The Company leases its principal executive office at 1105 North Market Street, Suite 1230, Wilmington, Delaware under an operating lease expiring in October 2009. RSLIC leases its administrative office at 2001 Market Street, Suite 1500, Philadelphia, Pennsylvania, under an operating lease expiring in December 2015. SNCC owns its home office building at 2043 Woodland Parkway, Suite 200, St. Louis, Missouri, which consists of approximately 58,000 square feet. SNCC also owns a neighboring office building located at 2029 Woodland Parkway, St. Louis, Missouri. The building consists of approximately 17,000 square feet and is largely occupied by SNCC with a small portion leased to third parties. During 2005, SNCC bought land with the intended use for construction of a new home office. It is located at 1832 Schuetz Road, St. Louis, Missouri. During 2005, DCM and FRSLIC relocated their offices to the 29th and 30th floors of 590 Madison Avenue, New York, New York and are under an operating lease expiring in November 2010. A substantial portion of the former office space that DCM and FRSLIC leased at 153 East 53rd Street, 49th Floor, New York, New York, which is under an operating lease expiring in July 2008, has been sublet to third parties. Matrix leases its principal office at 5225 Hellyer Avenue, Suite 210, San Jose, California under an operating lease expiring in December 2010. The Company also maintains sales and administrative offices throughout the country to provide nationwide sales support and service existing business.
(3) In 2001, the Company used the proceeds from the sales of a substantial majority of investments of its investment subsidiaries during the fourth quarter of 2000 to repay $150.0 million of outstanding borrowings under its revolving credit facilities, to repurchase $64.0 million liquidation amount of the Capital Securities and to repurchase $8.0 million principal amount of the Matured Senior Notes. See "Business - Other Transactions." The Company recognized a gain on extinguishment of debt and capital securities of $11.5 million in connection with these repurchases. In the second quarter of 2002, the Company repurchased $10.5 million aggregate principal amount of the Matured Senior Notes and recognized a loss on extinguishment of debt of $0.3 million in connection with this repurchase.
(5) Results for 2001 include a charge of $0.91 per diluted share or $28.8 million, net of an income tax benefit of $15.5 million and reinsurance coverages of $21.8 million, for reserve strengthening primarily related to an unusually high number of large losses in the Company's excess workers' compensation business. Included in this charge, on a pre-tax basis, are additions to excess workers' compensation case reserves of $9.0 million and incurred but not reported ("IBNR") reserves of $24.0 million. This charge also includes reported workers' compensation losses of $6.3 million and a $5.0 million addition to long-term disability IBNR reserves attributable to the terrorist attacks on the World Trade Center. In the years subsequent to 2001, the number of large losses experienced by the Company returned to the Company's pre-2001 historical average.
During the second half of 2004, the Company's income taxes payable was reduced by $6.6 million primarily from the favorable resolution of Internal Revenue Service ("IRS") audits of the 1998 through 2002 tax years. This reduction represented the release of previous accruals for potential audit adjustments which were subsequently settled or eliminated and the further refinement of existing tax exposures.
Income from continuing operations and net income include realized investment gains (losses), net of federal income tax expense (benefit) and the (loss) gain on extinguishment of debt and capital securities, net of federal income tax (benefit) expense, as follows:
The following discussion and analysis of the results of operations and financial condition of the Company should be read in conjunction with the Consolidated Financial Statements and related notes. The preparation of financial statements in conformity with GAAP requires management, in some instances, to make judgments about the application of these principles. The amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period could differ materially from the amounts reported if different conditions existed or different judgments were utilized. A discussion of how management applies certain critical accounting policies and makes certain estimates is presented below under the caption "Critical Accounting Policies and Estimates" and should be read in conjunction with the following discussion and analysis of results of operations and financial condition of the Company. In addition, a discussion of uncertainties and contingencies which can affect actual results and could cause future results to differ materially from those expressed in certain forward-looking statements contained in this Management's Discussion and Analysis of Financial Condition and Results of Operations can be found in Item 1A. "Risk Factors." See "Forward-Looking Statements And Cautionary Statements Regarding Certain factors That May Affect Future Results."
