The following management assessment of the financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes thereto contained in Item 8, “Financial Statements and Supplementary Data.” Our consolidated financial statements and certain disclosures made in this Form 10-K have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and require us to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the dates of the financial statements, and the reported amounts of revenues and expenses during each reporting period. The estimates most susceptible to material changes due to significant judgment are identified as critical accounting policies. The results of these estimates are critical because they affect our profitability and may affect key indicators used to measure our performance. See “Critical Accounting Policies and Estimates.”
GAAP results for 2010 reflected less favorable claims experience in the Insurance Services segment and net capital losses recognized on real estate acquired in satisfaction of debt through foreclosure or the acceptance of deeds in lieu of foreclosure on commercial mortgage loans (“real estate owned”) and additional provisions to our commercial mortgage loan loss allowance. These factors were partially offset by higher earnings in the Asset Management segment, the effect of a decrease in diluted weighted-average common shares outstanding and a reduction in operating expenses reflecting the completion of our 2009 operating expense reduction initiatives and careful expense management during 2010.
The increase in GAAP net income for 2009 compared to 2008 reflected a decline in net capital losses and increased net investment income in the Asset Management segment, partially offset by costs associated with our 2009 operating expense reduction initiatives and declines in premiums in our group insurance businesses. Net investment income in the Asset
We will continue to focus on our long-term objectives and address challenges that arise with financial discipline and from a position of financial strength. We manage for long-term profitability by focusing on good business diversification, disciplined product pricing, sound underwriting, effective claims management and high-quality customer service.
Return on average equity, excluding after-tax net capital gains and losses from net income and accumulated other comprehensive income and losses from equity, to be in the range of 12% to 13%.
Benefit ratio-We expect our annual benefit ratio for our group insurance business to be consistent with the experience of the previous five years, during which it has ranged from 73.6% to 78.3%.
Share repurchases-We expect the level of share repurchases will remain consistent with 2010 activity.
Since the third quarter of 2008, economic uncertainty has led to a period of significant widening and tightening of credit spreads. Given the uncertainty surrounding credit spreads and the direction of interest rates, we may experience lower new money interest rates in the future if credit spreads remain tight and interest rates remain low. New money interest rates are also affected by the current volume and mix of commercial mortgage loan originations and purchases of fixed maturity securities.
The increase in net investment income for 2009 compared to 2008 was primarily due to an increase in average invested assets resulting from additional individual annuity assets under administration. Also contributing to the increase were higher average yields in our commercial mortgage loan portfolio. The increase in net investment income was supplemented by an increase in the fair value of our S&P 500 index options.
We originate commercial mortgage loans containing a provision requiring the borrower to pay a prepayment fee. The prepayment provision assures that our expected cash flow from commercial mortgage loan investments would be protected in the event of prepayment. As interest rates decrease, potential prepayment fees increase. These potentially larger prepayment fees deter borrowers from refinancing during a low interest rate environment. Approximately 98% of our commercial mortgage loan portfolio contains this prepayment provision. Commercial mortgage loans without a make whole prepayment provision generally contain fixed percentage prepayment fees that mitigate prepayments but may not fully protect our expected cash flows in the event of prepayment. Commercial mortgage loan prepayment fees were $3.4 million, $2.8 million and $7.3 million for 2010, 2009 and 2008, respectively. The lower prepayment fees in 2010 and 2009 reflect fewer customer prepayments due to increases in fees charged for prepayment in a low interest rate environment.
Net capital losses for 2010 were primarily related to the foreclosure and restructuring of commercial mortgage loans with a single borrower during the second quarter of 2010 recorded as additional provisions to our commercial mortgage loan loss allowance. Capital losses were also recognized due to impairments on properties acquired from the above mentioned borrower resulting from the receipt of independent appraisals and on low-income housing tax credit investments. These losses were partially offset by net capital gains related to the sale of certain fixed maturity securities and from the sale of real estate investments. See “Liquidity and Capital Resources-Investing Cash Flows-Commercial Mortgage Loans” and “Business Segments-Other-Net Capital Gains (Losses).”
Assumptions used to establish related reserves - the assumptions used to establish the related reserves reflect expected incidence and severity, and the discount rate. The discount rate is affected by new money investment interest rates and the overall portfolio yield. See “Critical Accounting Policies and Estimates-Reserves for Future Policy Benefits and Claims.”
Growth of our in force block - the benefit ratio, calculated as benefits to policyholders and interest credited as a percentage of premiums, is utilized to provide a measurement of claims normalized for premium growth.
The increase in benefits to policyholders for 2010 compared to 2009 was primarily due to higher incidence and fewer claim closures in the group long term disability insurance business and a few large claims in the group life insurance business. Benefits to policyholders for 2009 included approximately $18 million of additional individual disability insurance reserves recorded during the first quarter of 2009 due to the termination of reinsurance on certain reinsured policies and claims. See “Business Segments-Insurance Services Segment-Benefits and Expenses-Benefits to Policyholders (including interest credited).”
Changes in new investment interest rates and overall portfolio yield, which influence our interest crediting rate for our customers.
The following table sets forth interest credited and associated key indicators:
The following table sets forth operating expenses and costs incurred during our 2009 operating expense reduction initiatives:
The decrease in operating expenses for 2010 compared to 2009 was primarily related to the completion of our 2009 operating expense reduction initiatives and careful expense management during 2010. Operating expenses for 2009 included $18.6 million of costs related to our 2009 operating expense reduction initiatives. These costs were recorded in our Other category. The cost savings resulting from these initiatives were primarily reflected in the Asset Management segment for 2010. See “Business Segments.”
The increase in commissions and bonuses for 2010 compared to 2009 was primarily due to an increase in our Insurance Services segment sales, partially offset by a change in our individual annuity product mix. The decrease for 2009 compared to 2008 was primarily due to lower maintenance commissions as a result of lower assets under administration in our retirement plans business for the first three quarters of 2009 and lower premium levels in our group insurance businesses.
Net Change in Deferred Acquisition Costs (“DAC”), Value of Business Acquired (“VOBA”) and Other Intangible Assets
An increase in deferrals in our group insurance businesses resulting from higher sales.
A decrease in amortization driven by favorable persistency in our group and individual disability insurance businesses.
The net increase in DAC, VOBA and other intangible assets decreased for 2009 compared to 2008 primarily due to lower individual annuity sales and an increase in DAC amortization resulting from derivative gains from our indexed annuities. In addition, net deferrals in the Insurance Services segment decreased for 2009, primarily due to lower individual disability sales and the termination of a small block of individual disability contracts.
During the first quarter of 2010, the 2010 Health Care Act, as amended by the 2010 Health Care Reconciliation Act, became law. Included among the provisions of the law is a change in the tax treatment of the Medicare Part D subsidy, which we participate in as a part of our postretirement medical plan. This change in the law resulted in additional tax expense of $1.0 million, which increased our effective tax rate for 2010 by 0.3%. The change in tax treatment for the subsidy was recorded in the first quarter of 2010 and will affect the tax rate for 2010 but will not have a similar effect on the tax rate in future years.
During 2010, capital losses due to increased foreclosures and the acceptance of deeds in lieu of foreclosure on commercial mortgage loans resulted in a decrease in the average effective state income tax rate, offsetting the increase as discussed above.
At December 31, 2010, the years open for audit by the Internal Revenue Service (“IRS”) were 2007 through 2010. See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 7-Income Taxes” for more information on the change in the effective tax rate.
We operate through two reportable segments: Insurance Services and Asset Management, as well as an Other category. Resources are allocated and performance is evaluated at the segment level. The Insurance Services segment offers group and individual disability insurance, group life and accidental death and dismemberment (“AD&D”) insurance, group dental and group vision insurance, and absence management services. The Asset Management segment offers full-service 401(k) plans, 403(b) plans, 457 plans, defined benefit plans, money purchase pension plans, profit sharing plans and non-qualified deferred compensation products and services. This segment also offers investment advisory and management services, financial planning services, commercial mortgage loan origination and servicing, individual fixed-rate annuity products, group annuity contracts and retirement plan trust products. The Other category includes return on capital not allocated to the product segments, holding company expenses, operations of certain unallocated subsidiaries, interest on debt, unallocated expenses including costs incurred during our 2009 operating expense reduction initiatives, net capital gains and losses and adjustments made in consolidation.
Income before income taxes decreased for 2010 compared to 2009 primarily due to less favorable claims experience and lower premiums. Results for 2009 reflected lower premiums in our group insurance business, partially offset by higher premiums and favorable claims experience in our individual disability business compared to 2008.
