The Company occupies over 3,000,000 square feet of space at four principal operating centers in Chattanooga, Tennessee; Portland, Maine; Worcester, Massachusetts; and Columbia, South Carolina.
The Company leases and occupies approximately 111,600 square feet of office space in Glendale, California and 146,400 square feet in facilities located in Ontario, Canada. The leased Canadian office space will either be assigned to the buyer of that operation or terminated through lease buyouts upon closing of the sale of the Canadian branch during the first half of 2004. Additionally, the Company leases other office space, for periods principally from five to ten years, for use by its affiliates and sales forces.
(2) In 2001, the Company early redeemed $172.5 million of debt and wrote off the remaining associated deferred debt costs of $4.5 million. The write-off was previously reported as an extraordinary loss, net of a $1.6 million tax benefit. The Company adopted Statement of Financial Accounting Standards No. 145 (SFAS 145), Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections, effective January 1, 2003, and reclassified the 2001 loss to conform to current reporting requirements.
(4) In conjunction with the fourth quarter 2003 classification of the Canadian branch as an asset held for sale, the Company tested the goodwill related to the Canadian branch for impairment and determined that the balance of $190.9 million was impaired. The Company also recognized a loss of $9.3 million before tax and $6.0 million after tax to write down the value of bonds in the Canadian branch investment portfolio to market value. These two charges, which total $196.9 million after tax, are included in the 2003 loss from discontinued operations.
The Company is the largest provider of group and individual income protection insurance products and a leading provider of life, accident, and long-term care products in the United States and the United Kingdom. Through its U.S. brokerage operation, which represents approximately 82 percent of total segment operating revenue, the Company markets a portfolio of group, individual, and voluntary benefit products and services to employers and their employees, as well as offering a limited number of products to individual customers. The Company believes that its product line, its commitment to high quality service, and its claims management approach position the organization well to compete in this highly competitive business. In addition to competition, portions of the Company’s business are sensitive to economic and financial market factors, including consumer confidence, employment levels, and the level of interest rates.
During the second half of 2003, claim resolution rates increased 7.5 percent from the lower levels experienced during the fourth quarter of 2002 through the second quarter of 2003. Claim incidence rates continue at historically high levels and are an important part of the Company’s 2004 plans, addressed below.
• The Company has faced increased media, regulatory, and litigation actions. Beginning in October 2002, the Company became the subject of a number of media stories that criticized its processing of disability claims. This negative media attention created a significant public relations challenge for the Company. As a result of this negative attention, the Company has experienced an increase in attention from its regulators, particularly state insurance departments. In addition, more than 20 purported class action and stockholder derivative lawsuits have been brought against the Company and/or its subsidiaries’ directors and officers. Refer to Item 8 Note 15 of the “Notes to Consolidated Financial Statements” for information on the Company’s litigation.
• Claim and investment results combined to weaken the Company’s balance sheet in late 2002 and early 2003, leading the Company to raise capital in various ways in mid- to late-2003. The cumulative effect of statutory investment portfolio losses and claim results reduced the Company’s risk-based capital ratio for its U.S. insurance subsidiaries. The weighted average risk-based capital ratio based on the NAIC Company Action Level formula moved from 250 percent as of December 31, 2001 to 210 percent as of December 31, 2002.
- Entering into agreements to sell several non-core businesses and product lines on terms that result in increased statutory capital. Specifically, the Company entered into agreements to divest its Canadian branch operation, its majority interest in its subsidiary in Argentina, and its income protection subsidiary in Japan. In the United States, it reinsured certain of its insurance policies distributed through associations.
Company’s underwriting and pricing strategy may place it in a somewhat competitive disadvantage in the near term, although it is believed that it will produce improved profit margins over time. While price will always be a paramount factor in buying decisions, the Company believes that its products, services, and prices, taken as a whole, give it a competitive position. These steps are intended to position the Company to benefit from a recovering economy and are discussed throughout Item 7.
- Shifting emphasis from revenue growth to profit margin expansion in this line;
- Restoring a more balanced mix of business between small, medium, and large employer customers, shifting the Company’s focus from large case business which is often more price sensitive and vulnerable to weak economic conditions; and,
- Improving the cost structure of the Company and lowering the expense ratios.
Claim reserves, unlike policy reserves, are subject to revision as current claim experience and projections of future factors affecting claim experience change. In a reporting period, actual experience may deviate from the long-term assumptions used to determine the claim reserves. The Company reviews annually, or more frequently as appropriate, emerging experience to ensure that its claim reserves make adequate and reasonable provision for future benefits and expenses. The Company’s reserves for group and individual income protection products include a provision for future payments, other than legal expenses, on all claim-related lawsuits for which the cause of action has already occurred. This includes known lawsuits and those yet to be filed. The reserve amount is the Company’s estimate of the payments on all such lawsuits based on past payments and expected future payments.
Claim reserves on continuing operations, net of ceded reinsurance, were $20.4 billion at December 31, 2003. Claim reserves, in general, are an estimate of the current value of future, otherwise unfunded, benefit commitments or liabilities. The calculation of claim reserves involves numerous assumptions. In setting these assumptions, the Company depends upon industry information and experience, Company experience and analysis, and reasoned judgment. There can be no guarantee that these assumptions individually, or collectively, will be duplicated by actual experience over time. The primary assumptions related to claim reserves are the discount rate, the claim resolution rate, and the incidence rate for incurred but not reported (IBNR) claims.
Deferred costs related to group and individual income protection products are amortized over a twenty-year period, with approximately 75 percent and 90 percent of the original deferred costs related to group income protection products expected to be amortized by years ten and fifteen, respectively. For individual income protection policies, approximately 45 percent and 75 percent of the original deferred costs are expected to be amortized by years ten and fifteen, respectively. Deferred costs for group life products are amortized over a fifteen-year period, with approximately 85 percent of the cost expected to be amortized by year ten. Deferred costs for group and individual long-term care products are amortized over a twenty-year period, with approximately 50 percent and 75 percent of the original deferred costs expected to be amortized by years ten and fifteen, respectively. Due to the Company’s actual persistency experienced in recent years relative to what was expected when policies were issued, the Company lowered its premium persistency assumptions for costs deferred in 2002 and 2003 for certain of its products to reflect the Company’s current estimate of persistency. This accelerates the amortization of group income protection and group life acquisition costs deferred in those years into the early life of the policy.
Based on this review of the entire investment portfolio, individual investments may be added to or removed from the Company’s “watch list”, which is a list of securities subject to enhanced monitoring and a more intensive review. The Company also determines if its investment portfolio is overexposed to an issuer that is showing warning signs of deterioration and, if so, the Company makes no further purchases of that issuer’s securities and may seek opportunities to sell securities it holds from that issuer to reduce the Company’s exposure. The Company monitors below-investment-grade securities as to individual exposures and in comparison to the entire portfolio as an additional credit risk management strategy, looking specifically at the Company’s exposure to individual securities currently classified as below-investment-grade. In determining current and future business prospects and cash availability, the Company considers the parental support of an issuer in its analysis but does not rely heavily on this support.
Private placement fixed maturity securities, including the fixed maturity securities reported as discontinued operations, had a carrying value of approximately $3.7 billion, or 12.0 percent of total fixed maturity securities at December 31, 2003. Private placement fixed maturity securities do not have readily determinable market prices. For these securities, the Company uses internally prepared valuations combining matrix pricing with vendor purchased software programs, including valuations based on estimates of future profitability, to estimate the fair value. Additionally, the Company obtains prices from independent third-party brokers to establish valuations for certain of these securities. The Company’s ability to liquidate its positions in some of these securities could be impacted to a significant degree by the lack of an actively traded market, and the Company may not be able to dispose of these investments in a timely manner. Although the Company believes its estimates reasonably reflect the fair value of those securities, the key assumptions about the risk-free interest rates, risk premiums, performance of underlying collateral (if any), and other factors involve significant assumptions and may not reflect those of an active market. The Company believes that generally these private placement securities carry a credit quality comparable to companies rated Baa or BBB by major credit rating organizations.
As of December 31, 2003, the key assumptions used to estimate the fair value of private placement fixed maturity securities included the following:
• Risk free interest rates of 3.25 percent for five-year maturities to 5.07 percent for 30-year maturities were derived from the current yield curve for U.S. Treasury Bonds with similar maturities.
There are a number of significant risks inherent in the process of monitoring the Company’s fixed maturity securities for impairments and determining when and if an impairment is other than temporary. These risks and uncertainties include the following possibilities:
• New information may become available concerning the security, such as disclosure of accounting irregularities, fraud, or corporate governance issues.
• Significant changes in credit spreads may occur in the related industry.
would cause the Company to review goodwill for impairment more frequently than annually. Changes in the Company’s businesses, such as the sale of the Canadian branch, may require impairment testing and can result in impairment. Changes in the Company’s reporting segments can change the level at which goodwill is tested and may result in an impairment of goodwill at the time the reporting segments are changed.
The goodwill reported as an asset in the Company’s consolidated statements of financial condition is attributable primarily to the acquisition of Paul Revere and relates to individual income protection business. The impairment testing for the individual income protection goodwill involves estimating the fair value of the individual income protection block of business based upon the present value of future cash flows using assumptions as to future sales, morbidity experience, portfolio yield rate, and the rate of return at which the Company believes the market would price the business for purchase. Adverse changes in any of these factors could result in an impairment of goodwill.
The amount of income taxes paid by the Company is subject to ongoing audits in various jurisdictions, and a material assessment by a governing tax authority could affect profitability. Management believes that adequate accruals have been provided for all years; however, the amount ultimately paid upon resolution of issues raised could differ materially from the amount accrued.
During 2003, the Company’s insurance subsidiary in the United Kingdom, Unum Limited, acquired the United Kingdom group income protection business of Sun Life Assurance Company of Canada (UK) Ltd (Sun Life) together with the renewal rights to Sun Life’s group life business, at a price of approximately $37.2 million. Also in 2003, Unum Limited entered into an agreement with Swiss Life (UK) plc (Swiss Life) wherein Unum Limited would become responsible for the ongoing administration and management of the United Kingdom portion of Swiss Life’s group income protection claims portfolio, and Swiss Life would also reinsure this portfolio to Unum Limited. Unum Limited will also become a multi-national pooling partner for Swiss Life Insurance & Pension Company with respect to business written in the United Kingdom. The arrangement became effective January 1, 2004.
During 2003, the Company entered into an agreement to sell its Canadian branch to RBC Insurance, the insurance operation of Royal Bank of Canada. The transaction is expected to improve the statutory capital position of the Company’s insurance subsidiary which currently owns the Canadian branch, Provident Life and Accident Insurance Company, and is expected to close during the first half of 2004. The Canadian branch is accounted for as an asset held for sale at December 31, 2003 and also meets the accounting criteria for being reported as a discontinued operation in the consolidated financial statements. In conjunction with the classification of the Canadian branch as an asset held for sale, the Company tested the goodwill related to the Canadian branch for impairment and determined that the balance of $190.9 million was impaired. The Company also recognized a loss of $9.3 million before tax and $6.0 million after tax to write down the value of bonds in the Canadian branch investment portfolio to market value. These two charges, which total $196.9 million after tax, are included in the 2003 loss from discontinued operations in the consolidated statements of operations. See “Discontinued Operations” contained herein in Item 7 and Note 2 of the “Notes to Consolidated Financial Statements” contained herein in Item 8 for further discussion of the Company’s discontinued operations.
With the goal of focusing on its core operations, in 2003, the Company entered into agreements to sell its Japanese operation and reduce its ownership position in its Argentinean operation. The Company entered into an agreement to sell its wholly-owned subsidiary Unum Japan Accident Insurance Co., Ltd. to Hitachi Capital Corporation (Hitachi). The Company also entered into an agreement with Hitachi to reinsure certain existing income protection business and intends to have a continuing presence in these operations for at least one year. The Japanese operation is accounted for as an asset held for sale, and in conjunction with that classification, during the fourth quarter of 2003, the Company recognized an impairment loss of $1.2 million before tax and $0.8 million after tax. The Company also recognized a tax benefit of $6.8 million. The transaction closed in January 2004.