Summary of Results. Net income was $113.3 million, or $3.38 per diluted share, in 2005 as compared to $123.5 million, or $3.75 per diluted share, in 2004. Net income in 2005 and 2004 included realized investment gains (net of the related income tax expense) of $5.9 million, or $0.17 per diluted share, and $10.0 million, or $0.30 per diluted share, respectively. Net income in 2005 benefited from growth in income from the Company's core group employee benefit products, increased product spreads on the Company's asset accumulation products and an increase in net investment income, and was adversely impacted by losses from discontinued operations and an increase in interest expense. Core group employee benefit products include group life, disability, excess workers' compensation, travel accident and dental insurance. See "Business - Group Employee Benefit Products." Premiums from these core group employee benefit products increased 19% in 2005 and the combined ratio (loss ratio plus expense ratio) for these products was modestly lower than in 2004. Net investment income in 2005, which increased 10% from 2004, reflects an 11% increase in average invested assets. During 2005 and 2004, the Company had (losses) income from discontinued operations (net of the related income tax (benefit) expense) of $(13.4) million, or $(0.40) per diluted share, and $2.1 million, or $0.07 per diluted share, respectively, attributable its non-core property catastrophe reinsurance business which it decided to exit during the fourth quarter of 2005. The increase in interest expense was primarily due to the increases in the Company's weighted average borrowings and the weighted average borrowing rate due to increases in the levels of the short-term interest indices referenced under the Company's revolving credit facility during 2005 as compared to the full year of 2004. In addition, net income for the 2004 period included a reduction of income tax expense of $6.6 million primarily resulting from the favorable resolution of IRS audits of the 1998 through 2002 tax years. This reduction represented the release of previous accruals for potential audit adjustments which were subsequently settled or eliminated and the further refinement of existing tax exposures.
Premium and Fee Income. Premium and fee income in 2005 was $990.2 million as compared to $828.1 million in 2004, an increase of 20%. Premiums from core group employee benefit products increased 19% to $936.2 million in 2005 from $785.0 million in 2004. This increase reflects normal growth in employment and salary levels for the Company's existing customer base, price increases, new business production and an increase in premium income related to an indemnity reinsurance arrangement which the Company entered into in the fourth quarter 2004. Under this arrangement, the Company assumes certain group disability insurance policies on an ongoing basis and is responsible for underwriting, pricing and claims management with respect to the reinsured business. The increase also reflects a decrease in premiums ceded by the Company to reinsurers for these products. Premiums from excess workers' compensation insurance for self-insured employers increased 15% to $220.3 million in 2005 from $190.8 million in 2004. This increase was primarily due to the demand for this product as a result of high primary workers' compensation rates. SNCC continued to obtain significant improvements in contract terms, in particular higher SIR levels, while maintaining its pricing in connection with its renewals of insurance coverage during 2005. On average, SIR levels increased approximately 8% in 2005. SNCC has continued to maintain its pricing on its 2006 renewals and SIRs are up 9% in these renewals. Excess workers' compensation new business production, which represents the amount of new annualized premium sold, increased 62% to $46.0 million in 2005 from $28.4 million in 2004 and the retention of existing customers in 2005 remained strong. New business production for 2005 and 2006 benefited from a renewal rights agreement that SNCC entered into in July 2005. Under the agreement, SNCC acquired, among other things, the right to offer renewal quotes to expiring excess workers' compensation policies of a former competitor. Premiums from the Company's other core group employee benefit products increased 20% to $715.9 million in 2005 from $594.2 million in 2004, reflecting new business production and a decrease in premiums ceded by the Company to reinsurers for these products. See "Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Reinsurance." New business production for the Company's other core group employee benefit products was $198.1 million in 2005 and $180.9 million in 2004. New business production includes only directly written business, and does not include business reinsured under the Company's indemnity reinsurance arrangement discussed above. The level of production achieved from these products reflects the Company's focus on the small case niche (insured groups of 10 to 500 individuals) which resulted in a 14% increase in production based on the number of cases sold as compared to 2004. The Company continues to maintain its underwriting discipline under competitive market conditions for these products and to implement price increases for certain existing disability and group life customers.