Revenues for the Insurance Services segment are driven primarily by growth in Insurance Services premiums. The slight decrease in revenues for 2010 compared to 2009 was primarily due to lower premiums in our individual disability insurance business due to a single premium of approximately $18 million received in the first quarter of 2009 related to the termination of reinsurance on certain individual disability reinsured policies and claims. Revenues decreased for 2009 compared to 2008 primarily due to decreased premiums in our group insurance business, partially offset by increased premiums in our individual disability business.
Persistency. Persistency in our group insurance business increased to 88.7% for 2010, compared to 83.8% for 2009. Persistency in our group insurance business for 2010 was at the high end of our historical range. Persistency in our individual disability products remained above 90%.
The following table sets forth benefits to policyholders (including interest credited) and the benefit ratios for the Insurance Services segment:
The increase in Insurance Services benefits to policyholders (including interest credited) for 2010 compared to 2009 was primarily due to higher incidence and fewer claim closures in the group long term disability insurance business, a few large claims in the group life insurance business and an increase in individual disability claims reserves of $7.8 million recorded as part of our regular assessments of the adequacy of our reserves. Offsetting these factors was the reduction of reserves for group long term disability claims of $14.6 million, also recorded as part of our reserve assessments, and the inclusion of approximately $18 million of additional individual disability insurance reserves in 2009 benefits to policyholders recorded due to the termination of reinsurance on certain reinsured policies and claims.
The decrease in the individual disability benefit ratio for 2009 was primarily due to a decline in the severity of new claims and favorable claims termination experience during 2009. The benefit ratios for 2009 and 2008 for our individual disability business included approximately $18 million and $3.7 million, respectively, of premiums and approximately $18 million and $3.9 million, respectively, of additional reserves related to the termination of reinsurance on certain reinsured policies and claims. Excluding the effects of this termination of reinsurance, the benefit ratio would have been 65.8% for 2009, compared to 78.0% for 2008. Due to the relatively small size of our individual disability business, individual disability claims experience and the corresponding benefit ratio tend to fluctuate widely from quarter to quarter.
The following table sets forth operating expenses for the Insurance Services segment:
The decrease in Insurance Services operating expenses for 2010 compared to 2009 was primarily due to a decrease in lease obligations and compensation related expenses resulting from our 2009 operating expense reduction initiatives and careful expense management during 2010. This was partially offset by increased costs associated with several new customer service programs implemented in 2010. The decrease in operating expenses for 2009 compared to 2008 was primarily due to a decline in compensation related expenses as a result of cost reduction initiatives implemented in 2009 and a decline in consulting expenses. Costs related to our 2009 operating expense reduction initiatives are included in the Other category. See “Other.”
Income before income taxes increased for 2010 compared to 2009 primarily due to an increase in net investment income, an increase in administrative fee revenues and reduced operating expenses resulting from the implementation of our 2009 operating expense reduction initiatives. The increase for 2009 compared to 2008 reflected an increase in net investment income and lower operating expenses.
Revenues for the Asset Management segment include retirement plan trust product administration fees, fees on investments held in separate account assets and private client wealth management assets under administration, and investment income on general account assets under administration. Premiums and benefits to policyholders reflect both the sale of immediate annuities by our individual annuity business and the conversion of retirement plan assets into life-contingent annuities. Most of the sales for this segment are recorded as deposits and are therefore not reflected as premiums. Individual fixed-rate annuity deposits earn investment income, a portion of which is credited to policyholders.
The increase in net investment income for 2009 compared to 2008 was primarily due to an increase in average individual annuity assets under administration, higher average yields in our commercial mortgage loan portfolios enhanced by an increase in the fair value of our S&P 500 Index options. The fair value adjustment to derivative assets resulted in an increase to net investment income for 2009 compared to a decrease for 2008. See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 11-Derivative Financial Instruments” for further derivative disclosures.
The following table sets forth interest credited and associated key indicators for the Asset Management segment:
The increase in interest credited for 2009 compared to 2008 primarily reflected changes in the fair value of index-based interest guarantees and growth in average individual annuity assets under administration from individual annuity sales. Average assets under administration for individual fixed-rate annuities increased for 2009 compared to 2008. The increase in the contribution of the change in fair value of the index-based interest guarantees was primarily due to fluctuations in the S&P 500 Index.
The following table sets forth operating expenses for the Asset Management segment:
The decrease in Asset Management operating expenses for 2010 compared to 2009 was due to decreases in lease obligations and compensation related expenses resulting from our 2009 operating expense reduction initiatives and careful expense management during 2010. The decrease in operating expenses for 2009 compared to 2008 was primarily due to a decline in compensation related expenses as a result of our 2009 operating expense reduction initiatives. Costs related to operating expense reduction initiatives are included in the Other category. See “Other.”
The decrease in losses before income taxes for 2009 compared to 2008 was primarily due to lower net capital losses partially offset by an increase in operating expenses related to our 2009 operating expense reduction initiatives.
Net capital gains and losses are not likely to occur in a stable pattern and primarily occur as a result of OTTI of assets in our bond portfolio, from additional provisions to our commercial mortgage loan loss allowance, from losses recognized due to impairment of real estate and from sales of our assets for more or less than amortized cost.
Net capital losses for 2009 were primarily due to the foreclosure and restructuring of commercial mortgage loans recorded as additional provisions to our commercial mortgage loan loss allowance, sales of fixed maturity securities that included losses on holdings in financial institutions, including holdings of certain insurance companies that were downgraded by rating agencies during 2009 and OTTI on fixed maturity securities. The capital losses for 2009 were partially offset by capital gains from the sale of certain fixed maturity securities.
Our financial instruments are exposed to financial market volatility and potential disruptions in the market that may result in certain financial instruments becoming less valuable. Financial market volatility includes interest rate risk. We have analyzed the estimated loss in fair value of certain market sensitive financial assets held at December 31, 2010 and 2009, using a hypothetical 10% increase in interest rates and related qualitative information on how we manage interest rate risk. The interest rate sensitivity analysis was based upon our fixed maturity securities and commercial mortgage loans held at December 31, 2010 and 2009. Interest rate sensitivity of our financial assets was measured assuming a parallel shift in interest rates. All security yields were increased by 10% of the year-end 10-year U.S. Government Treasury bond yield, or 0.33% and 0.38% for the 2010 and 2009 analyses, respectively. The change in fair value of each security was estimated as the change in the option adjusted value of each security. Option adjusted values were computed using our payment models and provisions for the effects of possible future changes in interest rates. The analyses did not explicitly provide for the possibility of non-parallel shifts in the yield curve, which would involve discount rates for different maturities being increased by different amounts. The actual change in fair value of our financial assets can be significantly different from that estimated by the model. The hypothetical reduction in the fair value of our financial assets that resulted from the model was estimated to be $150 million and $144 million at December 31, 2010 and 2009, respectively.
Net cash provided by operating activities is net income adjusted for non-cash items and accruals and was $355.1 million, $441.4 million and $361.8 million for 2010, 2009 and 2008, respectively.
The insurance laws of the states of domicile and other states in which the insurance subsidiaries conduct business regulate the investment portfolios of the insurance subsidiaries. Relevant laws and regulations generally limit investments to bonds and other fixed maturity securities, mortgage loans, common and preferred stock and real estate. Decisions to acquire and dispose of investments are made in accordance with guidelines adopted and modified from time to time by the Boards of Directors of our insurance subsidiaries. Each investment transaction requires the approval of one or more members of senior investment staff, with increasingly higher approval authorities required for transactions that are more significant. Transactions are reported quarterly to the Audit Committee of the Board of Directors for Standard Insurance Company (“Standard”) and to the Board of Directors for The Standard Life Insurance Company of New York.
We maintain prudent diversification across industries, issuers and maturities. We have avoided the types of structured products that do not meet an adequate level of transparency for good decision making. Our corporate bond industry diversification targets are based on the Bank of America Merrill Lynch U.S. Corporate Master Index, which is reasonably reflective of the mix of issuers broadly available in the market. We also target a specified level of government, agency and municipal securities in our portfolio for credit quality and additional liquidity. Our fixed maturity securities below investment grade are primarily managed by a third party.
The estimated average loan to value ratio for the overall portfolio was approximately 68% at December 31, 2010. The average loan balance of our commercial mortgage loan portfolio was approximately $0.8 million at December 31, 2010. We have the contractual ability to pursue personal recourse on approximately 70% of our loans and partial personal recourse on a majority of the remaining loans. The average capitalization rate for the portfolio at December 31, 2010 was approximately 9%. Capitalization rates are used internally to annually value our commercial mortgage loan portfolio.