Regarding the Company’s reduction of its ownership position in its Argentinean operation, the Company entered into an agreement in principle that will result, upon completion of the restructuring, in a 40 percent Company ownership interest in the Argentinean operation. The transaction is expected to close in March 2004, subject to the execution and closing of a definitive agreement and approval by Argentine regulators. The Argentinean operation is accounted for as an asset held for sale at December 31, 2003, but not as a discontinued operation because of the Company’s partial ownership and continuing involvement in the operation after the transaction is completed. During the fourth quarter of 2003, the Company recognized an impairment loss of $13.5 million before tax and $11.3 million after tax related to this operation.
In order to strengthen its capital position, during 2003, the Company issued 45,980,000 shares of common stock, par value $0.10 per share, in a public offering and received approximately $476.3 million in proceeds from the sale of the shares after deducting underwriting discounts. Also in 2003, the Company issued 20,000,000 8.25% adjustable conversion-rate equity security units (units) in a public offering and received approximately $485.0 million in proceeds from the sale of the units after deducting underwriting discounts. Subsequently in 2003, the Company sold 6,897,000 additional shares of common stock and 3,000,000 additional units pursuant to the exercise of the underwriters’ overallotment option relating to the above offering resulting in proceeds to the Company of approximately $71.4 million and approximately $72.8 million, respectively, after deducting underwriting discounts. Each unit has a stated amount of $25 and will initially consist of (a) a contract pursuant to which the holder agrees to purchase, for $25, shares of the Company’s common stock on May 15, 2006 and (b) a 1/40, or 2.5%, ownership interest in a senior note issued by the Company due May 15, 2008 with a principal amount of $1,000. Proceeds from the offerings were used primarily to increase the capitalization of the Company’s insurance subsidiaries and to repay amounts loaned to the Company from its insurance subsidiaries. Upon settlement of the common stock purchase contract and successful remarketing of the senior note element of the units, the Company will receive proceeds of approximately $575.0 million and will issue between 43.3 million and 52.9 million shares of common stock.
than those experienced in the full years 2002, 2001, and 2000. The analysis indicated not only a decrease in overall claim resolution rates, but also a change in claim resolution rates by claim duration. The analysis of emerging claim resolution rates and the reasons driving the changes resulted in a reduction in the Company’s long-term expectations with respect to claim resolution rates. The Company’s long-term expectations applied to all claims incurred regardless of the date of incurral. In addition, the Company reviewed the reserve discount rate, which is the interest rate at which future cash flows for benefit and expenses to be paid are discounted to determine the current value of those cash flows. The Company concluded at that time that a change in its discount rate assumptions was not warranted. Based on the April 2003 analysis, in the first quarter of 2003 the Company increased its group long-term income protection claim reserves by $454.0 million before tax, or $295.1 million after tax, to reflect its current estimate of future benefit obligations. The active claim reserve for claims already reported to the Company and still in open claim status was increased by $516.0 million, the IBNR reserve was decreased by $23.0 million, and the reopen reserve was decreased by $39.0 million before tax. The first quarter 2003 change represented a 6.5 percent increase in total net group long-term income protection reserves as of March 31, 2003, which for continuing operations equaled $7.017 billion prior to this increase and equaled $6.618 billion as of December 31, 2002.
In January 2004, the Company completed its annual review of claim reserves to ensure that its claim reserves make adequate and reasonable provision for future benefits and expenses. Based upon this review, as of December 31, 2003, the Company increased its group long-term income protection claim reserves by $421.0 million and its group short-term income protection claim reserves by $19.0 million, for a total increase of $440.0 million before tax and $286.0 million after tax. Approximately $300.0 million of the reserve strengthening reflected implementation of a lower discount rate for the Company’s group income protection claim reserves. The discount rate was lowered to reflect the Company’s actual change in investment portfolio yield rates during 2003, the expectation of future investment portfolio yield rates, and the Company’s new discount rate management approach of maintaining a wider spread between its group income protection portfolio investment yield rate and its average discount rate. The Company’s new discount rate management approach is intended to better reflect the current investment environment and position the Company to be more responsive with discount rates on new incurred claims as changes to the investment environment emerge. Approximately $140.0 million of the reserve increase related to a strengthening of the morbidity assumptions to reflect the impact of the Company’s view of a continuing jobless economic recovery on claim incidence and severity. Of this amount, approximately $64.0 million was established to reflect higher claim incidence expectations. Claim incidence in the second half of 2003 was 8.4 percent higher than the first half of the year and 5.8 percent above the second half of 2002. The Company’s January 2004 review indicated that claim incidence is expected to continue at an elevated level for several quarters as the Company believes that early indications of a recovering economy are not yet reflected in improved consumer confidence or job creation. Also included in the $140.0 million strengthening was approximately $76.0 million to reflect higher severity expectations driven primarily by a lengthening of claim duration expectations in those claims that have been open 36 months or longer. The $440.0 million reserve increase represented a 5.4 percent increase in total net group income protection reserves as of December 31, 2003, which totaled $8.186 billion prior to this increase.
fourth entity is a trust containing a highly rated bond for principal protection, unrelated equity securities, and several partnership equity investments. The Company contributed the bond and partnership investments into the trust at the time it was established. The purpose of this trust was to allow the Company to maintain its investment in the partnerships while at the same time protecting the principal of the investment. The fair values of the bond, equity securities, and partnerships were $61.8 million, $7.0 million, and $51.7 million, respectively, at the time of transition to FIN 46, which were equivalent to the fair values at which they would have been reported as fixed maturity securities. The adoption of FIN 46 had no impact on the fair value of total invested assets reported in the Company’s consolidated statements of financial condition.
The adoption of DIG Issue B36 resulted in an increase in fixed maturity securities of $61.3 million to record the fair value of the embedded derivatives, a decrease of $116.1 million in miscellaneous assets, $18.4 million in reinsurance receivable, and $134.5 million in accumulated other comprehensive income (net unrealized gain on securities) to eliminate the previously reported adjustment to fair value of the marketable securities held in the trust and the related effects on claim reserves, and a $39.9 million cumulative effect of accounting principle change, net of $21.4 million in tax. The fair value of the embedded derivatives related to these reinsurance contracts was $62.1 million as of December 31, 2003. See Item 8, Notes 1 and 5 of the “Notes to Consolidated Financial Statements” for further discussion.
Continued declines in the performance of equity investment markets combined with steadily increasing pension liabilities reduced the Company’s U.S. and foreign pension plans funding levels such that in December 2002, in accordance with the provisions of Statement of Financial Accounting Standards No. 87, Employer’s Accounting for Pensions (SFAS 87), the Company recorded a $145.0 million non-cash minimum pension liability adjustment, net of tax, to accumulated other comprehensive income in stockholders’ equity. In December 2003, as a result of improvements in the performance of the equity investment markets, the Company reduced the non-cash minimum pension liability adjustment by $19.7 million, net of tax.
Effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets. SFAS 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets. Under SFAS 142, goodwill is no longer amortized but is subject to annual impairment tests. Other intangible assets continue to be amortized over their useful lives.
Transition to the provisions of SFAS 142 required the Company to complete, within the year of adoption, transitional impairment tests of goodwill existing at January 1, 2002, measured as of that date using a fair value approach. The Company had previously, prior to the adoption of SFAS 142, used undiscounted cash flows to determine if goodwill was recoverable. The Company completed the required tests during 2002 and determined the carrying value of its goodwill should be reduced $11.0 million. The charge, net of a $3.9 million tax benefit, was $7.1 million and is reported as a cumulative effect of accounting principle change in the consolidated statements of operations.
During 2001, the Company reinsured on a 100 percent indemnity coinsurance basis certain cancer policies written by one of the Company’s insurance subsidiaries and ceded approximately $113.6 million of reserves to the reinsurer. The transaction had an effective date of November 1, 2001.
In 2001, the Company acquired the assets of EmployeeLife.com, an Internet Capital Group partner company. This acquisition has served to enhance customer service by offering internet business solutions to help employers efficiently manage and administer employee benefits. The Company also acquired Resource Opportunities, Inc. (ROI), a national provider of medical and vocational case management services. ROI has helped improve GENEX’s ability to service its customers, in turn benefiting the Company’s insurance customers.
During 2001, the Company wrote off the remaining goodwill balance related to its operation in Argentina, resulting in a $5.4 million decrease in income before tax and net income.
The following table presents consolidated financial information for the years indicated.
The Company has field sales personnel who specialize in (1) employer-provided plans for employees and (2) supplemental benefit plans that include multi-life income protection and long-term care product offerings and products sold to groups of employees through payroll deduction at the workplace. These field sales personnel partner with Company representatives from claims, customer service, and underwriting who work in conjunction with independent brokers and consultants to present coverage solutions to potential customers and to manage existing customer accounts. The Company focuses on integrated selling and expects that this organizational focus on customers will continue to favorably affect sales growth, but management intends to maintain pricing discipline to balance sales growth and profitability, which may slow the rate of long-term sales growth. The Company also utilizes an agency field sales force to market the products offered by its Colonial segment.
The results shown above are discussed under the segment operating results, as applicable. Prior year amounts have been restated to conform to current year reporting of ASO fees, which were previously reported on a premium equivalent basis.
As previously discussed in Item 1 contained herein, effective January 1, 2003, the Company’s new segment reporting includes the following five business segments: Income Protection segment, Life and Accident segment, Colonial segment, Other segment, and Corporate segment. Prior year numbers have been reclassified to conform to the new segment reporting.
In the following segment financial data and discussions of segment operating results, “operating revenue” excludes net realized investment gains and losses. “Operating income” or “operating loss” excludes net realized investment gains and losses, income tax, results of discontinued operations, and cumulative effects of accounting principle changes. These are considered non-GAAP financial measures. A non-GAAP financial measure is a numerical measure of a company’s performance, financial position, or cash flows that excludes or includes amounts that are not normally excluded or included in the most directly comparable measure calculated and presented in accordance with accounting principles generally accepted in the United States (GAAP).
Sales for individual income protection decreased 8.1 percent in 2003 relative to the prior year. Sales increased 40.7 percent in the Company’s brokerage voluntary income protection line of business, offset by declines in the Company’s United Kingdom operations and in the Company’s U.S. operations for non-voluntary income protection. The sales decline occurred primarily in the U.S. individual sales market rather than in the multi-life market. The portion of the individual income protection sales attributable to multi-life business in the Company’s U.S. operations was approximately 77 percent of 2003 sales and 73 percent for full year 2002 sales. Sales for group long-term care increased 14.9 percent over the prior year, while sales for individual long-term care decreased 31.1 percent.
The Company expects that the rate of sales growth for both group and individual income protection products may decline due to the current competitive pricing environment. The Company intends to continue to emphasize premium growth through a balance of new sales, renewal programs, and persistency of the existing block of business, but no assurance can be given that such premium growth will occur or be sustainable.
Fully insured sales for group long-term income protection increased $1.8 million in 2002 compared to the prior year. The Company’s U.S. operations reported a decrease of 3.8 percent, partially offset by a 19.4 percent sales increase in the Company’s United Kingdom operations. Sales in the U.S. operations declined in all case size markets, with the largest percentage decrease occurring in the small-employer market. Fully insured sales for short-term income protection were down 20.7 percent in 2002 compared to the prior year due to a decline in sales in all case size markets. Sales for short-term income protection ASO increased 62.9 percent compared to 2001.