(Loss) Income from Discontinued Operations. During the fourth quarter of 2005, the Company decided to exit its non-core property catastrophe reinsurance business, due to the volatility associated with such business and other strategic considerations, and has not thereafter entered into or renewed any assumed property reinsurance contracts. In 2005 and 2004, the Company recognized after-tax operating (loss) income of $(13.4) million, or $(0.40) per diluted share, and $2.1 million, or $0.07 per diluted share, respectively, net of income tax (benefit) expense of $(7.2) million and $1.2 million, respectively, from this business. See Note S to the Consolidated Financial Statements.
Non-core group employee benefit products include LPTs, primary workers' compensation, bail bond insurance, workers' compensation reinsurance and reinsurance facilities. Premiums from non-core group employee benefit products were $16.1 million in 2004 as compared to $14.9 million in 2003.
Net Investment Income. Net investment income in 2004 was $202.4 million as compared to $186.3 million in 2003, an increase of 9%. The level of net investment income in the 2004 period reflects an increase in average invested assets in 2004 partially offset by a decrease in the tax equivalent weighted average annual yield. The tax equivalent weighted average annual yield on invested assets was 6.4% on average invested assets of $3,273.0 million in 2004 and 6.5% on average invested assets of $2,948.2 million in 2003.
Benefits and Expenses. Policyholder benefits and expenses were $863.1 million as compared to $754.6 million in 2003, an increase of 14%. This increase primarily reflects the increase in premiums from the Company's group employee benefit products discussed above, and also reflects an addition to reserves for prior years' claims and claim expenses in the amount of $12.8 million, which arose primarily from adverse loss experience in the Company's excess workers' compensation line, principally due to moderately increased claim frequency, relative to prior periods, relating to policies written during the competitive market cycle years from 1997 to 2000. If this experience trend were to continue in the future, absent favorable loss developments in other policy years, the Company's results of operations could be materially adversely affected. The combined ratio (loss ratio plus expense ratio) for the Company's group employee benefits products was 95.0% in 2004 and 2003. Benefits and expenses related to the Company's asset accumulation products decreased $3.0 million primarily due to a decrease in the weighted average annual crediting rate on these products, which reflected the effects of the first year bonus crediting rate on certain newly issued products, from 5.5% in 2003 to 4.7% in 2004.
Income from Discontinued Operations. After-tax operating income from the Company's discontinued property catastrophe reinsurance business in 2004 and 2003 was $2.1 million, or $0.07 per diluted share, and $3.6 million, or $0.11 per diluted share, respectively, net of related income tax expense of $1.2 million and $2.0 million, respectively. During the fourth quarter of 2005, the Company decided to exit its non-core property catastrophe reinsurance business, due to the volatility associated with such business and other strategic considerations, and has not thereafter entered into or renewed any assumed property reinsurance contracts. See Note S to the Consolidated Financial Statements.
In May 2005, the Company entered into a new $200 million revolving credit facility with Bank of America, N.A. as administrative agent, and a group of major banking institutions (the "Credit Agreement"), which replaced the existing $100 million revolving credit facility scheduled to expire in December 2006. This facility, which expires in May 2010, contains certain financial and various other affirmative and negative covenants considered ordinary for this type of credit
The Company's current liquidity needs, in addition to funding its operating expenses, include principal and interest payments on outstanding borrowings under the Credit Agreement, interest payments on the 2033 Senior Notes, and distributions on the Capital Securities and the 2003 Capital Securities. The maximum amount of borrowings available under the Company's Credit Agreement is $200.0 million. The 2033 Senior Notes mature in their entirety in May 2033 and are not subject to any sinking fund requirements but are redeemable by the Company at par at any time on or after May 15, 2008. The junior subordinated deferrable interest debentures underlying the Capital Securities are not redeemable prior to March 25, 2007. The junior subordinated deferrable interest debentures underlying the 2003 Capital Securities are redeemable, in whole or in part, beginning May 15, 2008. See Notes D and J to the Consolidated Financial Statements.
(3) Includes interest on the outstanding junior subordinated debentures underlying the Capital Securities and the 2003 Junior Subordinated Debentures underlying the 2003 Capital Securities. Interest on the 2003 Junior Subordinated Debentures was computed using the indexed rate in effect at December 31, 2005 of 8.43%.
