
Following adoption of SEC Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in the Current Year Financial Statements (“SAB No. 108”), the Company performed an analysis to determine the appropriate portion of commissions to be deferred over the lives of the underlying policies. Generally, the first year and second year commission rates are higher than the renewal year commission rates, and, as such, the Company has determined that the preferred approach is to capitalize the excess commissions associated with those earlier years and amortize the capitalized costs ratably over the estimated life of the policy. Accordingly, the Company has elected to change its accounting methodology by amortizing the first and second year excess commissions ratably over the average life of the policy which approximates a two year period.
The Company elected to utilize the one time special transition provisions of SAB 108 and recorded an adjustment to retained earnings effective January 1, 2006 to reflect this change in accounting policy with respect to the capitalization and amortization of DAC associated with excess first and second year commissions. As of January 1, 2006, the change in accounting policy resulted in an increase in the Company’s capitalized DAC of $77.6 million, a related increase to its deferred tax liability by $27.1 million, and a net increase to shareholders’ equity of $50.5 million. The adoption of this new accounting policy had the effect of increasing reported underwriting, acquisition and insurance expenses (classified to its SEA Division) in 2006 by $15.5 million and, correspondingly, reducing after-tax net income by $10.1 million.
Market risk is the risk of loss arising from adverse changes in market rates and prices. Market risk is directly influenced by the volatility and liquidity in the markets in which the related underlying assets are traded.
Sensitivity analysis is defined as the measurement of potential loss in future earnings, fair values or cash flows of market sensitive instruments resulting from one or more selected hypothetical changes in interest rates and other market rates or prices over a selected time. In the Company’s sensitivity analysis model, a hypothetical change in market rates is selected that is expected to reflect reasonably possible near-term changes in those rates. “Near term” is defined as a period of time going forward up to one year from the date of the consolidated financial statements.
The Company’s Investment Committee monitors the investment portfolio of the Company and its subsidiaries. The Investment Committee receives investment management services from external professionals and from the Company’s in-house investment management team. The internal investment management team monitors the performance of the external managers as well as directly managing approximately 84% of the investment portfolio.
Corporate bonds, included in the fixed maturity portfolio, consist primarily of short term and medium term investment grade bonds. The Company’s investment policy with respect to concentration risk limits individual investment grade bonds to 3% of assets and non-investment grade bonds to 2% of assets. The policy also limits the investments in any one industry to 20% of assets. As of December 31, 2008, the largest concentration in any one investment grade corporate bond was $87.5 million, which represented 8.5% of total invested assets. This security was received as payment on the sale of the Student Insurance Division. To limit its credit risk, the Company has taken out $75.0 million of credit default insurance on this bond, reducing its default exposure to $19.8 million, or 1.9% of total invested assets. The largest concentration in any one non-investment grade corporate bond was $4.3 million, which represented less than 1% of total invested assets. The largest concentration to any one industry was less than 10%. Additionally, due primarily to long standing conservative investment guidelines, our direct exposure to sub prime investments and auction rate securities is limited to 3.2% of investments.
Included in the fixed maturity portfolio are mortgage-backed securities, including collateralized mortgage obligations, mortgage-backed pass-through certificates and commercial mortgage-backed securities. To limit its credit risk, the Company invests in mortgage-backed securities that are rated investment grade by the public rating agencies. The Company’s mortgage-backed securities portfolio is a conservatively structured portfolio that is concentrated in the less volatile tranches, such as planned amortization classes and sequential classes. The
Company seeks to minimize prepayment risk during periods of declining interest rates and minimize duration extension risk during periods of rising interest rates. The Company has less than 1% of its investment portfolio invested in the more volatile tranches.
A quality distribution for fixed maturity securities at December 31, 2008 is set forth below:
The Company recognized $26.0 million of net realized losses in 2008 from other than temporary impairments of fixed maturity securities and other invested assets. For the year ended December 31, 2008, the Company had gross unrealized losses in our investments of $58.9 million. While we believe that these impairments are temporary and that we have the intent and ability to hold such securities until maturity or recovery, given the current market conditions and the significant judgments involved, there is a continuing risk that further declines in fair value may occur and additional material other than temporary impairments may be recorded in future periods.
Inflation historically has had a significant impact on the health insurance business. In recent years, inflation in the costs of medical care covered by such insurance has exceeded the general rate of inflation. Under basic hospital medical insurance coverage, established ceilings for covered expenses limit the impact of inflation on the amount of claims paid. Under catastrophic hospital expense plans and preferred provider contracts, covered expenses are generally limited only by a maximum lifetime benefit and a maximum lifetime benefit per accident or sickness. Thus, inflation may have a significantly greater impact on the amount of claims paid under catastrophic hospital expense and preferred provider plans as compared to claims under basic hospital medical coverage. As a result, trends in healthcare costs must be monitored and rates adjusted accordingly. Under the health insurance policies issued in the self-employed market, the primary insurer generally has the right to increase rates upon 30-60 days written notice and subject to regulatory approval in some cases.
The business of insurance is primarily regulated by the states and is also affected by a range of legislative developments at the state and federal levels. Recently-adopted legislation and regulations governing the use and security of individuals’ nonpublic personal data by financial institutions, including insurance companies, may have a significant impact on the financial condition and results of operations. See Item 1. Business - Regulatory and Legislative Matters.
The state of domicile of each of the Company’s domestic insurance subsidiaries imposes minimum risk-based capital requirements that were developed by the NAIC. The formulas for determining the amount of risk-based capital specify various weighting factors that are applied to financial balances and premium levels based on the perceived degree of risk. Regulatory compliance is determined by a ratio of a company’s regulatory total adjusted capital, as defined, to its authorized control level risk-based capital, as defined. Companies’ specific trigger points or ratios are classified within certain levels, each of which requires specified corrective action. At December 31, 2008, the risk-based capital ratio of each of our insurance subsidiaries exceeds the ratio for which regulatory corrective action would be required.
Dividends paid by domestic insurance companies out of earned surplus in any year are limited by the law of the state of domicile. See Item 5. Market for Registrant’s Common Stock and Related Stockholder Matters and Note 12 of Notes to Consolidated Financial Statements.