Persistency during 2003 for the overall block of group long-term income protection on average improved from that experienced in 2002. Persistency for fully insured short-term income protection also improved, on average, over the prior year. Persistency for short-term income protection ASO business declined relative to 2002. During 2002 and 2001, persistency for group long-term and short-term income protection was lower for certain issue years when compared to the persistency expected at the time the business was written. This resulted in additional amortization of deferred policy acquisition costs of $12.9 million in 2002 and $26.3 million in 2001 for group income protection. There was no additional amortization of deferred policy acquisition costs in 2003. Since the Company’s actual persistency experienced in recent years was lower than that expected when policies were issued, the Company lowered its premium persistency assumptions for costs deferred in 2002 and 2003 to reflect its current estimate of persistency. This accelerates the amortization of group long-term and short-term income protection acquisition costs deferred in those years into the early life of the policy by using lower premium persistency assumptions to determine the “scheduled” or expected amortization. Although persistency in the future may be lower than historical levels, particularly in certain issue years due to the Company’s increased emphasis on retaining profitable business, the acceleration of “scheduled”
amortization may eliminate the need for additional amortization related to the decline in actual persistency relative to “scheduled” or expected persistency. The persistency of individual income protection and long-term care continues to be within expected levels.
The Company’s renewal programs have generally been successful at retaining group income protection business that is relatively more profitable than business that terminated. It is expected that the additional premium and related profits associated with renewal activity will continue to emerge. The Company intends to maintain a disciplined approach in the re-pricing of renewal business, while balancing the need to maximize persistency and retain producer relationships. This disciplined approach may lead to lower persistency or lower profit margins on affected renewal cases than originally planned.
The Company, similar to all financial institutions, has some exposure in a severe and prolonged economic recession, but many of the Company’s products can be re-priced, which would allow the Company to reflect in its pricing any fundamental change which might occur in the risk associated with a particular industry or company within an industry. Although approximately 30 percent of the Company’s overall block of group income protection business is in the manufacturing and wholesale/retail industry segments, which tend to be economically sensitive, the Company has a well-diversified book of insurance exposure, with no disproportionate concentrations of risk in any one industry. The Company has also made changes in recent years through the application of best practices in the claims organization and believes it can respond to increased levels of submitted claims which might result from a further slowing economy.
(1) Before-tax reserve strengthening of $894.0 million was excluded from the computation of the benefit ratio and the before-tax operating income ratio for 2003. Including this strengthening, the ratios would have been 121.5% and (25.3)%, respectively.
Group income protection reported operating revenue of $3,794.5 million for 2003 compared to $3,473.5 million for 2002. The operating loss was $767.2 million for 2003 compared to operating income of $350.4 million for 2002. As previously discussed, during the fourth and first quarters of 2003, the Company strengthened its group income protection claim reserves $440.0 million and $454.0 million, respectively.
Operating revenue for group income protection improved due to increases in both premium income and net investment income. The $233.5 million growth in premium income during 2003 compared to the prior year is due to new sales growth in 2002 and favorable renewal activity and improved persistency on the existing block of business. Also contributing to premium growth was the 2003 acquisition of the United Kingdom group income protection business of Sun Life, as previously discussed. Premium income in the Company’s United Kingdom group long-term income protection business increased 41.2 percent, or $108.4 million, in 2003 relative to 2002. A portion of that reported growth also resulted from the favorable foreign currency exchange rate in 2003 relative to 2002. When measured in pounds sterling, the growth rate in premium income in the United Kingdom’s group long-term income protection was approximately 30.0 percent year over year. Net investment income grew $65.1 million primarily due to the growth in invested assets supporting this line of business. Included in other income are ASO fees of $46.5 million for 2003 and $33.9 million for the prior year.
Persistency during 2003 on the overall block of group income protection improved over 2002, with group long-term income protection persistency on the Company’s U.S. business at 87.2 percent compared to 86.5 percent in 2002. Group short-term income protection persistency for 2003 was 84.5 percent versus 81.5 percent for the year 2002.
A critical part of the Company’s strategy for group income protection involves executing its renewal program and managing persistency in its existing block of business, both of which management expects to have a positive effect on future profitability. The Company has implemented a pricing strategy in the group income protection line wherein prices may increase or decrease by market segment, as appropriate, to respond to current claim experience and other factors and assumptions, although pricing changes typically lag the changes in actual claim experience by several quarters.
The 2003 benefit ratio for group income protection was higher than in 2002, with the increase attributable to long-term income protection. Both submitted and paid claim incidence for group long-term income protection increased from 2002, although submitted incidence improved in the fourth quarter of 2003 relative to the third quarter. This continues to be driven in part by economic trends, including lower consumer confidence. Claim resolution rates for group long-term income protection in 2003 were lower than 2002 and 2001. Also contributing to the increase in the benefit ratio for group long-term income protection was the lower claim reserve discount rate used for new claims occurring in 2003, which resulted in the establishment of higher claim reserves in 2003. Payments to settle group long-term income protection claims in litigation increased in 2003 compared to 2002, while the number of new lawsuits filed decreased.
For short-term income protection, the 2002 benefit ratio was lower than in 2001. Paid claim incidence was marginally higher than 2001. The average weekly indemnity and premium per life continued to increase as expected, but the growth in premium per life was greater than the growth in the average weekly indemnity compared to the growth level relationships experienced in 2001. The average claim duration for closed short-term income protection claims was lower than in 2001.
Operating revenue was $607.6 million for 2003 compared to $528.5 million in 2002. Premium income increased 14.7 percent over the prior year, and net investment income increased 15.8 percent. Operating income in this block was $140.7 million in 2003 compared to $146.8 million in 2002. The benefit ratio for 2003 increased relative to the prior year, with a ratio of 57.5 percent in 2003 compared to 57.1 percent in 2002. The interest adjusted loss ratio was 44.7 percent and 43.4 percent for 2003 and 2002, respectively. The increase in the interest adjusted loss ratio is due to higher submitted incidence, offset partially by an increase in the net claim resolution rate. Individual income protection - recently issued results benefited from an improvement in both the commission and operating expense ratios relative to 2002.
Year Ended December 31, 2002 Compared with Year Ended December 31, 2001
Operating revenue for long-term care was $487.9 million, a 24.2 percent increase over 2002. Operating income for long-term care was $42.5 million for 2003 as compared to $23.1 million for 2002. The increase resulted primarily from continued growth in premium and net investment income and a decrease in commission and operating expense ratios.
Operating revenue for long-term care was $392.8 million in 2002, a 28.2 percent increase over 2001. Operating income in the long-term care line of business decreased to $23.1 million for 2002 compared to $31.8 million for 2001 due to an increase in the benefit ratio. The benefit ratio increase was driven primarily by the increase in active life reserves resulting from higher policy persistency and lower claim resolutions. The 2002 new claim rate, weighted by reserve dollar, exceeded the 2001 rate. The increase in the new claim rate over the prior year was driven by an increase in the average reserve size of new claims. The claim recovery rate decreased from the prior year. The commission and operating expense ratios both improved relative to 2001.
The Life and Accident segment includes insurance for life, accidental death and dismemberment, cancer, and critical illness marketed primarily to employers and multi-life employee groups by the Company’s sales force through independent brokers and consultants.
Sales for group life decreased 6.7 percent from 2002 due to a decrease in sales in the Company’s U.S. operations, partially offset by an increase in sales in the United Kingdom operations. The decline in U.S. group life sales is primarily attributable to lower large case sales and the continuing impact of the Company’s strategic decision, which was fully implemented during 2002, to focus on integrated sales of life and income protection and less on stand-alone life sales. The increase in the United Kingdom sales is partially due to the inclusion of additional sales generated as a result of the 2003 Sun Life acquisition. Sales for accidental death and dismemberment declined 35.3 percent in 2003 relative to sales in 2002 as the Company’s stand-alone large-employer life strategy impacts the accidental death and dismemberment rider sales in this product line. Brokerage voluntary life and other sales in 2003 increased 31.0 percent over the comparable prior year. It is expected that brokerage voluntary life and other will continue to report sales growth year over year.
Shown below are key performance indicators for group life and accidental death and dismemberment.
Group life and accidental death and dismemberment reported 2003 operating revenue of $1,875.7 million, a 4.7 percent increase over 2002, due to increases in group life premium income. Operating income was $227.9 million in 2003 compared to $221.9 million in 2002.
“scheduled” amortization may eliminate the need for additional amortization related to the deterioration of actual persistency relative to “scheduled” or expected persistency.
The benefit ratio and operating expense ratio both declined in 2002 relative to 2001. The amortization of deferred policy acquisition costs for 2002 includes $9.2 million of additional amortization due to the higher level of terminations for group life and accidental death and dismemberment products experienced during 2002 than expected at the time the policies were written. The unfavorable variance of actual to expected terminations occurred primarily in the group life product line. Although the overall block of group life business experienced favorable persistency compared to the previous year, certain issue year business did not persist at the levels expected when the business was issued. The additional amortization during 2001 for group life and accidental death and dismemberment was $15.2 million.
Shown below are key performance indicators for brokerage voluntary life and other.
The Company considers the group life and accidental death and dismemberment products as being complimentary to its group income protection products. Sales of stand-alone group life, without additional lines of coverage, are not a focus of the Company. Sales of group life and accidental death and dismemberment are expected to be relatively flat with 2003 levels and, like group income protection, will be primarily focused on a more balanced mix of sales between large, medium, and small employer markets. The Company intends to continue its disciplined approach to risk selection and pricing. Since the group life and accidental death and dismemberment products are primarily sold in conjunction with group income protection, the more focused renewal effort in group income protection is expected to reduce persistency somewhat in the group life line as well. The benefit ratio is expected to remain relatively flat with the prior year.
The Company will continue to concentrate on sales growth and increased profitability for its voluntary brokerage and other lines and expects that the sales growth pattern of recent years will continue during 2004.
The Colonial segment includes insurance for income protection, accident and sickness, life, cancer, and critical illness issued by the Company’s subsidiary Colonial Life & Accident Insurance Company and marketed primarily to employees through an agency field sales force.
Sales for the Colonial segment in 2003 increased 10.9 percent compared to sales in 2002. The sales increase in 2003 relative to 2002 is primarily attributable to 13.1 percent growth in the life product line and 9.1 percent in income protection. The accident line included in the income protection block had a 2003 sales increase of 28.3 percent relative to 2002. Sales growth was strong in 2002 as well, with an increase of 5.8 percent over 2001. The Company expects continued strong sales results in this segment.
Operating income for 2003 was $146.7 million compared to $137.5 million in 2002. The overall 2003 benefit ratio for this segment was slightly higher than 2002. The life and income protection product lines each reported an increase in the benefit ratio compared to the prior year. The individual short-term income protection line reported a decrease in claim incidence for 2003 compared with the prior year while the average claim duration for closed claims was above the prior year. The average indemnity for individual short-term income protection was higher than 2002. For accident and sickness, the claim incidence rate increased slightly in 2003 relative to 2002. In the life product line, average paid claims decreased in 2003 compared to last year. The 2003 incidence rate for the cancer products and the critical illness products decreased from the prior year. The segment reported an increase in the commission ratio but a decline in the operating expense ratio for 2003 relative to 2002.
For 2002, the benefit ratio for this segment decreased relative to 2001. The individual short-term income protection product reported an increase in the average indemnity relative to 2001 but a decline in the average claim duration for closed claims and a flat incidence rate relative to the prior year. Life paid claims, as well as the average claim size, increased in 2002 relative to 2001. The cancer block results benefited from the reinsurance transaction entered into during the fourth quarter of 2001, as previously discussed. The segment reported increases in the commission and operating expense ratios for 2002 relative to 2001.
The Company’s key areas of focus in 2004 for Colonial are sales growth, revenue growth and increased profitability. Continuation of efforts in providing quality service will also be a focus for the Company. While the Colonial segment is already profitable and efficiently operated, past sales results have not grown at the same rate as the Company believes it can competitively achieve. In 2004, the emphasis will be on achieving consistent, profitable, sales growth by focusing on the recruitment and productivity of agents, improved business tools, enhanced marketing research and development, balanced sales compensation, and focused recognition and incentive programs.