Sources of liquidity available to the Company on a parent company-only basis, including the undistributed earnings of its subsidiaries and additional borrowings available under the Credit Agreement, are expected to exceed the Company's current and long-term cash requirements. The Company from time to time engages in discussions with respect to acquiring blocks of business and insurance and financial services companies, any of which could, if consummated, be material to the Company's operations.
Cash Flows. Operating activities increased cash by $309.4 million, $264.1 million and $237.5 million in 2005, 2004 and 2003, respectively. Net investing activities used $362.1 million of cash during 2005 primarily for the purchase of securities, and financing activities provided $56.9 million of cash principally due to the increase in borrowings under the Credit Agreement, partially offset by the repayment of certain Federal Home Loan Bank advances.
Share Repurchase Program. The Company's board of directors has authorized a share repurchase program. Share repurchases are effected by the Company in the open market or in negotiated transactions in compliance with the safe harbor provisions of Rule 10b-18 under the Securities Exchange Act of 1934. Execution of the share repurchase program is based on management's assessment of market conditions for its common stock and other potential uses of capital. During 2005, the Company repurchased 150,000 shares of its Class A Common Stock for a total cost of $7.1 million with a volume weighted average price of $47.19 per share. At December 31, 2005, the repurchase of approximately 0.9 million shares remained authorized under this program.
At December 31, 2005, approximately 35% of the Company's total invested assets were comprised of corporate fixed maturity securities. Eighty-two percent of the Company's corporate fixed maturity portfolio, based on fair values, has been rated investment grade by nationally recognized statistical rating organizations. Investment grade corporate fixed maturity securities are distributed among the various rating categories as follows: AAA - 4%, AA - 6%, A - - 31%, and BBB - 41%. Corporate fixed maturity securities subject the Company to credit risk and, to a lesser extent, interest rate risk. To reduce its exposure to corporate credit risk, the Company diversifies its investments across economic sectors, industry classes and issuers.
Asset/Liability Management and Market Risk. Because the Company's primary assets and liabilities are financial in nature, the Company's consolidated financial position and earnings are subject to risks resulting from changes in interest rates. The Company manages this risk by active portfolio management focusing on minimizing its exposure to fluctuations in interest rates by matching its invested assets and related liabilities and by periodically adjusting the crediting rates on its annuity products and the discount rate used to calculate reserves on the Company's other products. In its asset/liability matching process, the Company determines and monitors on a quarterly basis the duration of its insurance liabilities in the aggregate and the duration of the investment portfolio supporting such liabilities in order to ensure that the difference between such durations, or the "duration gap," remains below an internally specified maximum, and similarly determines and monitors the duration gap as between its interest-sensitive liabilities, substantially all of which consist of its asset accumulation products, and the components of its investment portfolio supporting such liabilities in relation to a separate internally specified maximum. As of December 31, 2005, the Company maintained these duration gaps within the aforementioned maximums. In addition, the Company, at times, has utilized futures and option contracts and interest rate or credit default swap agreements primarily to reduce the risk associated with changes in the value of its fixed maturity portfolio. At December 31, 2005, the Company had no material outstanding futures or option contracts or interest rate or credit default swap agreements. The Company, at times, may also invest in non-dollar denominated fixed maturity securities that expose it to fluctuations in foreign currency rates, and therefore, may hedge such exposure by using currency forward contracts. The Company's investment in non-dollar denominated fixed maturity securities during 2005 was less than 0.3% of total invested assets.
The Company regularly analyzes the results of its asset/liability matching through cash flow analysis and duration matching under multiple interest rate scenarios. These analyses enable the Company to measure the potential gain or loss in fair value of its interest-rate sensitive financial instruments due to hypothetical changes in interest rates. Based on these analyses, if interest rates were to immediately increase by 10% from their year-end levels, the fair value of the Company's interest-sensitive assets, net of corresponding changes in the fair value of cost of business acquired and insurance and investment-related liabilities, would decline by approximately $61.0 million at December 31, 2005 as compared to a decline of approximately $49.8 million at December 31, 2004. These analyses incorporate numerous assumptions and estimates and assume no changes in the composition of the Company's investment portfolio in reaction to such interest rate changes. Consequently, the results of this analysis will likely be materially different from the actual changes in the value of the Company's assets that will be experienced under given interest rate scenarios.