At December 31, 2010, we did not have any direct exposure to sub-prime or Alt-A mortgages in our commercial mortgage loan portfolio. When we undertake mortgage risk, we do so directly through loans that we originate ourselves rather than in packaged products such as commercial mortgage-backed securities. Given that we service the vast majority of loans in our portfolios, we are prepared to deal with them promptly and proactively. Should the delinquency rate or loss performance of our commercial mortgage loan portfolio increase significantly, the increase could have a material adverse effect on our business, financial position, results of operations or cash flows.
Our largest concentration of commercial mortgage loan property type was retail properties and primarily consisted of convenience related properties in strip malls, convenience stores and restaurants.
Through our concentration of commercial mortgage loans in California, we are exposed to potential losses from an economic downturn in California as well as to certain catastrophes, such as earthquakes and fires that may affect certain areas of the western region. We require borrowers to maintain fire insurance coverage. We diversify our commercial mortgage loan portfolio within California by both location and type of property in an effort to reduce certain catastrophe and economic exposure. However, diversification may not always eliminate the risk of such losses. Historically, the delinquency rate of our California-based commercial mortgage loans has been substantially below the industry average and is consistent with our experience in other states. We do not require earthquake insurance for the properties when we underwrite new loans. However, we consider the potential for earthquake loss based upon seismic surveys and structural information specific to each property. We do not expect a catastrophe or earthquake damage in the western region to have a material adverse effect on our business, financial position, results of operations or cash flows. Currently, our California exposure is primarily in Los Angeles County, Orange County, San Diego County and the Bay Area Counties. We have a smaller concentration of commercial mortgage loans in the Inland Empire and the San Joaquin Valley where there has been greater economic decline. Due to the concentration of commercial mortgage loans in California, a continued economic decline in California could have a material adverse effect on our business, financial position, results of operations or cash flows. See Part I, Item 1A, “Risk Factors.”
In the normal course of business, we commit to fund commercial mortgage loans generally up to 90 days in advance. At December 31, 2010, we had outstanding commitments to fund commercial mortgage loans totaling $70.8 million, with fixed interest rates ranging from 5.75% to 7.75%. These commitments generally have fixed expiration dates. A small percentage of commitments expire due to the borrower’s failure to deliver the requirements of the commitment by the expiration date. In these cases, we will retain the commitment fee and good faith deposit. Alternatively, if we terminate a commitment due to the disapproval of a commitment requirement, the commitment fee and good faith deposit may be refunded to the borrower, less an administrative fee.
The performance of our commercial mortgage loan portfolio may fluctuate in the future. However, based on our business approach of diligently underwriting high-quality loans, we believe our delinquency rate will remain contained and our portfolio will continue its history of solid performance. We have steadfastly avoided the types of structured products that do not meet an adequate level of transparency for good decision making.
Real estate owned is initially recorded at estimated net realizable value, which includes an estimate for disposal costs. These amounts may be adjusted in a subsequent period as independent appraisals are received. Real estate acquired during 2010 increased from 2009 primarily due to our acceptance of deeds in lieu of foreclosure from a single borrower in the second quarter of 2010. For 2010, we recorded capital losses of $26.0 million, primarily due to impairments recognized on 62 properties we acquired during the second quarter of 2010 from a single borrower. See “Critical Accounting Policies and Estimates-Investment Valuations-Commercial Mortgage Loans” for our commercial mortgage loan loss allowance policy.
The increase in the provisions for the commercial mortgage loan loss allowance for 2010 compared to 2009 was primarily related to the foreclosure and restructuring of commercial mortgage loans with a single borrower during the second quarter of 2010. The increase to charge offs for 2010 compared to 2009 was primarily related to the acceptance of deeds in lieu of foreclosure on commercial mortgage loans related to a single borrower during the second quarter of 2010. The increase in our commercial mortgage loan loss allowance in 2009 compared to 2008 was to account for probable future losses based on conditions existing at December 31, 2009.
The following table sets forth the average recorded investment in impaired commercial mortgage loans before specific allowance for losses:
The amount of interest income recognized on impaired commercial mortgage loans was $2.8 million, $0.1 million and $0.1 million for 2010, 2009 and 2008, respectively. The cash received by us in payment of interest on impaired commercial mortgage loans was $3.3 million, $0.1 million and $0.1 million for 2010, 2009 and 2008, respectively.
Financing cash flows primarily consist of policyholder fund deposits and withdrawals, borrowings and repayments on the line of credit, borrowings and repayments on long-term debt, repurchases of common stock and dividends paid on common stock. Net cash provided by financing activities was $181.7 million, $294.0 million and $741.9 million for 2010, 2009 and 2008, respectively. The decrease in funds provided by financing cash flows for 2010 compared to 2009 was primarily due to an increase in cash used to repurchase shares of common stock and a reduction in the level of new individual annuity deposits, resulting in a smaller increase of policyholder deposits net of withdrawals. See “Capital Management-Share Repurchases” for further discussion on share repurchases.
The decrease in funds provided by financing cash flows for 2009 compared to 2008 was primarily due to a reduction in the level of new individual annuity deposits, resulting in a decrease of policyholder deposits net of withdrawals, and by an increase in cash used to repurchase shares of common stock.
We have $300 million of 6.90%, junior subordinated debentures (“Subordinated Debt”). The Subordinated Debt has a final maturity on June 1, 2067, is non-callable at par for the first 10 years (prior to June 1, 2017) and is subject to a replacement capital covenant. The covenant limits replacement of the Subordinated Debt for the first 40 years to be redeemable after year 10 (on or after June 1, 2017) and only with securities that carry equity-like characteristics that are the same as or more equity-like than the Subordinated Debt. The principal amount of the Subordinated Debt is payable at final maturity. Interest is payable semi-annually at 6.90% in June and December for the first 10 years up to June 1, 2017, and quarterly thereafter at a floating rate equal to three-month London Interbank Offered Rate plus 2.51%. We have the option to defer interest payments for up to five years. We have not deferred interest on the Subordinated Debt.
The level of capital in excess of targeted RBC we generate varies inversely in relation to the level of our premium growth. As premium growth increases, capital is utilized to fund additional reserve requirements, meet increased regulatory capital requirements based on premium and cover certain acquisition costs associated with policy issuance, leaving less available capital beyond our target level. Higher levels of premium growth can result in increased utilization of capital beyond that which is generated by the business, and at very high levels of premium growth, we could generate the need for capital
infusions. At lower levels of premium growth, additional capital produced by the business exceeds the capital utilized to meet these requirements, which can result in additional capital above our targeted RBC level. At our expected growth rate, in 2011, we anticipate generating between $150 million and $200 million of capital in excess of our 300% RBC target. In addition to the capital carried on the insurance subsidiaries, we hold cash and capital at the holding company and non-insurance subsidiaries.
Our ability to pay dividends to our shareholders, repurchase our shares and meet our obligations substantially depends upon the receipt of distributions from our subsidiary Standard. Standard’s ability to pay dividends to StanCorp is affected by factors deemed relevant by Standard’s Board of Directors. One factor considered by the Board is the ability to maintain adequate capital according to Oregon statute. Under Oregon law, Standard may pay dividends only from the earned surplus arising from its business. If the proposed dividend exceeds certain statutory limitations, Standard must receive the prior approval of the Director of the Oregon Department of Consumer and Business Services-Insurance Division (“Oregon Insurance Division”). The current statutory limitations are the greater of (a) 10% of Standard’s combined capital and surplus as of December 31 of the preceding year, or (b) the net gain from operations after dividends to policyholders and federal income taxes before realized capital gains or losses for the 12-month period ended on the preceding December 31. In each case, the limitation must be determined under statutory accounting practices. Oregon law gives the Oregon Insurance Division broad discretion to decline requests for dividends in excess of these limits. There are no regulatory restrictions on dividends from our non-insurance subsidiaries.
The estimated payments expected to be due by period for insurance obligations reflect future estimated cash payments, for pending and future potential claims, to be made to policyholders and others for future policy benefits, policyholders’ account balances, policyholders’ dividends, and reinsurance payables. These future estimated net cash payments are based on mortality, morbidity, lapse and other assumptions comparable with our experience, consider future premium
receipts on current policies in force, and assume market growth and interest crediting consistent with assumptions used in amortizing DAC and VOBA. These net cash payments are undiscounted with respect to interest and, as a result, the sum of the net cash payments shown for all years in the table of $7.58 billion exceeds the corresponding liability amount of $5.50 billion included in the Consolidated Financial Statements as of December 31, 2010. We have made significant assumptions to determine the future estimated net cash payments related to the underlying policies and contracts. Due to the significance of the assumptions used, actual net cash payments will differ, possibly materially, from these estimates.