Growth in revenue and profitability will be driven by increasing premium income through sales growth and stable persistency while maintaining a focus on high-quality business and the management of expenses.
The Company’s reinsurance operations include the reinsurance management operations of Duncanson & Holt, Inc. (D&H) and the risk assumption, which includes reinsurance pool participation; direct reinsurance which includes accident and health (A&H), long-term care (LTC), and long-term disability coverages; and Lloyd’s of London (Lloyd’s) syndicate participations. During the years 1999 through 2001, the Company exited its reinsurance pools and management operations through a combination of a sale, reinsurance, and/or placement of certain components in run-off.
The reinsurance pools and management operations reported premium income of $6.6 million in 2003 compared to $16.7 million and $61.3 million in 2002 and 2001. During 2003 and 2002, the reinsurance pools and management operations reported operating losses of $7.1 million and $3.2 million, respectively, compared to operating income of $0.1 million in 2001.
Total operating revenue for individual life and corporate-owned life insurance was $39.9 million, $42.2 million, and $42.9 million in 2003, 2002, and 2001, respectively. Operating income for the same periods was $33.5 million, $41.6 million, and $39.4 million.
Operating results for 2001 were negatively impacted relative to 2003 and 2002 due to goodwill amortization of $21.2 million, which included a $5.4 million write-down of goodwill related to the Company’s Argentinean operation. See previous discussion under “Other Segment Operating Results.”
During 2003, the Company entered into an agreement to sell its Canadian branch to RBC Insurance, the insurance operation of Royal Bank of Canada. The Canadian branch is accounted for as an asset held for sale at December 31, 2003 and also meets the accounting criteria for being reported as a discontinued operation in the consolidated financial statements. The transaction is expected to close in the first half of 2004.
In conjunction with the classification of the Canadian branch as an asset held for sale, the Company tested the goodwill related to the Canadian branch for impairment and determined that the balance of $190.9 million was impaired, based on fair value measurements which used the quoted market value of the Canadian branch. The Company also recognized a loss of $9.3 million before tax and $6.0 million after tax to write down the value of bonds in the Canadian branch investment portfolio to market value. These two charges are included in the $161.7 million loss from discontinued operations, net of tax, reported in the consolidated statements of operations.
• The majority of investments are in high quality publicly traded securities to ensure the desired liquidity and preserve the capital value of the Company’s portfolios.
• The Company intends to manage the risk of losses due to changes in interest rates by matching asset duration with liabilities to within a range of +/- 3 years.
• The portfolio is to be diversified across industry classification and geographic lines.
• Derivative instruments may be used to hedge interest rate risk and match liability duration and cash flows consistent with the plan approved by the board of directors.
• The allocation of assets and the selection and timing of the acquisition and disposition of investments are subject to ratification by the investment subcommittee of the board of directors on a weekly basis. These actions are also reviewed and approved by the board of directors on a quarterly basis.
• These investment policies and guidelines are reviewed and appropriately adjusted by the board of directors annually, or more frequently if deemed necessary.
As previously discussed, during 2003 the Company entered into an agreement to sell its Canadian branch. The transaction is expected to close during the first half of 2004. The Canadian branch meets the accounting criteria for being reported as a discontinued operation in the consolidated financial statements and as such, its assets and liabilities are reported separately in the Company’s consolidated statements of financial condition. The Company will be retaining a portion of the Canadian branch fixed maturity bond portfolio according to the terms of the transaction. The specific bonds to be transferred have not yet been identified by the buyer, although the aggregate fair value of bonds to be transferred is approximately $1.1 billion, or 3.5 percent of the fair value of the Company’s total fixed maturity bond portfolio as of December 31, 2003. Because the specific investments to be transferred have not been identified, the disclosures on the following pages will in some instances necessarily include the total Canadian investment portfolio, including those which will be transferred to the buyer when the transaction closes, with an appropriate disclosure noting that the information includes fixed maturity securities reported separately as discontinued operations in the consolidated statements of financial condition.
Net investment income increased $129.5 million in 2003, or 6.4 percent, over the previous year. For 2002, net investment income increased $77.8 million, or 4.0 percent, relative to 2001. The overall yield in the portfolio, including fixed maturity securities reported as discontinued operations, was 7.15 percent as of December 31, 2003, compared to 7.76 percent and 8.02 percent at the end of 2002 and 2001, respectively. In the current low interest rate market, the Company expects that the portfolio yield will continue to gradually decline, until the market rates increase above the level of the overall yield, due to lower yields on new purchases.
The Company reported before-tax net realized investment losses during the last three years as shown in the following chart, which excludes an estimate of realized investment gains and losses related to the fixed maturity securities reported as discontinued operations in each applicable time period. Write-downs were recognized as a result of management’s determination that the value of certain fixed maturity and equity securities had other than temporarily declined during the applicable reporting period, as well as the result of further declines in the values of fixed maturity and equity securities that had initially been written down in a prior period. The value of the securities was determined to have other than temporarily declined or to have further declined from the initial impairment based on the factors discussed herein in “Critical Accounting Policies.” The Company anticipates additional investment losses may occur during 2004. The Company adopted DIG Issue B36, as previously discussed, effective October 1, 2003, and reported the fourth quarter changes in fair values of the embedded derivatives in realized investment gains and losses, as shown in the following chart.
Approximately 46 percent of the 2003 write-downs in continuing operations occurred in the energy and utilities industries. The following list includes write-downs representing five percent or greater of the total 2003 write-downs, the circumstances that contributed to the write-downs, the length of time the security had been in a continual loss position, whether it was investment-grade or below-investment-grade at the time of initial purchase and at the time of the write-down, and how the circumstances of the write-down might cause impairments in other material investments held by the Company.
• $11.0 million loss during the third quarter of 2003 on securities issued by a travel services company located in the United Kingdom. The write-down represented 5.9 percent of the total write-downs for 2003. The write-down was taken following discussions between the issuer and its creditors regarding difficulties in the issuer’s businesses due to geopolitical unrest and persistent weakness in demand for leisure travel and requests for certain waivers and consents of debt covenants. These securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the first quarter of 2003. At the time of the write-down, these securities had been continuously in an unrealized loss position for a period of greater than 270 days but less than one year. The circumstances of this impaired investment have no impact on other investments.
• $44.0 million loss during the second quarter of 2002 on securities issued by a Canadian telecommunications company engaged in transporting voice and data over its global fiber optic network. The write-down represented 9.9 percent of the total write-downs for 2002. This company had an investment-grade rating immediately prior to the time its parent company unexpectedly withdrew its support for the subsidiary in April 2002. The investment was subsequently downgraded to below-investment-grade in the second quarter of 2002. Prior to its write-down, the investment had been in an unrealized loss position for a period of greater than two years but less than three years. The Company owns fixed maturity securities issued by another regulated subsidiary under common ownership, but this investment has not been negatively impacted, is not considered impaired, and was in an unrealized gain position at December 31, 2003.
Approximately 50 percent of the 2001 write-downs in continuing operations occurred in the communications sector. The following list includes write-downs representing five percent or greater of the total 2001 write-downs, the circumstances that contributed to the write-downs, and how those circumstances might cause impairments in other material investments held by the Company.
• $29.0 million loss during the fourth quarter of 2001 on securities issued by a global integrated telecommunications company, after the company announced in January 2002 that it would be seeking bankruptcy protection. The write-down represented 13.7 percent of the total write-downs for 2001. The company had approximately $2 billion of cash as of September 30, 2001, the most recent reporting date prior to the write-down. The investment was originally purchased as part of the Company’s below-investment-grade strategy. Prior to its write-down, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The circumstances of this impaired investment have no impact on other investments.
• $23.6 million loss during the fourth quarter of 2001 on securities issued by a leading U.S. based energy company. The write-down represented 11.1 percent of the total write-downs for 2001. This company had an investment-grade rating prior to allegations of fraud and accounting irregularities in November 2001. The company subsequently filed for Chapter 11 bankruptcy protection in December 2001. The investment was downgraded to a below-investment-grade status in the fourth quarter of 2001. Prior to its write-down, the investment had been in an unrealized loss position for a period of greater than 180 days but less than 270 days. At the time of the write-down, the Company owned senior notes of a related entity. This security was subsequently sold during 2002. The Company also owns securities of another related entity, a utility
• $15.0 million loss during the third quarter of 2001 on securities issued by an internet data and web-hosting company, after it was deemed probable in September 2001 that the company might seek to restructure. The write-down represented 7.1 percent of the total write-downs for 2001. The investment was originally purchased as part of the Company’s below-investment-grade strategy. Prior to its write-down, the investment had been in an unrealized loss position for a period greater than one year but less than two years. The circumstances of this impaired investment have no impact on other investments.
Realized Investment Losses During 2003 - Sale of Fixed Maturity Securities
During the year ended December 31, 2003, the Company realized a loss of $143.6 million on the sale of fixed maturity securities in its continuing operations. The securities sold had a book value of $821.0 million and a fair value of $677.4 million at the time of sale and represented 94 different issuers, of which approximately 59 percent were a part of the Company’s previously discussed program to reduce its below-investment-grade fixed maturity securities holdings. Realized investment losses representing five percent or more of the total loss recognized during 2003 are as follows:
• $11.1 million loss during the second and fourth quarters of 2003 on the sale of unsecured debt and private, secured debt obligations issued by a major domestic airline, representing 7.7 percent of the realized investment loss on sales of fixed maturity securities in 2003. The Company sold the securities to reduce its exposure to the airline. These securities had an investment-grade rating until downgraded in the third quarter of 2001. At the time of sale, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The circumstances of this investment have no impact on other investments.
• The Company realized $34.0 million in losses on the sale of securities issued by a U.S. based global telecommunications company providing global voice and data services, representing 54.8 percent of the total realized investment loss on sales of fixed maturity securities in 2002. This company had misclassified certain expenses, materially changing the reported financial condition and profitability of the business. The price of this issuer’s securities dropped significantly in the second quarter of 2002 as the information became public. This company is under multiple investigations, and several senior officers of the issuer have been accused of committing major accounting fraud. These circumstances were significant enough for the Company to change its intent to hold these securities to maturity or recovery. The investment was downgraded to below-investment-grade in the second quarter of 2002, and, at the time of sale, had been in
• The Company realized $5.9 million in losses on the sale of securities issued by an energy services company engaged in offshore seismic surveying and floating energy production, representing 9.5 percent of the total realized investment loss on sales of fixed maturity securities in 2002. Industry conditions in the energy sector, which is cyclical and driven by the supply and demand for oil and gas, had impacted profit margins, and the company lacked liquidity in the near-term. The investment was downgraded to below-investment-grade status in the second quarter of 2002, causing the investment holdings of this issuer to exceed the Company’s individual issuer group limits established by the Company’s board of directors. As a result, the Company sold the securities in order to lower its overall holding of securities issued by this company. At the time of sale, the investment had been in an unrealized loss position for a period of more than three years. The circumstances of this investment have no impact on other investments.
• The Company realized $3.9 million in losses on the sale of a below-investment-grade structured security backed by a pool of high yield bonds, representing 6.3 percent of the total realized investment loss on sales of fixed maturity securities in 2002. The continued high level of defaults in the high-yield market and in this pool in particular continued to impact the credit quality of this investment. A review of the investment led to the conclusion that, while a decline in the level of defaults in the general market was expected, no improvement in the prospects for this structured security was expected. This conclusion resulted from the deterioration of the underlying pool of high yield bonds and the deteriorating performance record of the pool’s manager. The investment was downgraded to below-investment-grade status in the third quarter of 2001 and, at the time of sale, had been in an unrealized loss position for a period of greater than 270 days but less than 360 days. The circumstances of this investment have no impact on other investments.