The Company manages the composition of its borrowed capital by considering factors such as the ratio of borrowed capital to total capital, future debt requirements, the interest rate environment and other market conditions. At December 31, 2005, a hypothetical 10% decrease in market interest rates would cause a corresponding $9.3 million increase in the fair value of the Company's fixed-rate corporate debt which matures in 2033 as compared to an increase of $11.0 million at December 31, 2004. Because interest expense on the Company's floating-rate corporate debt that was outstanding at
December 31, 2005 would have fluctuated as prevailing interest rates changed, changes in market interest rates would not have materially affected its fair value.
RSLIC Performance-Contingent Options. In December 2005, the Stock Option and Compensation Committee (the "Committee") of the Board of Directors of the Company granted additional performance-contingent incentive options to purchase 50,000 shares of the Company's Class A Common Stock to each of Lawrence E. Daurelle, President and Chief Executive Officer of RSLIC, and the other six members of executive management of RSLIC. Such options have a ten-year term and an exercise price equal to the fair market value of a share of the Stock at the date of grant. The options have the same five-year financial performance target and performance period as the performance-contingent incentive options that were granted in April 2004. The options will become exercisable if the specified target is met; otherwise a reduced number of such options will become exercisable according to where the performance target falls within a specified range, as defined and computed under the related option agreements for the five-year performance period consisting of fiscal years 2004 through 2008. See Note N to the Consolidated Financial Statements.
SNCC Performance-Contingent Options. Also, in December 2005, the Committee approved the amendment of the respective performance-contingent incentive options to purchase 225,000 shares of the Company's Class A Common Stock previously granted to each of Harold F. Ilg, Chairman of the Company's subsidiary, SNCC, and the other four members of executive management of SNCC. Pursuant to such amendment, such options will become exercisable if the aggregate consolidated Pre-Tax Operating Income of SIG Holdings, Inc., SNCC's intermediate parent company, as defined and computed under the related option agreements ("SIG PTOI"), for the five-year performance period consisting of fiscal years 2003 through 2007 is at least $417.2 million; otherwise, a reduced number of such options will become exercisable to the extent that the aggregate SIG PTOI for such period exceeds $370.4 million, determined by interpolating between zero and 225,000 according to where the SIG PTOI amount falls in the range between $370.4 million and $417.2 million. None of such options became exercisable for the three-year performance period consisting of fiscal years 2003 through 2005. See Note N to the Consolidated Financial Statements.
Future Policy Benefits and Unpaid Claims and Claim Expenses. The Company establishes reserves that are intended to be sufficient to fund the future policy benefits and unpaid claims and claim expenses relating to its insurance products. These reserves, which totaled $1,862.9 million at December 31, 2005, represent management's best estimate of future policy benefits and unpaid claims and claim expenses. The reserves are calculated using various generally recognized actuarial methodologies and are based upon assumptions and estimates that management believes are appropriate and which vary by type of product. Annually, external actuarial experts also review the Company's methodologies, assumptions and the resulting reserves. The Company's projected ultimate insurance liabilities and associated reserves are estimates, which are subject to variability. This variability arises because the factors and events affecting the ultimate liability for claims have not all taken place, and thus cannot be evaluated with certainty. As a result, actual future ultimate losses will not develop exactly as projected and may vary significantly from the projections. The estimation process is complex and involves information obtained from company-specific and industry-wide data, as well as general economic information. The Company's insurance reserves are based upon management's informed estimates and judgments using currently available data. As additional experience emerges and other data become available, these estimates and judgments are reviewed and may be revised. The methods and assumptions used to establish the Company's insurance reserves are continually reviewed and updated based on current circumstances, and any resulting adjustments may result in reserve increases or decreases that would be reflected in the Company's results of operations for the periods in which such revisions are made. There were no material changes in the current year in the actuarial methods and/or assumptions from those used in the previous periods; however, in 2005 and 2004, the Company experienced a degree of adverse variance in loss experience from its past projections. See Item 1, "Business - Property and Casualty Insurance Reserves."