While historical withdrawal patterns indicate withdrawal primarily occurs in periods in excess of one year, policyholder fund obligations in the amount of $3.37 billion have been included in the less than one year column of the table as they may be withdrawn upon request. These net cash payments are undiscounted with respect to interest but reflect an offsetting effect due to reinsurance receivables and, as a result, the sum of the net cash payments shown for all years in the table of $4.34 billion differs from the corresponding liability amount of $4.63 billion included in the Consolidated Financial Statements as of December 31, 2010. Due to the significance of the assumptions used, actual net cash payments will differ, possibly materially, from these estimates.
Other long-term obligations reflected in our balance sheet at December 31, 2010, consisted of $350.4 million in expected benefit payments for supplemental, home office, and field office retirement plans, $183.5 million in expected benefit payments for the postretirement benefit plan, $37.6 million in capital commitments related to our low-income housing tax credit investments, a $14.8 million tax reimbursement liability related to the block of life insurance business sold to Protective Life Insurance Company (“Protective Life”) in 2001, and a $10.5 million liability for our deferred compensation plan.
Insolvency regulations exist in many of the jurisdictions in which our subsidiaries do business. Such regulations may require insurance companies operating within the jurisdiction to participate in guaranty associations. The associations levy assessments against their members for the purpose of paying benefits due to policyholders of impaired or insolvent insurance companies. Association assessments levied against us from January 1, 2008, through December 31, 2010, aggregated $1.0 million. At December 31, 2010, we maintained a reserve of $0.8 million for future assessments with respect to currently impaired, insolvent or failed insurers.
Bonds and commercial mortgage loans are reported principally at adjusted carrying value and amortized cost, respectively.
Annuity reserves follow the commissioner’s annuity reserve valuation methodology rather than GAAP guidance for investment contracts.
Our consolidated financial statements and certain disclosures made in this Form 10-K have been prepared in accordance with GAAP and require us to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosures of contingent assets and contingent liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The estimates most susceptible to material changes due to significant judgment (identified as the “critical accounting policies”) are those used in determining investment valuations, DAC, VOBA and other intangible assets, the reserves for future policy benefits and claims, pension and postretirement benefit plans and the provision for income taxes. The results of these estimates are critical because they affect our profitability and may affect key indicators used to measure our performance. These estimates have a material effect on our results of operations and financial condition.
In our quarterly fixed maturity security impairment analysis, we evaluate whether a decline in value of the fixed maturity security is other than temporary by considering the following factors:
The Company maintains an internally identified list of securities with characteristics that could indicate potential impairment (“watch list”). At December 31, 2010, our fixed maturity securities watch list totaled $0.7 million at fair value and $1.0 million at amortized cost. There was no OTTI on the fixed maturity securities on our watch list at December 31, 2010. We recorded OTTI related to credit loss due to impairments of $0.7 million for 2010, compared to $5.9 million for
2009. We recorded no OTTI related to noncredit loss due to impairments for 2010 and 2009. See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 1-Summary of Significant Accounting Policies-Investment Valuations-Fixed Maturity Securities-Available-for-Sale” for further disclosures.
The debt securities had noncredit losses previously recognized as OTTI in earnings,
Commercial mortgage loans are stated at amortized cost less a loan loss allowance for probable uncollectible amounts. The commercial mortgage loan loss allowance is estimated based on evaluating known and inherent risks in the loan portfolio and consists of a general loan loss allowance and a specific loan loss allowance. The general loan loss allowance is based on our analysis of factors including changes in the size and composition of the loan portfolio, actual loan loss experience and individual loan analysis. An impaired commercial mortgage loan is a loan that is not performing to the contractual terms of the loan agreement. A specific allowance for losses is recorded when a loan is considered to be impaired. We also hold specific allowances for losses on certain performing loans that we continue to monitor and evaluate. Impaired commercial mortgage loans without specific allowances for losses are those for which we have determined that it remains probable that we will collect all amounts due. In addition, for impaired commercial mortgage loans, we evaluate the loss to dispose of the underlying collateral, any significant out of pocket expenses the loan may incur, the loan-to-value ratio and other quantitative information we have concerning the loan. Portions of loans that are deemed uncollectible are generally written off against the allowance, and recoveries, if any, are credited to the allowance. See “Liquidity and Capital Resources-Investing Cash Flows-Commercial Mortgage Loans.”
Real estate owned is initially recorded at the lower of cost or estimated net realizable value, which includes an estimate for disposal costs. This amount may be adjusted in a subsequent period as independent appraisals are received. Real estate
owned is considered an investment held for sale. We will begin to depreciate our real estate owned one year after acquisition, unless a sale is probable.
Total real estate increased $97.1 million to $210.6 million at December 31, 2010 compared to December 31, 2009. Real estate investments increased primarily due to additional investments in low-income housing tax credit investments during 2010. Real estate owned increased due to $103.2 million of real estate acquired through acceptance of deeds in lieu of foreclosure on commercial mortgage loans primarily related to a single borrower. The increase in real estate was partially offset by net capital losses on real estate of $15.9 million recorded during 2010 primarily due to impairments recognized on 62 properties we acquired from a single borrower in the second quarter of 2010.
Based on past experience, future changes in DAC and VOBA balances due to changes in underlying assumptions are not expected to be material. However, significant, unanticipated changes in key assumptions, which affect the determination of expected gross profits, may result in a large unlocking event that could have a material adverse effect on our financial position or results of operations.
Our other intangible assets are subject to amortization and consist of certain customer lists from Asset Management business acquired and an individual disability marketing agreement. Customer lists were obtained in connection with acquisitions and have a combined estimated weighted-average remaining life of approximately 9.3 years. The marketing agreement accompanied the Minnesota Life transaction and provides access to Minnesota Life agents, some of whom now market Standard’s individual disability insurance products. The amortization period for the Minnesota Life marketing agreement is up to 25 years. The accumulated amortization of other intangible assets was $23.0 million and $17.2 million at December 31, 2010 and 2009, respectively.
Policy reserves include reserves established for individual disability insurance, individual and group immediate annuity businesses and individual life insurance. Policy reserves are calculated using our best estimates of assumptions and considerations at the time the policy was issued, adjusted for the effect of adverse deviations in actual experience. These assumptions are not subsequently modified unless policy reserves become inadequate, at which time we may need to
Policy reserves for our individual disability block of business are established at the time of policy issuance using the net level premium method as prescribed by GAAP and represent the current value of projected future benefits including expenses less projected future premium. Assumptions used to calculate individual disability policy reserves may vary by the age, gender and occupation class of the claimant, the year of policy issue and specific contract provisions and limitations.
Policy reserves for our individual and group immediate annuity blocks of business are established at the time of policy issue and represent the present value of future payments due under the annuity contracts. The contracts are single premium contracts, and therefore, there is no projected future premium. Assumptions used to calculate immediate annuity policy reserves may vary by the age and gender of the annuitant and year of policy issue.
Claim reserves are subject to revision as our current claim experience and expectations regarding future factors, which may influence claim experience, change. During each quarter, we monitor our emerging claim experience to ensure that
Claim reserves for our group life and AD&D products are established for death claims reported but not yet paid, IBNR for death and waiver claims and waiver of premium benefits. The death claim reserve is based on the actual amount to be paid. The IBNR claim reserves are calculated using historical information, and the waiver of premium benefit is calculated using a tabular reserve method that takes into account company experience and published industry tables.
Reserve discount rates for newly incurred claims are reviewed quarterly and, if necessary, are adjusted to reflect our current and expected new investment yields. The discount rate is based on the average rate we received on newly invested assets during the previous 12 months, less a margin. We also consider our average investment yield and average discount rate on our entire block of claims when deciding whether to increase or decrease the discount rate. Based on our current size, every 25 basis point decrease in the discount rate would result in an increase of approximately $2 million per quarter
of benefits to policyholders. We do not adjust group insurance premium rates based on short-term fluctuations in investment yields. Any offsetting adjustments of group insurance premium rates due to sustained changes in investment yields can take from one to three years given that most new contracts have rate guarantees in place.
As a result of favorable long-term trends compared to reserving assumptions for our group long term disability insurance, we released IBNR claim reserves totaling $11.7 million and claim reserves totaling $2.9 million in 2010, compared to a release of IBNR claim reserves totaling $16.6 million in 2009. There were no similar reserve changes in 2008.