During the year ended December 31, 2001, the Company realized a loss of $32.0 million on the sale of fixed maturity securities in its continuing operations. These securities had a book value of $525.0 million and a fair value of $493.0 million at the time of sale and represented 62 different issuers. Realized investment losses representing five percent or more of the total loss recognized during 2001 are as follows:
• The Company realized $9.8 million in losses on the sale of senior unsecured notes of the finance subsidiary of a large global food and beverage packaging manufacturer, representing 30.6 percent of the total realized investment loss on sales of fixed maturity securities in 2001. This company had a large asbestos liability, limited liquidity, and a large amount of maturing debt in the near term relative to expected cash flows. The Company sold these bonds in anticipation of further credit deterioration, price depreciation, rating downgrades, and a possible bankruptcy. At the time of sale, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The circumstances of this investment have no impact on other investments.
U.S. Government Agencies and Municipalities: This sector includes the U.S. Government Treasury Department, government agencies, and government-sponsored enterprises. The increase in U.S. Treasury interest rates during the third quarter of 2003 adversely affected the market value of the Company’s holdings in this sector. The sector has minimal credit risk and excellent liquidity, which enables the Company to maintain a higher limitation on investments in these subsectors.
is power generation over-capacity in several parts of the U.S. where supply may exceed demand for several years. Those power plants whose main fuel supply is natural gas will continue to experience deteriorating margins due to the high cost of that commodity. A number of investigations and court rulings have been resolved due to the western states power crisis in 2001 and 2002, but several still remain outstanding, which could result in negative outcomes for certain utility companies.
The following table shows the length of time the Company’s below-investment-grade fixed maturity bonds had been in a gross unrealized loss position as of December 31, 2003. The fair value and gross unrealized losses are categorized by the relationship of the current fair value to amortized cost for those securities on December 31, 2003. The fair value to amortized cost relationships are not necessarily indicative of the fair value to amortized cost relationships for the securities throughout the entire time that the securities have been in an unrealized loss position nor are they necessarily indicative of the relationships subsequent to December 31, 2003.
As previously discussed under “Critical Accounting Policies” contained herein, in determining whether a decline in fair value below amortized cost of a fixed maturity security is other than temporary, the Company utilizes a formal, well-defined, and disciplined process to monitor and evaluate its fixed income investment portfolio. It includes certain members of senior management in addition to the Company’s other investment and accounting professionals. The process results in a thorough evaluation of problem investments and write-downs on a timely basis of investments determined to have an other than temporary impairment.
The Company has an investment in a special purpose entity which is a collateralized bond obligation asset trust in which the Company holds interests in several of the tranches and for which the Company acts as investment manager of the underlying securities. This special purpose entity did not meet the consolidation requirements of FIN 46. The Company’s investment in this entity was reported at fair value with fixed maturity securities in the consolidated statements of financial condition. The fair value of this investment was derived from the fair value of the underlying assets. The fair value and amortized cost of this investment was $27.0 million and $26.1 million, respectively, at December 31, 2003, and $6.9 million and $30.9 million, respectively, at December 31, 2002.
The Company had no impaired mortgage loans at December 31, 2003. At December 31, 2002, impaired mortgage loans totaled $6.0 million. Impaired mortgage loans are not expected to have a material impact on the Company’s liquidity, financial position, or results of operations.
Restructured mortgage loans totaled $7.5 million and $7.8 million at December 31, 2003 and 2002, respectively, and represent loans that have been refinanced with terms more favorable to the borrower. Interest lost on restructured loans was immaterial for 2003 and 2002.
The Company uses a comprehensive rating system to evaluate the investment and credit risk of each mortgage loan and to identify specific properties for inspection and reevaluation. The Company establishes an investment valuation allowance for mortgage loans based on a review of individual loans and the overall loan portfolio, considering the value of the underlying collateral. Investment valuation allowances for real estate held for sale are established based on a review of specific assets. If a decline in value of a mortgage loan or real estate investment is considered to be other than temporary or if the asset is deemed permanently impaired, the investment is reduced to estimated net realizable value, and the reduction is recognized as a realized investment loss. Management monitors the risk associated with these invested asset portfolios and regularly reviews and adjusts the investment valuation allowance. At December 31, 2003, the balance in the valuation allowances for real estate was $9.3 million. No valuation allowance was held for mortgage loans at December 31, 2003.
During 2003, the Company recognized net gains of $79.6 million on the termination of cash flow hedges and reported $79.1 million in other comprehensive income (loss) and $0.5 million as a component of realized investment gains and losses. The Company amortized $17.3 million of net deferred gains into net investment income during 2003. The Company’s current credit exposure on derivatives, which is limited to the value of those contracts in a net gain position, was $62.9 million at December 31, 2003. Additions and terminations, in notional amounts, to the Company’s hedging programs for 2003, were $3,945.0 million and $1,326.6 million, respectively. The notional amount of derivatives outstanding under the hedge programs was $4,001.2 million at December 31, 2003.
The Company’s exposure to non-current investments totaled $235.9 million at December 31, 2003, or 0.8 percent of invested assets from continuing operations, excluding ceded policy loans. These non-current investments are fixed income securities, foreclosed real estate, and mortgage loans that became more than thirty days past due in principal and interest payments. Approximately $155.9 million of these investments had principal and interest payments past due for a period greater than one year.
Operating cash flows are primarily attributable to the receipt of premium and investment income, offset by payments of claims, commissions, expenses, and income taxes. Premium income growth is attributable not only to new sales, but to renewals of existing business, renewal price increases, and stable persistency. Investment income growth is due to the growth in the underlying assets supporting the Company’s insurance reserves, somewhat offset by a decline in portfolio yield rates. The growth in commissions and operating expenses is attributable primarily to new sales growth and the first year acquisition expenses associated with new business. The increase in paid claims is due partially to the continued growth and aging of the block of business and also to the general economy, as previously discussed in the operating results by segment.
Net cash used in investing activities decreased $132.0 million in 2002 relative to 2001, to $1,586.9 million compared to $1,718.9 million in the prior year. In 2002, the Company had a net sale of short-term investments of $162.0 million compared to a net purchase of $101.2 million in 2001. Additionally, the Company generated $468.8 million in higher proceeds from maturities of available-for-sale securities in 2002 than in 2001 primarily due to an increase in bond calls and mortgage backed security prepayments.
Financing cash flows consist primarily of borrowings and repayments of debt, issuance or repurchase of common stock, and dividends paid to stockholders. Net cash provided by financing activities was $734.8 million for 2003 compared to net cash used of $178.4 million for 2002. The $913.2 million increase in cash from financing activities in 2003 from 2002 was due to the Company’s combined offering in May 2003, as discussed as follows under “Debt and Capital,” which provided $575.0 million in proceeds from the issuance of long-term debt, less underwriting discounts of $17.2 million, and $547.7 million in net proceeds from the issuance of common stock. Proceeds from the issuance of long-term debt in 2002 were $400.0 million, used primarily to refinance existing commercial paper borrowings.
The ability of the Company to continue to receive dividends from its insurance subsidiaries without regulatory approval will be dependent upon the level of earnings of its insurance subsidiaries as calculated under law. In addition to regulatory restrictions, the amount of dividends that will be paid by insurance subsidiaries will depend on additional factors, such as risk-based capital ratios, funding growth objectives at an affiliate level, and maintaining appropriate capital adequacy ratios to support the ratings desired by the Company. Insurance regulatory restrictions do not limit the amount of dividends available for distribution to the Company from its non-insurance subsidiaries except where the non-insurance subsidiaries are held directly or indirectly by an insurance subsidiary and only indirectly by the Company. The Company’s risk-based capital (RBC) ratio for its U.S. insurance subsidiaries, calculated on a weighted average basis using the NAIC Company Action Level formula, was 247 percent and 210 percent at the end of 2003 and 2002, respectively. The increase in the ratio during 2003 resulted primarily from capital contributions of $510.0 million in cash and $119.6 million in other assets. The cash contributions resulted from the combined offering in May 2003, as further discussed under “Debt and Capital” below. The individual RBC ratios for the Company’s principal operating subsidiaries ranged from 216 percent to 305 percent at December 31, 2003. The individual RBC ratio for each insurance subsidiary is above the range that would require state regulatory action. The Company anticipates that its RBC ratio for its U.S. insurance subsidiaries, calculated on a weighted average basis, will increase from 247 percent, as reported at the end of 2003, to approximately 277 percent upon completion of the sale of the Canadian branch.
At December 31, 2003, the debt to total capital ratio was 31.6 percent compared to 29.5 percent at December 31, 2002 and 29.8 percent at December 31, 2001. The debt to total capital ratio, when calculated allowing 50 percent equity credit for the Company’s junior subordinated debt securities and 80 percent equity credit for the Company’s adjustable conversion-rate equity security units, was 24.7 percent at December 31, 2003 compared to 27.7 percent at December 31, 2002 and 28.0 percent at December 31, 2001.
During 2001 the Company redeemed its $172.5 million par value 8.8% monthly income debt securities (junior subordinated debt), which were due in 2025 but callable at par in 2000 and thereafter. The early extinguishment of debt resulted in a fourth quarter of 2001 write-off of the remaining deferred debt cost of $4.5 million associated with the issuance of the securities.
In 1998, Provident Financing Trust I issued $300.0 million of 7.405% capital securities in a public offering. These capital securities, which mature on March 15, 2038, are fully and unconditionally guaranteed by the Company, have a liquidation value of $1,000 per capital security, and have a mandatory redemption feature under certain circumstances. The Company issued $300.0 million of 7.405% junior subordinated deferrable interest debentures, which mature on March 15, 2038, to Provident Financing Trust I in connection with the capital securities offering. The sole assets of Provident Financing Trust I are the junior subordinated debt securities.
During the second quarter of 2002, the Company’s board of directors authorized a common stock repurchase program under which the Company acquired approximately 1.8 million shares of its common stock in the open market at an aggregate cost of approximately $45.0 million. The treasury stock is used in connection with the Company’s benefit and compensation plans and for other corporate purposes. The program expired in 2003.
Contractual debt, junior subordinated debt securities, adjustable conversion-rate equity security units, and lease commitments are as follows (in millions of dollars):
The table below reflects the debt ratings, as of the date of this filing, for the Company and the financial strength ratings for the U.S. domiciled insurance company subsidiaries.
The Company maintains separate U.S. and foreign pension plans and a U.S. post-retirement benefit plan. The U.S. pension plans comprise the majority of the total benefit obligation and pension expense for the Company. The value of the benefit obligations is determined based on a set of economic and demographic assumptions that represent the Company’s best estimate of future expected experience. These assumptions are reviewed annually. Two of the economic assumptions, the discount rate and the long-term rate of return, are adjusted accordingly based on key external indices. The assumptions chosen for U.S. pension plans and the U.S. postretirement plan use consistent methodology but reflect the differences in the plan obligations. The Company follows Statements of Financial Accounting Standards No. 87, Employer’s Accounting for Pensions (SFAS 87), No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions (SFAS 106), and No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits (SFAS 132) in its financial reporting and accounting for its pension and post-retirement benefit plans.
postretirement plan cash flows, a discount rate of 6.10 percent was used as of December 31, 2003. The discount rate for the postretirement plan as of December 31, 2002 and 2001 was the same as that used for the U.S. pension plans. Lowering the discount rate by 0.5 percent would have increased the 2003 pension expense for the U.S. pension plans by $8.5 million and would be expected to result in an $8.6 million increase in the 2004 pension plan expense.
For the U.S. pension plans, the actual asset allocation at December 31, 2003 was 75 percent equities and 25 percent fixed income securities. The Company adopted a new investment policy in December 2003, as previously discussed, and began rebalancing the asset mix of the investment portfolio at that time. The investment portfolio contains a diversified blend of large, mid, small, and convertible equity securities, as well as core and high yield fixed income securities. The Company uses a compound interest method in computing the rate of return on pension plan assets. Lowering the expected long-term rate of return on the plan assets by 0.5 percent would have increased the 2003 pension expense by approximately $1.8 million. For 2004, lowering the assumption by 0.5 percent would increase pension expense by approximately $2.1 million.