The Company's actuaries select an ultimate loss reserve amount for its property and casualty insurance products by reviewing the results of the actuarial methods described above, as well as other tertiary methods which serve to provide supplemental data points, and applying judgments to achieve a point estimate for the ultimate loss amount, rather than calculating ranges around the reserves. Reserves for unpaid claims and claim expenses for such products represent management's best estimate and are based upon this actuarially derived point estimate. In reviewing and determining the adequacy of this estimate, management considers several factors such as historical results, changes to policy pricing, terms and conditions, deductibles and attachment points, claims-handling staffing, practices and procedures, effects of claim inflation, industry loss trends, reinsurance coverages, underwriting initiatives, and changes in state legislative and regulatory environments.
Investments. Investments are primarily carried at fair value with unrealized appreciation and depreciation included as a component of other comprehensive income in shareholders' equity, net of the related income tax benefit or expense and the related adjustment to cost of business acquired. Ninety seven percent of the Company's fixed maturity and equity securities portfolio are actively traded in a liquid market or have other liquidity mechanisms. Securities acquired through
Declines in the fair value of investments that are considered in the judgment of management to be other than temporary are reported as realized investment losses. The Company evaluates, among other things, the financial position and prospects of the issuer, conditions in the issuer's industry and geographic area, liquidity of the investment, changes in the amount or timing of expected future cash flows from the investment, and recent downgrades of the issuer by a rating agency to determine if and when a decline in the fair value of an investment below amortized cost is other than temporary. The length of time and extent to which the fair value of the investment is lower than its amortized cost and the Company's ability and intent to retain the investment to allow for any anticipated recovery in the investment's fair value are also considered. In 2005, 2004 and 2003, the Company recognized losses totaling $4.2 million, $3.9 million and $13.0 million, respectively, for the other than temporary decline in the value of certain fixed maturity securities. These losses were recognized as a result of events that occurred in the respective periods, such as downgrades in an issuer's credit ratings, deteriorating financial results of issuers, adverse changes in the amount and timing of estimated future cash flows from securities and the impact of adverse economic conditions on issuers' financial positions. Investment grade and non-investment grade fixed maturity securities comprised 75.9% and 7.1%, respectively, of the Company's total investment portfolio at December 31, 2005. Gross unrealized appreciation and gross unrealized depreciation, before the related income tax expense or benefit and the related adjustment to cost of business acquired, attributable to investment grade fixed maturity securities totaled $70.4 million and $24.0 million, respectively, at December 31, 2005. Gross unrealized appreciation and gross unrealized depreciation, before the related income tax expense or benefit and the related adjustment to cost of business acquired, attributable to non-investment grade fixed maturity securities totaled $3.2 million and $13.5 million, respectively, at December 31, 2005. Unrealized appreciation and depreciation, net of the related income tax expense or benefit and the related adjustment to cost of business acquired, has been reflected on the Company's balance sheet as a component of other comprehensive income. The Company anticipates that if certain existing declines in security values are determined to be other than temporary, it may recognize additional investment losses in the range of $7 million to $15 million pre-tax ($5 million to $10 million on an after-tax basis) with respect to the relevant securities. However, the extent of any such losses will depend on future market developments and changes in security values, and such losses may exceed or be lower than such range. It is not possible to predict the extent of any future changes in value, positive or negative, or the results of the future application of the Company's procedures for the evaluation of other than temporary impairment in valuation. There can be no assurance that the Company will realize investment gains in the future in an amount sufficient to offset any such losses.
The Company also invests in certain limited partnerships and limited liability companies which invest in various financial instruments. These investments are reflected in the Company's financial statements under the equity method; accordingly, positive or negative changes in the value of the investees' underlying investments are included in net investment income. For this purpose, the Company estimates the values of its investments in these entities based on values provided by their managers, as adjusted based on available information concerning the underlying investment portfolios. As of December 31, 2005 and 2004, there were no adjustments in such values, as compared with a reduction in value of $6.7 million as of December 31, 2003. The Company believes that its estimates reasonably reflect the values of its investments in these entities; however, there can be no assurance that such values will ultimately be realized upon liquidation of such investments.