We refined the claim termination rate assumptions for the reserves on a small block of individual disability claims based on a blend of our experience and industry data in 2008, 2009 and 2010 which resulted in an increase in reserves of $2.5 million, $11.5 million and $12.5 million, respectively. Our block of business is relatively small, and, as a result, we view a blend of the industry data and our own experience as a more appropriate method for establishing termination assumptions compared solely to our own experience. We will continue to monitor the credibility of our developing experience and, if necessary, will adjust reserves accordingly.
In accordance with the accounting principles related to our pension and other postretirement plans, we are required to make a significant number of assumptions in order to calculate the related liabilities and expenses each period. The major assumptions that affect net periodic benefit cost and the funded status of the plans include the weighted-average discount rate, the expected return on plan assets, and the rate of compensation increase.
The rate of compensation increase is a long-term assumption that is based on an estimated inflation rate in addition to merit and promotion-related compensation increase components.
For the postretirement benefit plan, the assumed health care cost trend rates are also a major assumption that affects expenses and liabilities. Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
GAAP requires management to use a more likely than not standard to evaluate whether, based on available evidence, each deferred tax asset will be realized. A valuation allowance is recorded to reduce a deferred tax asset to the amount expected to be realized.
From time to time StanCorp or its representatives make written or oral statements, including some of the statements contained or incorporated by reference in this Annual Report on Form 10-K and in other reports, filings with the Securities and Exchange Commission, press releases, conferences or otherwise, that are other than purely historical information. These statements, including estimates, projections, statements related to business plans, strategies, objectives and expected operating results and the assumptions upon which those statements are based, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and Section 21E of the Exchange Act, as amended. Forward-looking statements also include, without limitation, any statement that includes words such as “expects,”
Availability of capital required to support business growth and the effective utilization of capital, including our ability to achieve financing through debt or equity.
Changes in our liquidity needs and the liquidity of assets in our investment portfolios.
Changes in the regulatory environment at the state or federal level including changes in income tax rates and regulations or changes in U.S. GAAP accounting principles, practices or policies.
The effect of changes in interest rates on reserves, policyholder funds, investment income and commercial mortgage loan prepayment fees.
Levels of employment and wage growth and the impact of rising benefit costs on employer budgets for employee benefits.
Adequacy of diversification of risk within our fixed maturity securities portfolio by industries, issuers and maturities.
We have audited the accompanying consolidated balance sheets of StanCorp Financial Group, Inc., and subsidiaries (the “Company”) as of December 31, 2010 and 2009, and the related consolidated statements of income and comprehensive income (loss), changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of StanCorp Financial Group, Inc., and subsidiaries as of December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010, in conformity with accounting principles generally accepted in the United States of America.
Standard Insurance Company (“Standard”), the Company’s largest subsidiary, underwrites group and individual disability insurance and annuity products, group life and accidental death and dismemberment (“AD&D”) insurance, and provides group dental and group vision insurance, absence management services and retirement plan products. Founded in 1906, Standard is domiciled in Oregon, licensed in all states except New York, and licensed in the District of Columbia and the U.S. territories of Guam and the Virgin Islands.
StanCorp Mortgage Investors, LLC (“StanCorp Mortgage Investors”) originates and services fixed-rate commercial mortgage loans for the investment portfolios of the Company’s insurance subsidiaries. StanCorp Mortgage Investors also generates additional fee income from the origination and servicing of commercial mortgage loans participated to institutional investors.
Standard Management, Inc. owns and manages certain real estate properties held for sale.
Adaptu, LLC provides an online service to help users plan and manage their financial lives.
In 2008, the Company identified opportunities and developed strategies to centralize key functions, streamline its processes and improve efficiencies. In January 2009, the Company adopted a restructuring plan to implement these strategies. The Company incurred $18.6 million of costs during its 2009 operating expense reduction initiatives.
The Company’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) which require management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosures of contingent assets and contingent liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The estimates most susceptible to material changes due to significant judgment are those used in determining investment valuations, deferred acquisition costs (“DAC”), value of business acquired (“VOBA”) and other intangible assets, goodwill, the reserves for future policy benefits and claims, pension and postretirement benefit plans and income taxes. The results of these estimates are critical because they affect the Company’s profitability and may affect key indicators used to measure the Company’s performance. These estimates have a material effect on the Company’s results of operations and financial condition.
Estimates regarding the issuer’s ability to make the scheduled payments associated with the fixed maturity security.
The Company’s intent to sell or whether it is more likely than not the Company will be required to sell a fixed maturity security before recovery of the security’s cost basis through the evaluation of facts and circumstances including, but not limited to, decisions to rebalance the Company’s portfolio, current cash flow needs and sales of securities to capitalize on favorable pricing.
The Company will continue to evaluate its holdings. Should the credit quality of the Company’s fixed maturity securities significantly decline, there could be a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
The general loan loss allowance is based on the Company’s analysis of factors including changes in the size and composition of the loan portfolio, actual loan loss experience and individual loan analysis.
An impaired commercial mortgage loan is a loan that is not performing to the contractual terms of the loan agreement. A specific allowance for losses is recorded when a loan is considered to be impaired and it is probable that all amounts due will not be collected. The Company also holds specific loan loss allowances on certain performing commercial mortgage loans that it continues to monitor and evaluate. Impaired commercial mortgage loans without specific allowances for losses are those for which the Company has determined that it remains probable that all amounts due will be collected. In addition, for impaired commercial mortgage loans, the Company evaluates the loss to dispose of the underlying collateral, any significant out of pocket expenses the loan may incur and other quantitative information management has concerning the loan. Portions of loans that are deemed uncollectible are written off against the allowance, and recoveries, if any, are credited to the allowance. See “Note 10-Investments-Commercial Mortgage Loans.”
The Company records interest income in net investment income and continues to recognize interest income on delinquent commercial mortgage loans until the loans are more than 90 days delinquent. Interest income and accrued interest receivable are reversed when a loan is put on non-accrual status. For loans that are less than 90 days delinquent, management may make a business decision to reverse interest income and the accrued interest receivable if there is a question on the collectability of the interest. Interest income on loans in the 90-day delinquent category is recognized in the period the cash is collected. The Company resumes the recognition of interest income when the loan becomes less than 90 days delinquent and management determines it is probable that the loan will remain performing.
Real estate investments are stated at cost less accumulated depreciation. Generally, the Company depreciates this real estate using the straight-line depreciation method with property lives varying from 30 to 40 years. Accumulated depreciation for real estate totaled $29.4 million and $32.7 million at December 31, 2010 and 2009, respectively. The Company records impairments when it is determined that the decline in fair value of the investment below its amortized cost is other than temporary. The impairment loss is charged to net capital losses, and the cost basis of the investment is permanently adjusted to reflect the impairment.
Real estate acquired in satisfaction of debt through foreclosure or the acceptance of deeds in lieu of foreclosure on commercial mortgage loans (“real estate owned”) is initially recorded at the lower of cost or estimated net realizable value, which includes an estimate for disposal costs. This amount may be adjusted in a subsequent period as independent appraisals are received. Real estate owned is considered an investment held for sale. We will begin to depreciate our real estate owned one year after acquisition, unless a sale is probable.
For any real estate expected to be sold, an impairment charge is recorded if the Company does not expect the investment to recover its amortized cost prior to the expected date of sale. Once an impairment charge has been recorded, the Company continues to review the investment for further potential impairment. If the fair value of the investment later recovers, the Company is not permitted to write the asset back up to its historical cost.
Total real estate increased $97.1 million to $210.6 million at December 31, 2010 compared to December 31, 2009. Real estate investments increased primarily due to additional investments in low-income housing tax credit investments during 2010. Real estate owned increased due to $103.2 million of real estate acquired through acceptance of deeds in lieu of foreclosure on commercial mortgage loans primarily related to a single borrower. The increase in real estate was partially offset by net capital losses on real estate of $15.9 million recorded during 2010 primarily due to impairments recognized on 62 properties the Company acquired from a single borrower in the second quarter of 2010.
calculated DAC balance. Costs that do not vary with the production of new business are not deferred as DAC and are charged to expense as incurred. Generally, annual commissions are considered expenses and are not deferred.