The Company holds an unrecognized net gain or loss representing cumulative liability and asset gains and losses that have not been recognized in pension expense. As of December 31, 2003, there was an estimated unrecognized loss of approximately $268.3 million in the U.S. pension plans. As of December 31, 2002 and 2001, the unrecognized loss was $291.2 million and $38.0 million, respectively. The unrecognized loss has increased due to asset market value losses that occurred during 2001 and 2002 and the drop in the year end discount rate from 7.35 percent at 2001, to 6.75 percent at 2002, and to 6.25 percent at 2003. The unrecognized net gain or loss is amortized in the pension expense. Only amounts outside of a corridor (equal to 10 percent of the greater of the projected benefit obligation or market-related value of assets) are amortized. The 2004 pension expense is expected to include a loss amortization of approximately $16.0 million. This loss amortization was $18.0 million in 2003 and $1.0 million in 2002. In 2001, the pension expense included gain amortization of $4.0 million.
We have audited the accompanying consolidated statements of financial condition of UnumProvident Corporation and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting and reporting for certain special purpose entities effective December 31, 2003; its method of accounting for embedded derivatives within certain reinsurance arrangements effective October 1, 2003; its method of accounting for stock-based employee compensation plans effective January 1, 2003; and, its method of accounting for goodwill and other intangible assets effective January 1, 2002.
sale is valued net of a valuation allowance that reduces the carrying value to the lower of cost less accumulated depreciation or fair value less estimated cost to sell. Accumulated depreciation on real estate was $13.2 million and $15.0 million as of December 31, 2003 and 2002, respectively.
Policy Loans are presented at unpaid balances directly related to policyholders. Included in policy loans are $2,684.5 million and $2,548.0 million of policy loans ceded to reinsurers at December 31, 2003 and 2002, respectively.
The accounting for changes in the fair value (i.e., gain or loss) of a derivative depends on whether it has been designated and qualifies as part of a hedging relationship, and further, on the type of hedging relationship. To qualify as a hedging instrument, a derivative must pass prescribed effectiveness tests, performed quarterly or on a more frequent basis using both qualitative and quantitative methods. For those derivatives that are designated and qualify as hedging instruments, the derivative is designated, based upon the exposure being hedged, as one of the following:
Cash flow hedge. To the extent it is effective, changes in the fair value of the derivative are reported in other comprehensive income and reclassified into earnings in the same period or periods during which the hedged item affects earnings. The ineffective portion of the hedge, if any, is recognized in current operating earnings during the period of change in fair value. The gain or loss on the termination of an effective cash flow hedge is reported in other comprehensive income and reclassified into earnings in the same period or periods during which the hedged item affects earnings.
Property and Equipment: Property and equipment is reported at cost less accumulated depreciation, which is calculated on the straight-line method over the estimated useful life. The accumulated depreciation for property and equipment was $422.4 million and $383.9 million as of December 31, 2003 and 2002, respectively.
Revenue Recognition: Traditional life and accident and health products are long duration contracts, and premium income is recognized as revenue when due from policyholders. If the contracts are experience rated, the estimated ultimate premium is recognized as revenue over the period of the contract. The estimated ultimate premium, which is revised to reflect current experience, is based on estimated claim costs, expenses, and profit margins. For interest-sensitive products, the amounts collected from policyholders are considered deposits, and only the deductions during the period for cost of insurance, policy administration, and surrenders are included in revenue. Policyholders’ funds represent funds deposited by contract holders and are not included in revenue.
Policyholders’ Funds: Policyholders’ funds represent customer deposits plus interest credited at contract rates. The Company controls its interest rate risk by investing in quality assets which have an aggregate duration that closely matches the expected duration of the liabilities.
Effective January 1, 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation, and selected the prospective method of adoption allowed under the provisions of Statement of Financial Accounting Standards No. 148 (SFAS 148), Accounting for Stock-Based Compensation - Transition and Disclosure. The recognition provisions will be applied to all employee awards granted, modified, or settled after January 1, 2003.
As previously discussed, effective January 1, 2003, the Company adopted the fair value recognition provisions of SFAS 123 and selected the prospective method of adoption allowed under the provisions of SFAS 148. SFAS 123 establishes financial accounting and reporting standards for stock-based employee compensation plans. SFAS 148 amended SFAS 123 to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS 148 also amended the disclosure requirements of SFAS 123. The adoption decreased after tax results for 2003 approximately $0.6 million.
Effective December 31, 2003, the Company adopted the provisions of Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51. FIN 46 expands upon ARB No. 51, Consolidated Financial Statements, to address financial accounting and reporting for certain entities in which a controlling financial interest cannot be identified based on an evaluation of voting interests. Transition to the provisions of FIN 46 required the Company to consolidate four special purpose entities whose purposes are to support the Company’s
Effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets. SFAS 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets. In accordance with SFAS 142, goodwill is no longer amortized but is subject to annual impairment tests. Prior to January 1, 2002, goodwill was amortized on a straight-line basis over a period not to exceed 40 years. Other intangible assets continue to be amortized over their useful lives.
The Company reclassified its January 1, 2002 goodwill asset balance of $663.7 million from the Corporate segment to the Income Protection segment, which is the segment expected to benefit from the originating business combinations. Had the amortization of goodwill been excluded from income for the year ended December 31, 2001, net income would have been $561.5 million ($2.30 per common share assuming dilution).
As discussed in Note 1, during 2003 the Company entered into an agreement to sell its Canadian branch and expects to close the transaction during the first half of 2004. This transaction will improve the statutory capital position of the Company’s insurance subsidiary which currently owns the Canadian branch as well as allow the Company to focus on its core operations. The Canadian branch is accounted for as an asset held for sale at December 31, 2003 and is reported as discontinued operations in the accompanying consolidated financial statements. During the fourth quarter of 2003, in conjunction with the classification of the Canadian branch as an asset held for sale, the Company tested the goodwill
Prior year operating results related to the Canadian branch, which previously were primarily reported in the Income Protection segment, have been reclassified to discontinued operations for all years presented.
The December 31, 2003 gross unrealized losses on the redeemable preferred stocks and equity securities are attributable to holdings from 2 issuers and 16 issuers, respectively.
Of the $491.0 million in gross unrealized losses on fixed maturity bonds at December 31, 2003, $337.1 million, or 68.7 percent, are related to investment-grade fixed maturity bonds. Unrealized losses on investment-grade fixed maturity securities principally relate to changes in interest rates or changes in market or sector credit spreads which occurred subsequent to the acquisition of the securities. The gross unrealized loss on below-investment-grade fixed maturity bonds (securities rated below Baa3 by Moody’s Investors Service or an equivalent internal rating) was $153.9 million at December 31, 2003, or 31.3 percent, of the total gross unrealized loss on fixed maturity bonds. Generally, below-investment-grade fixed maturity securities are more likely to develop credit concerns.
If the Company determines that the decline in value of an investment is other than temporary, the investment is written down to fair value, and an impairment loss is recognized in the current period to the extent of the decline in value. For those fixed maturity securities with an unrealized loss and on which the Company has not recorded an impairment write-down, the Company believes that the decline in fair value below amortized cost is temporary.
At December 31, 2003, the total investment in below-investment-grade fixed maturity securities was $2,442.7 million or 7.8 percent of invested assets excluding ceded policy loans and the fixed maturity securities reported as discontinued operations. The amortized cost of these securities was $2,495.4 million.
The Company has a significant investment in, but is not the primary beneficiary of, a certain special purpose entity. This entity is a collateralized bond obligation asset trust (CBO) in which the Company holds interests in several of the tranches and for which the Company acts as investment manager of the underlying securities. The Company issued the CBO in 1998, and its purpose is to securitize high yield bonds and earn a spread over the cost of the funds from the different tranches issued. The outstanding balance of all tranches was $355.3 million at December 31, 2003, of which third parties hold $299.0 million. These third parties have no recourse against the Company. The total value of the CBO assets is $295.1 million at December 31, 2003. The Company’s maximum exposure to loss and total carrying value of its interests in the CBO is $27.0 million at December 31, 2003.
At December 31, 2003, the Company had capital commitments of $38.8 million to fund certain of its private placement fixed maturity securities. The funds are due upon satisfaction of contractual notice from the issuer. These amounts may or may not be funded during the term of the security.
The components of the change in the net unrealized gain on securities and the change in the net gain on cash flow hedges included in other comprehensive income (loss) are as follows. Changes related to the fixed maturity securities reported as discontinued operations in the consolidated statements of financial condition are included. Certain prior year amounts have been reclassified to confirm to current year reporting.
To help limit the credit exposure of the derivatives, the Company has entered into master netting agreements with its counterparties whereby contracts in a gain position can be offset against contracts in a loss position. The Company also typically enters into bilateral, cross-collateralization agreements with its counterparties to help limit the credit exposure of the derivatives. These agreements require the counterparty in a loss position to submit acceptable collateral with the other counterparty in the event the net loss position meets or exceeds an agreed upon amount. The Company’s current credit exposure on derivatives, which is limited to the value of those contracts in a net gain position, was $62.9 million at December 31, 2003.
The Company’s derivatives all qualify as hedges and have been designated as cash flow hedges. The cash flow hedging programs are described as follows.
The Company has executed a series of cash flow hedges in the group income protection, individual income protection, and group and individual long-term care portfolios using forward starting interest rate swaps. The purpose of these hedges is to lock in the reinvestment rates on future anticipated cash flows through the year 2013 and protect the Company from the potential adverse impact of declining interest rates on the associated policy reserves. The Company plans on terminating these forward interest rate swaps at the time the projected cash flows are used to purchase fixed income securities.
The Company has executed a series of cash flow hedges using forward contracts on credit spreads. Forward contracts on credit spreads are used to hedge fluctuations in the credit risk rate and to improve the matching of assets and liabilities. A forward contract on credit spreads is an agreement in which the Company agrees with other parties to settle for cash, at a specified future date, the computed value of the change in credit spreads of a specific bond. The Company intends to purchase this specific bond at its current market value at the same time the forward contract is terminated. By entering into the forward contract, the Company is able to lock in the credit spread component of this specific bond’s purchase yield.
The Company has invested in certain structured fixed maturity securities that contain embedded derivatives. These embedded derivatives represent forward contracts and are accounted for as cash flow hedges. The purpose of these forward contracts is to hedge the risk of changes in cash flows related to the anticipated purchase of certain equity securities.
The Company has also used forward starting swaps to hedge the interest rate on anticipated issuance of debt. The Company recognized a loss of $10.6 million during 2002 upon the termination of these swaps and reported the loss in other comprehensive income (loss). The loss is being amortized into earnings as a component of interest expense over the expected remaining life of the hedged debt instrument. See Note 9 for further discussion.
During 2003, the Company recognized net gains of $79.6 million upon the termination of cash flow hedges and reported $79.1 million of these gains in other comprehensive income (loss) and $0.5 million in operating earnings as realized investment gains. During 2002, the Company recognized net gains of $45.4 million upon the termination of cash flow hedges and reported $42.1 million of these gains in other comprehensive income (loss) and $3.3 million in operating earnings as realized investment gains. The Company amortized $17.3 million and $12.4 million of net deferred gains into earnings during 2003 and 2002, respectively. The estimated amount of net deferred gains that will be amortized into operating earnings during 2004 is $16.2 million. The notional amount of derivatives outstanding under the hedge programs was $4,001.2 million at December 31, 2003. For the year ended December 31, 2003, there was no material ineffectiveness
The estimated net amortization of value of business acquired for each of the next five years is $52.2 million in 2004, $50.8 million in 2005, $39.5 million in 2006, $37.7 million in 2007, and $36.0 million in 2008.