These assumptions are modified to reflect actual experience when appropriate. Although a change in a single assumption may have an impact on the calculated amortization of DAC or VOBA for balances associated with investment contracts, it is the relationship of that change to the changes in other key assumptions that determines the ultimate impact on DAC or VOBA amortization. Because actual results and trends related to these assumptions vary from those assumed, the Company revises these assumptions annually to reflect its current best estimate of expected gross profits. As a result of this process, known as “unlocking,” the cumulative balances of DAC and VOBA are adjusted with an offsetting benefit or charge to income to reflect changes in the period of the revision. An unlocking event that results in an after-tax benefit generally occurs as a result of actual experience or future expectations being favorable compared to previous estimates. An unlocking event that results in an after-tax charge generally occurs as a result of actual experience or future expectations being unfavorable compared to previous estimates. As a result of unlocking, the amortization schedule for future periods is also adjusted.
estimated weighted-average remaining life of approximately 9.3 years. The marketing agreement accompanied the Minnesota Life transaction and provides access to Minnesota Life agents, some of whom now market Standard’s individual disability insurance products. The amortization period for the Minnesota Life marketing agreement is up to 25 years.
Other policyholder funds are liabilities for investment-type contracts and are based on the policy account balances including accumulated interest. Other policyholder funds include amounts related to advanced premiums, premiums on deposit and experience rated liabilities totaling $418.5 million and $431.6 million at December 31, 2010 and 2009, respectively.
Currently, years 2007 through 2010 are open for audit by the IRS. See “Note 7-Income Taxes.”
The following table sets forth the components of accumulated other comprehensive income:
Other comprehensive income (loss) includes changes in unrealized capital gains and losses on fixed maturity securities, net of the related tax effects, and changes in unrealized prior service costs and credits and net gains and losses associated with the Company’s employee benefit plans, net of the related tax effects.
ASU No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses
In July 2010, FASB issued ASU No. 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. ASU No. 2010-20 amends the codification guidance related to credit quality and credit loss disclosures for financing receivables. ASU No. 2010-20 requirements include additional disclosures that enable readers of the financial statements to understand:
How the portfolio’s credit risk is analyzed and assessed in order to arrive at the allowance for credit losses for each portfolio.
Disclosures previously required for financing receivables are now required to be disclosed on a disaggregated basis. In addition, the following new disclosures under ASU No. 2010-20 are required for each financing receivable class:
Significant purchases and sales of financing receivables during the reporting period.
The ASU No. 2010-20 disclosures required as of the end of a reporting period are effective and were implemented in the 2010 Form 10-K. Disclosures concerning the activity that occurs during a reporting period are effective for interim and annual periods beginning on or after December 15, 2010. The Company does not expect the remaining disclosures effective for periods beginning on or after December 15, 2010 to affect the consolidated financial results and will comply with the additional disclosures beginning in the first quarter of 2011 with troubled debt restructurings disclosures temporarily delayed until the FASB Board completes its re-deliberations on the project concerning what constitutes a troubled debt restructuring. The completion of the troubled debt restructuring project is anticipated in the first half of 2011.
ASU No. 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts
In October 2010, FASB issued ASU No. 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. ASU No. 2010-26 amends the codification guidance for insurance entities to eliminate the diversity of accounting treatment related to deferred acquisition costs. ASU No. 2010-26 limits the capitalization of deferred acquisition costs to incremental direct costs of contract acquisition and certain costs directly related to acquisition activities such as underwriting, policy issuance and processing, medical and inspection, and sales force contract selling. To be an incremental direct cost of contract acquisition, the cost must meet the following two requirements:
The weighted-average grant date fair value of options granted was $16.16, $11.52 and $12.30 for 2010, 2009 and 2008, respectively. The total intrinsic value of the options exercised was $4.5 million, $1.4 million and $5.0 million for the same periods, respectively. The amount that the Company received from the exercise of stock options was $8.1 million, $1.9 million and $5.7 million for 2010, 2009 and 2008, respectively. The related tax benefit derived from the tax deduction received by the Company for the difference between the market price of StanCorp common stock and the exercise price when the options were exercised was $1.6 million, $0.5 million and $1.8 million for 2010, 2009 and 2008, respectively.
The compensation cost of stock options is recognized over the vesting period, which is also the period over which the grantee must provide services to the Company. At December 31, 2010, the total compensation cost related to unvested option awards that had not yet been recognized in the financial statements was $5.8 million. This compensation cost will be recognized over the next four years. During 2009, certain executive officers of the Company retired, upon which the vesting of some of their options was accelerated in accordance with their option agreements. The accelerated vesting resulted in recognition of $1.8 million of additional compensation cost for 2009.
The following table sets forth a summary of the activity of performance-based restricted shares and cash performance units outstanding:
As of December 31, 2009, there were no unvested restricted shares or cash units. The total value of restricted shares vested and cash performance units paid was $0.8 million and $2.1 million for 2009 and 2008, respectively. There were no restricted shares that vested or cash units paid for 2010.
In 2006, the Organization & Compensation Committee of the Board of Directors approved a revised form of long-term incentive award agreement to be used in connection with future grants of performance-based stock awards (“Performance Shares”) to designated senior officers. Under the new agreement, Performance Share grants represent the maximum number of shares issuable to the designated senior officers and are generally granted two years before the beginning of the performance period. The actual number of shares issued at the end of the performance period is based on satisfaction of employment and Company financial performance conditions, with a portion of the shares withheld to cover required tax withholding. The new agreement replaced the restricted shares and cash performance unit arrangement previously used.
The Company issued 14,823, 10,339 and 9,820 shares of StanCorp common stock to directors for 2010, 2009 and 2008, respectively. The weighted-average fair value per share for the shares issued was $44.81, $28.19 and $53.22 for the same periods, respectively.
The Company’s ESPP allows eligible employees to purchase StanCorp common stock at a 15% discount off the lesser of the closing market price of StanCorp common stock on either the commencement or final date of each six-month offering
period. Under the terms of the plan, each eligible employee may elect to have up to 10% of the employee’s gross total cash compensation for the period withheld to purchase StanCorp common stock. No employee may purchase StanCorp common stock having a fair market value in excess of $25,000 in any calendar year.
The Company made a $6.0 million contribution to the employee pension in 2010. The Company did not make a contribution in 2009. The Company is not obligated to make any contributions to its pension plans for 2011. In addition, no plan assets are expected to be returned to the Company in 2011.
quarterly and rebalanced as necessary to keep the allocation of debt and equity securities within target allocation tolerance levels. The equity securities include pooled separate account funds comprised of large cap growth, large cap blend, large cap value, mid cap blend and foreign mutual funds and are diversified across investment strategies. The employee pension plan held no StanCorp equity securities as plan assets at December 31, 2010 and 2009. The plan invests in a stable asset fund comprised of debt securities represented by a Deposit Administration Contract with Standard. Standard maintains the contributions in an unallocated fund, whose assets are invested with other assets in the general account of Standard. The account is credited with earnings on the underlying investments and charged for plan withdrawals and administrative expenses charged by Standard Retirement Services. The stable asset fund contract may subject the plan to concentrations of risk as its contract value is dependent on the ability of Standard to honor its contractual commitments. There are no reserves against the contract value for credit risk of Standard or otherwise.
The Company recognizes the funded or underfunded status of the postretirement benefit plan, as an asset or liability on the balance sheet. The funded or unfunded status is measured as the difference between the fair value of the plan assets and the accumulated benefit obligation.
The Company contributed $0.5 million and $0.2 million to fund the postretirement benefit plan in 2010 and 2009, respectively. The Company expects to make contributions of $0.4 million to its postretirement benefit plan in 2011. No plan assets are expected to be returned to the Company in 2011.
Postretirement benefit plan assets are recorded at fair value and are disclosed below using a three-level hierarchy. See “Note 9-Fair Value” for additional fair value information. As there was not an active market for the Company’s municipal bond holdings at December 31, 2010, the municipal bonds were valued using Level 2 measurements.
StanCorp operates through two reportable segments: Insurance Services and Asset Management, as well as an Other category. Subsidiaries, or operating segments, have been aggregated to form our reportable segments. Resources are allocated and performance is evaluated at the segment level. The Insurance Services segment offers group and individual disability insurance, group life and AD&D insurance, group dental and group vision insurance, and absence management services. The Asset Management segment offers full-service 401(k) plans, 403(b) plans, 457 plans, defined benefit plans, money purchase pension plans, profit sharing plans and non-qualified deferred compensation products and services. This segment also offers investment advisory and management services, financial planning services, commercial mortgage loan origination and servicing, individual fixed-rate annuity products, group annuity contracts and retirement plan trust products. The Other category includes return on capital not allocated to the product segments, holding company expenses, operations of certain unallocated subsidiaries, interest on debt, unallocated expenses including costs incurred during the Company’s 2009 operating expense reduction initiatives, net capital gains and losses related to the impairment or the disposition of the Company’s invested assets and adjustments made in consolidation. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. See “Note 1-Summary of Significant Accounting Policies.”
Subsequent to the issuance of the Company’s 2009 consolidated financial statements, the Company determined that certain amounts should have been reflected within the operating and investing activities sections of the condensed statement of cash flows rather than the investing and financing activities sections, respectively. Specifically, the Company determined that the equity in net income from subsidiaries should be included as a non-cash adjustment to net income to arrive at cash flows from operating activities. The Company also determined that items that were deemed returns on investment should be reflected in cash provided by operating activities, whereas items that were determined to be return of capital or capital provided to subsidiaries should remain as an investing activity. In addition, the Company determined that financing receivables from subsidiaries should be reflected as investing activities due to the nature of these cash flows. As a result, the parent holding company financial information for the years ended December 31, 2009 and 2008 has been corrected. These misstatements do not impact the Company’s consolidated balance sheet, consolidated statement of income or consolidated statement of cash flows for any of the periods. Management believes the effects of these misstatements are not material to the Company’s previously issued consolidated financial statements.
The following tables set forth the adjustments made to amounts included in the parent holding company condensed financial information:
The following table sets forth the tax effect of temporary differences that gave rise to significant portions of the net deferred tax asset (liability):
limitations under IRS Section 382, which potentially reduces the annual amount that may be utilized. This carryforward will expire between 2019 and 2024. In addition, the Company has various state net operating loss carryforwards that expire at various dates through 2030. The Company is carrying forward a deferred tax asset of $4.8 million related to these losses.
The Company did not have any material unrecognized tax benefits in 2010 and 2009. It is the Company’s accounting policy to record income tax interest and penalties in the income tax provision. See “Note 1-Summary of Significant Accounting Policies-Income Taxes.”
The Company did not elect to measure and record commercial mortgage loans, policy loans, other policyholders funds that are investment-type contracts, and long-term debt at fair value on the Company’s consolidated balance sheets.
For disclosure purposes, the fair value of commercial mortgage loans was estimated using an option-adjusted discounted cash flow valuation. The valuation includes both observable market inputs and estimated model parameters.
For policy loans, the carrying value represents historical cost but approximate fair value. While potentially financial instruments, policy loans are an integral component of the insurance contract and have no maturity date.
The fair value for long-term debt was predominantly based on quoted market prices as of December 31, 2010 and 2009 and trades occurring close to December 31, 2010 and 2009.
Fixed maturity securities, Standard & Poor’s (“S&P”) 500 Index call spread options (“S&P 500 Index options”) and index-based interest guarantees embedded in indexed annuities (“index-based interest guarantees”) are recorded at fair value on a recurring basis. In the Company’s consolidated statements of income and comprehensive income (loss), unrealized gains and losses are reported in other comprehensive income for fixed maturity securities, in net investment income for S&P 500 Index options and in interest credited for index-based interest guarantees.
Separate account assets represent segregated funds held for the exclusive benefit of contract holders. The activities of the account primarily relate to participant-directed 401(k) contracts. Separate account assets are recorded at fair value on a recurring basis, with changes in fair value recorded in separate account liabilities. Separate account assets consist of mutual funds. The mutual funds’ fair value is determined through Level 1 and Level 2 inputs. The majority of the separate account assets are valued using quoted prices in an active market with the remainder of the assets valued using quoted prices from an independent pricing service. The Company reviews the fair values obtained from the pricing service for reasonableness through analytical procedures and performance reviews.
The pricing service also takes into account perceived market movements and sector news, as well as a bond’s terms and conditions, including any features specific to that issue that may influence risk, and thus marketability. Depending on the security, the priority of the use of observable market inputs may change as some observable market inputs may not be relevant or additional inputs may be necessary. The Company generally obtains one value from its primary external pricing service. On a case-by-case basis, the Company may obtain further quotes or prices from additional parties as needed.
Changes to the fair value of fixed maturity securities, excluding S&P 500 Index options, were recorded to other comprehensive income. Changes to the fair value of the S&P 500 Index options were recorded to net investment income. Changes to the fair value of the index-based interest guarantees were recorded as interest credited. The interest credited amount for 2010 and 2009 included negative interest on policyholder funds of $5.0 million and $2.4 million, respectively, due to changes in the Level 3 actuarial assumptions.
Certain assets and liabilities are measured at fair value on a nonrecurring basis such as impaired commercial mortgage loans with specific allowances for losses and real estate owned. The impaired commercial mortgage loans and real estate owned are valued using Level 3 measurements. These Level 3 inputs are reviewed for reasonableness by management and evaluated on a quarterly basis. The commercial mortgage loan measurements include valuation of the market value of the asset using general underwriting procedures and appraisals. Real estate owned is initially recorded at estimated net realizable value, which includes an estimate for disposal costs. These amounts may be adjusted in a subsequent period as independent appraisals are received. During 2010, the Company recorded capital losses of $23.4 million primarily related to impairments recognized on real estate owned resulting from the receipt of independent appraisals on properties acquired from a single borrower.
Commercial mortgage loans measured on a nonrecurring basis with a carrying amount of $64.3 million were written down to their fair value of $43.9 million, less selling costs, at December 31, 2010. The specific commercial mortgage loan loss allowance related to these commercial mortgage loans was $20.4 million at December 31, 2010. The real estate owned measured on a nonrecurring basis during 2010 and still held at December 31, 2010 had capital losses totaling $22.9 million for the year. See “Note 10-Investments-Commercial Mortgage Loans” for further disclosures regarding the commercial mortgage loan loss allowance.
Through its concentration of commercial mortgage loans in California, the Company is exposed to potential losses from an economic downturn in California as well as certain catastrophes, such as earthquakes and fires that may affect certain areas of the western region. Borrowers are required to maintain fire insurance coverage to provide reimbursement for any losses due to fire. Management diversifies the commercial mortgage loan portfolio within California by both location and type of property in an effort to reduce certain catastrophe and economic exposure. However, diversification may not always eliminate the risk of such losses. Historically, the delinquency rate of the California-based commercial mortgage loans has been substantially below the industry average and consistent with the Company’s experience in other states. In addition, when underwriting new loans, earthquake insurance is not required for the properties. However, management does consider the potential for earthquake loss based upon seismic surveys and structural information specific to each property. The Company does not expect a catastrophe or earthquake damage in the western region to have a material adverse effect on its business, financial position, results of operations or cash flows. Currently, the Company’s California exposure is
The Company assesses the credit quality of its commercial mortgage loan portfolio quarterly by reviewing the performance of its portfolio which includes evaluating its performing and nonperforming commercial mortgage loans. Nonperforming commercial mortgage loans include all commercial mortgage loans that are 60 days or more past due and commercial mortgage loans that are not 60 days past due but are not substantially performing to other original contractual terms. Nonperforming commercial mortgage loans do not include restructured commercial mortgage loans that are current with their payments and thus are considered performing. However, these restructured commercial mortgage loans may continue to be classified as impaired commercial mortgage loans for monitoring and review purposes.
The following table sets forth performing and nonperforming commercial mortgage loans by property type:
The increase in the impaired commercial mortgage loans at December 31, 2010 compared to 2009 was primarily due to an increase in restructured and sixty-day delinquent commercial mortgage loans that were not performing to the contractual terms of the loan agreements. As of December 31, 2010 and 2009, the Company did not have any commercial mortgage loans greater than 90 days delinquent that were accruing interest. See “Note 1-Summary of Significant Accounting Policies-Investment Valuations-Commercial Mortgage Loans” for the policies regarding interest income for delinquent commercial mortgage loans.
The amount of interest income recognized on impaired commercial mortgage loans was $2.8 million, $0.1 million, $0.1 million for 2010, 2009 and 2008, respectively. The cash received by the Company in payment of interest on impaired commercial mortgage loans was $3.3 million, $0.1 million, $0.1 million for 2010, 2009 and 2008, respectively. See “Note 1-Summary of Significant Accounting Policies-Investment Valuations-Commercial Mortgage Loans” for policies regarding interest income for delinquent commercial mortgage loans.