Note 7 - Liability for Unpaid Claims and Claim Adjustment Expenses - Continued
In January 2004, the Company completed its annual review of claim reserves to ensure that its claim reserves make adequate and reasonable provision for future benefits and expenses. Based upon this review, the Company increased its group income protection claim reserves as of December 31, 2003 by $440.0 million before tax, or $286.0 million after tax. Approximately $300.0 million of the reserve strengthening reflected implementation of a lower discount rate for the Company’s group income protection claim reserves. The discount rate was lowered to reflect the Company’s actual change in investment portfolio yield rates during 2003, the expectation of future investment portfolio yield rates, and the Company’s new discount rate management approach of maintaining a wider spread between its group income protection portfolio investment yield rate and its average discount rate. The Company’s new discount rate management approach is intended to better reflect the current investment environment and position the Company to be more responsive with discount rates on new incurred claims as changes to the investment environment emerge. Approximately $140.0 million of the reserve increase related to a strengthening of the morbidity assumptions to reflect the impact of the Company’s view of a continuing jobless economic recovery on claim incidence and severity. Of this amount, approximately $64.0 million was established to reflect higher claim incidence expectations. Claim incidence in the second half of 2003 was 8.4 percent higher than the first half of the year and 5.8 percent above the second half of 2002. Claim incidence is expected to continue at an elevated level for several quarters as the Company believes that early indications of a recovering economy are not yet reflected in improved consumer confidence or job creation. Also included in the $140.0 million strengthening was approximately $76.0 million to reflect higher severity expectations driven primarily by a lengthening of claim duration expectations in those claims that have been open 36 months or longer. The $440.0 million reserve increase represented a 5.4 percent increase in total net group income protection reserves as of December 31, 2003, which totaled $8.186 billion prior to this increase.
The unrealized adjustment to reserves for future policy and contract benefits reflects the changes that would be necessary to policyholder liabilities if the unrealized investment gains and losses related to the available-for-sale securities had been realized. Changes in these adjustments are reported as a component of other comprehensive income (loss).
Under the Life Insurance Company Tax Act of 1959, life companies were required to maintain a policyholders’ surplus account containing the accumulated portion of current income which had not been subjected to income tax in the year earned. The Deficit Reduction Act of 1984 requires that no future amounts be added after 1983 to the policyholders’ surplus account. Further, any future distributions from the account would become subject to federal income tax at the general corporate federal income tax rate then in effect. The amount of the policyholders’ surplus account at December 31, 2003, is approximately $228.8 million. Future distributions from the policyholders’ surplus account are deemed to
occur if a statutorily prescribed maximum for the account is less than the value of the account or if dividend distributions exceed the total amount accumulated as currently taxable income in the year earned. If the entire policyholders’ surplus account were deemed distributed in 2003, this would result in a tax of approximately $80.1 million. No current or deferred federal income taxes have been provided on these amounts because management considers the conditions under which such taxes would be paid to be remote.
The Company’s consolidated statements of operations include the following amounts of income subject to foreign taxation, including the results of the Canadian branch, and the related foreign income tax expense (benefit):
The Company had no short-term debt as of December 31, 2003. At December 31, 2002, short-term debt consisted of $20.0 million for the current portion of the Company’s medium-term notes, with a weighted average interest rate of 5.96 percent during 2002, and $235.0 million of reverse repurchase agreements, with a weighted average interest rate of 1.44 percent during 2002.
During the fourth quarter of 2002, the Company filed with the Securities and Exchange Commission (SEC) a shelf registration on Form S-3. The shelf was declared effective in April 2003. The shelf registration allowed the Company to issue various types of securities, including common stock, preferred stock, debt securities, depository shares, stock purchase contracts, units and warrants, or preferred securities of wholly-owned finance trusts up to an aggregate of $1.5 billion. The shelf registration enabled the Company to raise funds from the offering of any individual security covered by the shelf registration as well as any combination thereof, subject to market conditions and the Company’s capital needs. On May 7, 2003, the Company issued 45,980,000 shares of common stock, par value $0.10 per share, in a public offering and received approximately $476.3 million in proceeds from the sale of the shares of common stock after deducting underwriting discounts. Also on May 7, 2003, the Company issued 20,000,000 8.25% adjustable conversion-rate equity security units (units) in a public offering. The Company received approximately $485.0 million in proceeds from the sale of the units after deducting underwriting discounts. Each unit has a stated amount of $25 and will initially consist of (a) a contract pursuant to which the holder agrees to purchase, for $25, shares of the Company’s common stock on May 15, 2006 and (b) a 1/40, or 2.5%, ownership interest in a senior note issued by the Company due May 15, 2008 with a principal amount of $1,000. On May 14, 2003, the Company sold 6,897,000 additional shares of common stock pursuant to the exercise of the underwriters’ overallotment option relating to the above offering. The net proceeds to the Company were approximately $71.4 million after deducting underwriting discounts. Also on May 14, 2003, the Company sold 3,000,000 additional units pursuant to the exercise of the underwriters’ overallotment option relating to the above offering. The net proceeds to the Company were approximately $72.8 million after deducting underwriting discounts. The proceeds from these offerings were used primarily to increase the capitalization of the Company’s insurance subsidiaries and to repay amounts loaned to the Company from its insurance subsidiaries. No additional funding capacity remains on the shelf registration. Upon settlement of the common stock purchase contract and successful remarketing of the senior note element of the units, the Company will receive proceeds of approximately $575.0 million and will issue between 43.3 million and 52.9 million shares of common stock.
In 1998, Provident Financing Trust I (the trust) issued $300.0 million of 7.405% capital securities in a public offering. These capital securities, which mature on March 15, 2038, are fully and unconditionally guaranteed by the Company, have a liquidation value of $1,000 per capital security, and have a mandatory redemption feature under certain circumstances. The Company issued $300.0 million of 7.405% junior subordinated deferrable interest debentures which mature on March 15, 2038, to the trust in connection with the capital securities offering. The sole assets of the trust are the junior subordinated debt securities. As stated in Note 1, the adoption of FIN 46 in 2003 resulted in the de-consolidation of the trust. The capital securities which had previously been classified on the Company’s consolidated statements of financial condition as company-obligated mandatorily redeemable preferred securities of subsidiary trust holding solely junior subordinated debt securities of the company were eliminated, and the junior subordinated deferrable interest debentures of $300.0 million are included in long-term debt at December 31, 2003.
The Company sponsors several defined benefit pension and postretirement plans for its employees, including non-qualified pension plans. The following tables provide the changes in the benefit obligation and fair value of plan assets and statements of the funded status of the plans. The Company uses a December 31 measurement date for each plan. Certain prior year amounts have been adjusted for the pension plans of the foreign affiliates.
Amounts recognized in the consolidated statements of financial condition for the Company’s pension plans consist of the following:
To determine the net periodic pension cost for the year 2003, the expected long-term rate of return assumption used for the U.S. pension plan was 8.5 percent. In December 2003, the Company revised the investment policy which resulted in a target asset allocation of 70 percent equities and 30 percent fixed income securities as compared to a target asset allocation of 75 percent equities and 25 percent fixed income securities in 2002. The long-term rate of return assumption is the best estimate of the average annual assumed return that will be produced from the pension trust assets until current benefits are paid. The determination of the best estimate is based on a “building block” approach. This methodology examines the various elements of the expected return for each asset class, such as inflation, dividends, real return, and risk premium. The expected return for each asset class is calculated as the sum of the individual components. The total expected return for the portfolio equals the weighted average of the return for each asset class, based on the plan’s asset allocations. This long-term rate of return assumption is based on an average expected return of approximately 5.4 percent annually for fixed income investments and 10.0 percent annually for equities. The Company’s expectations for these future investment returns are based on a combination of historical market performance and the Company’s evaluations of investment forecasts prepared by external consultants and economists. The investment portfolio contains a diversified blend of large, mid, small and convertible equity securities and core and high yield fixed income securities. Investment risk is measured and monitored on an ongoing basis through annual liability measurements, periodic asset/liability studies, and quarterly investment portfolio reviews. Risk tolerance is established through careful consideration of plan liabilities, plan funded status, and corporate financial condition. The plan prohibits the use of derivative instruments.
The Company also maintains a reserve for life insurance benefits payable to certain former retirees covered under the postretirement welfare plan. The expected return assumption for this reserve was 6.0 percent, which was based on full investment in fixed income securities with an average book yield of 7.25 percent and 7.94 percent for 2003 and 2002, respectively.
Equity securities include the Company’s common stock in the amounts of $7.1 million, or 1.4 percent of total plan assets, and $7.9 million, or 1.9 percent of total plan assets, at December 31, 2003 and 2002, respectively. The amount of dividends paid during 2003 was immaterial.
In computing net income (loss) per share assuming dilution, only potential common shares that are dilutive (those that reduce net income per share) are included. Potential common shares are not used when computing net income per share assuming dilution if the results would be antidilutive, such as when a net loss from continuing operations is reported or if options are out-of-the-money. In-the-money options to purchase approximately 1.8 million common shares for the year ended December 31, 2003 were not considered dilutive due to a net loss being reported. Approximately 16.4 million, 15.3 million, and 10.2 million options for the years ended December 31, 2003, 2002, and 2001, respectively, were not considered dilutive due to the options being out of the money.
Prior to 2003, the Company accounted for its stock-based employee compensation plans under APB Opinion 25 and related Interpretations. Effective January 1, 2003, the Company adopted the fair value recognition provisions of SFAS 123. Under the prospective method of adoption selected by the Company under the provisions of SFAS 148, the recognition provisions will be applied to all employee awards granted, modified, or settled after January 1, 2003.
Substantially all of the Company’s employees are eligible to participate in an ESPP. Under the plan, up to 1,460,000 shares of the Company’s common stock are authorized for issuance. Stock may be purchased at the end of each financial quarter at a purchase price of 85 percent of the lower of its beginning or end of quarter market prices. The Company sold 318,499, 191,383, and 159,572 shares to employees with a weighted average exercise price of $9.73, $18.67, and $22.40 during the years 2003, 2002, and 2001, respectively.
The weighted average assumptions used in estimating compensation cost are as follows:
In the normal course of business, the Company assumes reinsurance from and cedes reinsurance to other insurance companies. The primary purpose of ceded reinsurance is to limit losses from large exposures. However, if the assuming reinsurer is unable to meet its obligations, the Company remains contingently liable. The Company evaluates the financial condition of reinsurers and monitors concentration of credit risk to minimize this exposure. The reinsurance receivable at December 31, 2003 relates to approximately 362 reinsurance relationships. Of the ten major relationships which account for approximately 89 percent of the reinsurance receivable at December 31, 2003, all are with companies rated A or better by A.M. Best Company or are fully securitized by letters of credit, investment-grade fixed maturity securities held in trust, and/or through agreements where the ceding company retains the assets in its general account. Virtually all of the remaining 11 percent is reinsured with companies rated A- or better by A.M. Best Company, or with overseas entities that have equivalent ratings and/or are backed by letters of credit or trust agreements. Two companies with B++ ratings hold less than one percent of the reinsurance receivable.
Premium income assumed was $445.7 million, $511.3 million, and $513.3 million during 2003, 2002, and 2001, respectively.
During 2003, the Company reinsured on a 100 percent indemnity coinsurance basis for non-New York policies and a 90 percent indemnity coinsurance basis for New York policies certain of its insurance policies, primarily individual income protection, previously sold through trade associations and ceded approximately $121.0 million of reserves to the reinsurer. The transaction had an effective date of April 1, 2003. The $31.1 million before-tax loss on this transaction was deferred and is being amortized into income based upon expected future premium income on the policies ceded.