The following table sets forth the aging of commercial mortgage loans by property type:
The Company purchases S&P 500 Index options for its interest crediting strategy used in its indexed annuity product. The S&P 500 Index options are purchased from investment banks and are selected in a manner that supports the amount of interest that is expected to be credited in the current year to annuity policyholder accounts that are dependent on the performance of the S&P 500 Index. The purchase of S&P 500 Index options is a pivotal part of the Company’s risk management strategy for indexed annuity products. The S&P 500 Index options are exclusively used for risk management. While valuations of the S&P 500 Index options are sensitive to a number of variables, valuations for S&P 500 Index options purchased are most sensitive to changes in the S&P 500 Index value and the implied volatilities of this index. The Company generally purchases fewer than five S&P 500 Index option contracts per month, which all have an expiry date of one year from the date of purchase.
Fluctuations in the fair value of the S&P 500 Index options related to the volatility of the S&P 500 Index increased net investment income for 2010 and 2009 and decreased net investment income for 2008. Fluctuations in the fair value of the index-based interest guarantees related to the volatility of the S&P 500 Index and the Company’s annual update of the key assumptions used to value the index-based interest guarantees, a process known as “unlocking,” increased interest credited for 2010 and decreased interest credited for 2009 and 2008.
The Company does not bear derivative-related risk that would require it to post collateral with another institution, and its S&P 500 Index options do not contain counterparty credit-risk-related contingent features. The Company is exposed to the credit worthiness of the institutions from which it purchases its S&P 500 Index options and these institutions’ continued abilities to perform according to the terms of the contracts. The current values for the credit exposure have been affected by fluctuations in the S&P 500 Index. The Company’s maximum credit exposure would require an increase of approximately 6.6% in the value of the S&P 500 Index. The maximum credit risk is calculated using the cap strike price of the Company’s S&P 500 Index options less the floor price, multiplied by the notional amount of the S&P 500 Index options.
The value of DAC and VOBA is dependent on key assumptions. See “Note 1-Summary of Significant Accounting Policies-DAC, VOBA and Other Intangible Assets” for a discussion of the key assumptions used to determine the values of DAC and VOBA. Because actual results and trends related to these assumptions vary from those assumed, the Company revises these assumptions annually to reflect its current best estimate of expected gross profits. As a result of this process, known as “unlocking,” the cumulative balances of DAC and VOBA are adjusted with an offsetting benefit or charge to income to reflect changes in the period of the revision. An unlocking event that results in an after-tax benefit generally occurs as a result of actual experience or future expectations being favorable compared to previous estimates. An unlocking event that results in an after-tax charge generally occurs as a result of actual experience or future expectations being unfavorable compared to previous estimates. As a result of unlocking, the amortization schedule for future periods is also adjusted.
The accumulated amortization of VOBA was $60.4 million and $58.4 million at December 31, 2010 and 2009, respectively. The accumulated amortization of other intangible assets was $23.0 million and $17.2 million at December 31, 2010 and 2009, respectively. See “Note 1-Summary of Significant Accounting Policies-DAC, VOBA and Other Intangible Assets” for a discussion on the amortization policies for VOBA and other intangible assets.
The changes in amounts incurred related to prior years are not the result of a significant change in an underlying assumption or method used to determine the estimate. Instead the Company expects these amounts to change over time as a result of the growth in the size of the Company’s in force insurance business and the actual claims experience with respect to that business during the time periods captured for claims with an incurred date in years prior to the year of valuation. Interest is also a key component in the year-to-year development of the reserves and therefore the positive changes in amounts incurred related to prior years should not be taken as an indicator of the adequacy or inadequacy of the reserves held. In each of the years captured, there was a decrease in incurred amounts associated with prior years after the effect of interest is taken into account, indicating claim experience was favorable when compared to the assumptions used to establish the associated reserves.
Standard participates in a reinsurance and third-party administration arrangement with Northwestern Mutual Life Insurance Company (“Northwestern Mutual”) under which Northwestern Mutual group long term and short term disability products are sold using Northwestern Mutual’s agency distribution system. Generally, Standard assumes 60% of the risk and receives 60% of the premiums for the policies issued. If Standard were to become unable to meet its obligations, Northwestern Mutual would retain the reinsured liabilities. Therefore, in accordance with an agreement with Northwestern Mutual, Standard established a trust for the benefit of Northwestern Mutual with the market value of assets in the trust equal to Northwestern Mutual’s reinsurance receivable from Standard. The market value of assets required to be maintained in the trust at December 31, 2010, was $226.5 million. Premiums assumed by Standard for the Northwestern Mutual business accounted for 3.0% of the Company’s total premiums for each of the three years 2010, 2009 and 2008. In addition to assuming risk, Standard provides product design, pricing, underwriting, legal support, claims management and other administrative services under the arrangement.
The Company also maintains reinsurance coverage for certain catastrophe losses related to group life and AD&D with partial coverage of nuclear, biological and chemical acts of terrorism. Through a combination of this agreement and its participation in a catastrophe reinsurance pool discussed below, the Company has coverage of up to $450.9 million per event.
The Company is part of a catastrophe reinsurance pool with other insurance companies. This pool spreads catastrophe losses from group life and AD&D over 23 participating members. The annual fee paid by the Company in 2010 to participate in the pool was less than $30,000. As a member of the pool, the Company is exposed to maximum potential losses experienced by other participating members of up to $103.2 million for a single event for losses submitted by a single company and a maximum of $258.1 million for a single event for losses submitted by multiple companies. The Company’s percentage share of losses experienced by pool members will change over time as it is a function of the Company’s group life and AD&D in force relative to the total group life and AD&D in force for all pool participants. The reinsurance pool does not exclude war or nuclear, biological and chemical acts of terrorism.
Standard. The market value of assets required to be maintained in the trust is determined quarterly. The market value of assets required to be maintained in the trust at December 31, 2010, was $322.7 million. Approximately $60 million in VOBA was recorded related to the reinsurance agreement.
Effective January 1, 2001, Standard ceded to Protective Life, through a reinsurance agreement, Standard’s individual life insurance product line. Standard received a ceding commission of approximately $90 million and transferred to Protective Life approximately $790 million in assets and corresponding statutory liabilities. If Protective Life were to become unable to meet its obligations, Standard would retain the reinsured liabilities. Therefore, the liabilities remain on Standard’s consolidated balance sheets, and an equal amount is recorded as a recoverable from the reinsurer. In accordance with the agreement, Protective Life established a trust for the benefit of Standard with assets in the trust required to be equal to Standard’s reinsurance receivable from Protective Life. The amount of assets required to be maintained in the trust is determined quarterly.
Other operating expenses include operating expenses, commissions and bonuses, interest expense, premium taxes, and the net increase in DAC, VOBA and other intangible assets.
Initial commissions and expense allowance received for a block of reinsurance ceded net of taxes are reported as deferred gains in surplus and recognized as income in subsequent periods.
Standard and The Standard Life Insurance Company of New York are subject to statutory restrictions that limit the maximum amount of dividends and distributions that they could declare and pay to StanCorp without prior approval of the states in which the subsidiaries are domiciled. During 2010 and 2009, Standard made distributions to StanCorp totaling $244.0 million and $170.0 million, respectively.
State insurance departments require insurance enterprises to adhere to minimum Risk-based Capital (“RBC”) requirements promulgated by the NAIC. At December 31, 2010 and 2009, the insurance subsidiaries’ capital levels were significantly in excess of that which would require corrective action by the insurance subsidiaries or regulatory agencies. The Authorized Control Level RBC was $200.0 million and $187.9 million at December 31, 2010 and 2009, respectively.
The Company has $250 million of 6.875%, 10-year senior notes (“Senior Notes”), which mature on September 25, 2012. The principal amount of the Senior Notes is payable at maturity and interest is payable semi-annually in April and October.
In the normal course of business, the Company is involved in various legal actions and other state and federal proceedings. A number of actions or proceedings were pending at December 31, 2010. In some instances, lawsuits include claims for punitive damages and similar types of relief in unspecified or substantial amounts, in addition to amounts for alleged contractual liability or other compensatory damages. In the opinion of management, the ultimate liability, if any, arising from the actions or proceedings is not expected to have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
In the normal course of business, the Company commits to fund commercial mortgage loans generally up to 90 days in advance. At December 31, 2010, the Company had outstanding commitments to fund commercial mortgage loans totaling $70.8 million, with fixed interest rates ranging from 5.75% to 7.75%. These commitments generally have fixed expiration dates. A small percentage of commitments expire due to the borrower’s failure to deliver the requirements of the commitment by the expiration date. In these cases, the Company will retain the commitment fee and good faith deposit. Alternatively, if the Company terminates a commitment due to the disapproval of a commitment requirement, the commitment fee and good faith deposit may be refunded to the borrower, less an administrative fee.