In 1996, the Company executed a definitive reinsurance agreement with Centre Life Reinsurance Limited (Centre Re), a Bermuda-based reinsurance specialist, for reinsurance coverage of the existing United States noncancelable individual income protection active life reserves of one of the Company’s insurance subsidiaries, Unum Life Insurance Company of America. This agreement reinsures all claims incurred on or after January 1, 1996. The Company has the right, but no obligation, to recapture the business after six years without penalty. Under the agreement, Centre Re has an obligation to absorb losses within a defined risk layer. The Company retains the risk for all experience up to Centre Re’s defined risk layer, or attachment point. Once the attachment point is reached, Centre Re assumes the risk for all experience up to a contractually defined risk limit. Any experience above Centre Re’s defined risk limit reverts back to the Company. As of December 31, 2003, the attachment point had not been reached.
The following discloses the various layers in the agreement at December 31, 2003 (in millions of dollars):
Under this agreement, the Company funds a trust account equal to the amount of the Company’s exposure. This trust account provides security for amounts due by the Company prior to reaching the attachment point. The Company controls the management of the business, including premium collection and claims management, under this agreement. All premiums, less amounts for management expenses and claim payments, are transferred to the trust account on a quarterly basis. The Company also acts as the investment manager for 80 percent of the assets in the trust with Centre Re managing the remaining 20 percent.
Included in miscellaneous assets in the consolidated statements of financial condition at December 31, 2003, is a deposit asset for this reinsurance arrangement of approximately $441.9 million. The deposit asset is comprised of the Company’s experience layer. Previously included in the deposit asset were any unrealized gains or losses on the marketable securities held in the trust. These unrealized gains or losses and the related effects on claim reserves were included in other comprehensive income (loss) in the stockholders’ equity section of the consolidated statements of financial condition. Under the provisions of DIG Issue B36, any net unrealized gain is attributed to the value of the embedded derivative and is reported as such in fixed maturity securities. Any net unrealized loss will be attributed to the marketable securities held in the trust and reported as an adjustment to the deposit asset, with the related effects on claim reserves reflected in the reinsurance receivable for claim reserves.
Effective January 1, 2003, the Company’s reporting segments include the following five businesses: Income Protection segment, Life and Accident segment, Colonial segment, Other segment, and Corporate segment. The Income Protection segment includes insurance for loss of income due to either sickness or injury or the loss of two or more “activities of daily living”, disability management services, and customized disability programs. Included within this segment are group long-term and short-term income protection insurance, individual income protection insurance, and group and individual long-term care insurance, as well as various disability management services and programs. The products are marketed primarily to employers and multi-life employee groups by the Company’s sales force, working in conjunction with independent brokers and consultants. The Life and Accident segment includes insurance for life, accidental death and dismemberment, cancer, and critical illness marketed primarily to employers and multi-life employee groups by the Company’s sales force through independent brokers and consultants. The Colonial segment includes insurance for life, income protection, accident and sickness, cancer, and critical illness issued by the Company’s subsidiary Colonial Life & Accident Insurance Company and marketed primarily to employees through an agency field sales force. The Other segment includes products that the Company no longer actively markets, with the exception of certain individual income protection products. The Corporate segment includes investment income on corporate assets not specifically allocated to a line of business, corporate interest expense, and certain corporate expenses not allocated to a line of business.
Selected data by segment is presented as follows. Segment information for the years ended December 31, 2002 and 2001 has been reclassified to conform to current year reporting.
The Company has an agreement with an outside party wherein the Company is provided computer data processing services and related functions. The contract expires in 2010, but the Company may cancel this agreement effective August 2004 or later upon payment of applicable cancellation charges. The aggregate noncancelable contractual obligation remaining under this agreement is $101.1 million at December 31, 2003, with no annual payment expected to exceed $58.3 million. Effective January 1, 2004, the Company extended its agreement with the outside party. The contract expires in 2013, but the Company may cancel this agreement effective January 2006 or later upon payment of applicable cancellation charges. The aggregate noncancelable contractual obligation remaining under this agreement was $115.2 million at January 1, 2004, with no annual payment expected to exceed $53.4 million.
Also in 2003, as previously noted, the Company announced that it has agreed to sell its Canadian branch to RBC Insurance, the insurance operation of Royal Bank of Canada. This transaction is expected to close in the first half of 2004.
The career agent class action purports to represent all career agents of subsidiaries of Paul Revere whose employment relationships ended on June 30, 1997 and who were offered contracts to sell insurance policies as independent producers. The career agents claimed that the termination of their employment relationship was contrary, inter alia, to promises of lifetime employment. Class certification was denied for the career agents. The career agent plaintiffs have since re-filed their complaint seeking class action status by limiting the issues to compensation matters similar to those in the certified broker class action. A motion for certification of a class with respect to this narrower claim was filed, but has not been acted upon.
Each of these actions purport to be a shareholder’s derivative action brought for the benefit of nominal defendant UnumProvident Corporation against its Board of Directors and certain executive officers seeking to remedy alleged breaches of fiduciary duties and other violations of claims paying law. Plaintiffs allege, among other things, that the Individual Defendants established and perpetuated an illegal and improper policy of denying legitimate disability claims and engaged in improper financial reporting. Further, plaintiffs allege as a result of their responsibility for and knowledge of the Company’s policies and practices, the Individual Defendants knew that the Company was violating various state and federal laws, including the federal securities laws, thus exposing the Company to liability
On October 17, 2003, the district court consolidated these actions under the caption In re UnumProvident Corporation Derivative Actions. On February 24, 2004, the district court ordered plaintiffs to file a single consolidated amended complaint by no later than April 30, 2004. The defendants have 90 days thereafter to file a response. The defendants strongly deny the allegations in the complaints and will vigorously defend both the substantive and procedural aspects of the litigation.
The defendants have not yet answered or otherwise responded to these complaints. The Company denies the allegations and will vigorously defend against the allegations raised by the complaints.
On November 13, 2003, the case of Dauphinee, et al. v. UnumProvident, et al., was filed in the United States District Court for the Eastern District of Tennessee. This action is brought as a putative class action lawsuit on behalf of representative plaintiffs and all disabled individuals insured under a UnumProvident long-term disability plan. The complaint alleges that UnumProvident and its subsidiaries fraudulently and otherwise unlawfully denied and terminated long-term disability insurance benefits. Additionally, the complaint alleges misuse of authority as an ERISA claims fiduciary. The complaint seeks injunctive and declaratory relief to require, among other things, that UnumProvident re-evaluate all previously denied, terminated, or suspended claims. The Company denies the allegations in the complaint and will vigorously defend the litigation and any attempt to certify the putative class.
On December 22, 2003, the Tennessee Federal District Court entered an order consolidating all of the above actions other than the Taylor and Jewel actions for all pretrial purposes under the caption In re UnumProvident Corp. ERISA Benefit Denial Actions. Among other things, the Court in that order appointed a lead counsel in the actions and directed lead counsel to file a consolidated amended complaint by February 20, 2004. The Court entered a schedule providing for the completion of all pretrial proceedings in these actions by December 2005.
The Company and its insurance company subsidiaries, as part of their normal operations in managing disability claims, are engaged in claim litigation where disputes arise as a result of a denial or termination of benefits. Most typically those lawsuits are filed on behalf of a single claimant or policyholder, and in some of these individual actions punitive damages are sought, such as claims alleging bad faith in the handling of insurance claims. For claim litigation, the Company and its insurance company subsidiaries maintain reserves based on experience to satisfy judgments and settlements in the normal course. Management expects that the ultimate liability, if any, with respect to claim litigation, after consideration of the reserves maintained, will not be material to the consolidated financial condition of the Company. Nevertheless, given the inherent unpredictability of litigation, it is possible that an adverse outcome in certain claim litigation involving punitive damages could, from time to time, have a material adverse effect on the Company’s consolidated results of operations in a particular reporting period.
On January 23, 2003, a jury in California State Court in Marin County, in the case of Chapman v. UnumProvident Corporation, et al., returned a verdict of $31.6 million against UnumProvident and two of its subsidiaries, The Paul Revere Life Insurance Company and Provident Life and Accident Insurance Company. The largest portion of the verdict was $30.0 million in punitive damages. The Company strongly disagreed with the verdict because the evidence did not support it. The Company filed post-trial motions which challenged, among other things, the excessiveness of the punitive damage award. On March 25, 2003, the Court entered an order reducing the punitive damage award to $5.0 million, thereby reducing the total award to $6.1 million. On April 8, 2003, the plaintiff in the Chapman case accepted the reduced award. The Company has now appealed the final verdict to the California Court of Appeals.
The Company has experienced increased market conduct examinations by state insurance departments focused specifically on its disability claims handling policies and practices. On March 19, 2003, the Company consented to the entry of an order by the Georgia Insurance Commissioner that, among other things, ordered four of the Company’s insurance subsidiaries to each pay a monetary penalty of $250,000 and to adhere to certain claims handling practices. The order also placed these four companies on regulatory probation for two years, during which period certain Georgia claims and complaints will be reviewed on a quarterly basis. The Georgia order did not cite any violations of Georgia law or regulations.
Because of the number of market conduct examinations initiated during 2002 and 2003, a coordinated market conduct examination of the Company’s disability claims handling policies and practices was organized during 2003 by Massachusetts, Maine, and Tennessee, the states of domicile for several of the Company’s insurance subsidiaries. Currently 44 states and the District of Columbia are participating in this coordinated examination in which the domiciliary states are attempting to address common state concerns and also eliminate or reduce the number of duplicative individual examinations by multiple states. California, Arizona and New Mexico have chosen to continue pursuing their own examinations and investigations, although California has elected to participate in the multi-state examination as well. Additional state market conduct examinations may be commenced.
In addition, the Company received a letter in September 2003 from the office of the New York State Attorney General indicating that it is reviewing the disability claims-handling procedures of the Company and its insurance subsidiaries. The Company is cooperating and is in the process of gathering and providing information in response.
On July 11, 2003, the case of Chandler v. UnumProvident Corporation was filed in Chancery Court of Hamilton County, Tennessee. The plaintiff, J. Harold Chandler, former CEO of UnumProvident, alleges that his Employment Agreement was breached in connection with his termination and the improper calculation of his severance and retirement benefits. The Company disagrees with these allegations and will vigorously defend its position.
Restrictions under applicable state insurance laws limit the amount of ordinary dividends that can be paid to the Company from its insurance subsidiaries without prior approval by regulatory authorities. For life insurance companies domiciled in the United States, that limitation equals, depending on the state of domicile, either ten percent of an insurer’s statutory surplus with respect to policyholders as of the preceding year end or the statutory net gain from operations, excluding realized investment gains and losses, of the preceding year. Further, pursuant to the 1999 merger of Unum Corporation and Provident Companies, Inc., the Company is required to obtain approval from the Maine Bureau of Insurance (Maine Bureau) regarding payment of ordinary dividends from the Company’s Maine domiciled insurance subsidiary until July 2004.
The payment of ordinary dividends to the Company from its insurance subsidiaries is further limited to the amount of statutory surplus as it relates to policyholders. Based on the restrictions under current law, during 2004 $384.8 million is available for the payment of ordinary dividends to the Company from its domestic insurance subsidiaries. Of this amount, $117.7 million is conditional upon approval from the Maine Bureau.
The Company also has the ability to draw a dividend from its United Kingdom subsidiary, Unum Limited. Such dividends are limited based on insurance company legislation in the United Kingdom, which requires a minimum solvency margin. The amount available under current law for payment of dividends to the Company from Unum Limited during 2004 is approximately $135.0 million. Regulatory restrictions do not limit the amount of dividends available for distribution to the Company from its non-insurance subsidiaries.
Financial results previously reported were revised in the preceding table for the classification of the Company’s Canadian branch as a discontinued operation, as discussed in Notes 1 and 2. Net income (loss) did not change as a result of the classification. The amounts related to discontinued operations, which prior to the fourth quarter of 2003 were included in the financial results from continuing operations, are presented below. The financial results for the fourth quarter of 2003 are also presented for comparative purposes.