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 1832 Schuetz Road, St. Louis, Missouri, which consists of approximately 140,000 square feet. SNCC also owns land located at 1832 Schuetz Road, St. Louis, Missouri as well as its former home office building at 2043 Woodland Parkway, Suite 200, St. Louis, Missouri, which consists of approximately 58,000 square feet. DCM and FRSLIC leases its administrative office at 590 Madison Avenue, New York, New York on the 29th and 30th floors under an operating lease expiring in November 2016. 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. The Company believes that its properties and facilitates are suitable and adequate for current operations.
The Company also operates an asset accumulation business that focuses primarily on offering fixed annuities to individuals. In addition, during the first quarter of 2006, the Company issued $100 million in aggregate principal amount of fixed and floating rate funding agreements with maturities of three to five years in connection with the issuance by an unconsolidated special purpose vehicle of funding agreement-backed notes in a corresponding principal amount. Also, during the third quarter of 2008, the Company acquired a block of existing SPDA and FPA policies from another insurer through an indemnity assumed reinsurance transaction with such insurer that resulted in the assumption by the Company of policyholder account balances in the amount of $135.0 million. The Company has the right under this transaction to recommend to such insurer on an ongoing basis the interest rates to be credited with respect to the reinsured annuity policies, subject to the minimum crediting rates specified in such policies. The Company believes that its funding agreement program and annuity reinsurance arrangements enhance the Company’s asset accumulation business by providing alternative sources of funds for this business. The Company’s liabilities for its funding agreements and annuity reinsurance arrangements are recorded in policyholder account balances. Deposits from the Company’s asset accumulation business are recorded as liabilities rather than as premiums. Revenues from the Company’s asset accumulation business are primarily comprised of investment income earned on the funds under management. The profitability of asset accumulation products is primarily dependent on the spread achieved between the return on investments and the interest credited with respect to these products. The Company sets the crediting rates offered on its asset accumulation products in an effort to achieve its targeted interest rate spreads on these products, and is willing to accept lower levels of sales on these products when market conditions make these targeted spreads more difficult to achieve.
As noted above and elsewhere in this report, the management of the Company’s investment portfolio is an important component of its profitability. Over the second half of 2007 and continuing through 2008 and into 2009, due primarily to the extraordinary stresses affecting the banking system, the housing market and the financial markets generally, particularly the structured mortgage securities market, the financial markets have been the subject of extraordinary volatility and dramatically widened credit spreads in numerous sectors. See Part I, Item 1A - Risk Factors. At the same time the overall level of risk-free interest rates has declined substantially. These market conditions resulted in a significant
Premium and Fee Income. Premium and fee income in 2008 was $1,384.9 million as compared to $1,304.2 million in 2007, an increase of 6%. Premiums from core group employee benefit products increased 7% to $1,310.0 million in 2008 from $1,227.9 million in 2007. This increase reflects normal growth in employment and salary levels for the Company’s existing customer base, price increases and new business production. Premiums from excess workers’ compensation
Benefits and Expenses. Policyholder benefits and expenses were $1,366.9 million in 2008 as compared to $1,310.6 million in 2007. This increase primarily reflects the increase in premiums from the Company’s group employee benefit products discussed above. The combined ratio (loss ratio plus expense ratio) for the Company’s group employee benefits products decreased to 92.2% in 2008 from 92.4% in 2007. Amortization of cost of business acquired was decelerated by $10.9 million during 2008, primarily due to the decrease in the Company’s tax equivalent weighted average annual yield on invested assets. See “Critical Accounting Policies and Estimates - Deferred Acquisition Costs”. The weighted average annual crediting rate on the Company’s asset accumulation products, which reflects the effects of the first year bonus crediting rate on certain newly issued products, was 4.3% in 2008 and 2007.
Interest Expense. Interest expense was $31.6 million in 2008 as compared to $27.5 million in 2007, an increase of $4.1 million. This increase primarily resulted from interest payments on the 2007 Junior Debentures issued by the Company in the second quarter of 2007 and an increase in the weighted average borrowings under the Amended Credit Agreement. This increase was partially offset by a decrease in the interest rate on the weighted average borrowings under the Amended Credit Agreement and from the redemption of 2003 Junior Debentures in the third quarter of 2008. See “Liquidity and Capital Resources - General”.
Income Tax (Benefit) Expense. Income tax (benefit) expense was $(4.2) million in 2008 as compared to $68.0 million in 2007 primarily due to the lower level of the Company’s operating income. The Company’s effective tax rate was 13.1% in 2008 as compared to 29.3% in 2007 primarily due to the significantly higher proportion of net investment income represented by tax-exempt interest income.
Summary of Results. Net income was $164.5 million, or $3.19 per diluted share, in 2007 as compared to $142.1 million, or $2.79 per diluted share, in 2006. Net income in 2007 and 2006 included net realized investment losses, net of the related income tax benefit, of $1.2 million, or $0.02 per diluted share, and $0.6 million, or $0.01 per diluted share, respectively. Net income in 2007 benefited from growth in income from the Company’s core group employee benefit products, increased investment spreads on the Company’s asset accumulation products and an increase in net investment income, and was adversely impacted by an increase in interest expense and by a loss on the redemption of junior subordinated deferrable interest debentures. Core group employee benefit products include disability, group life, excess workers’ compensation, travel accident and dental insurance. See “Group Employee Benefit Products” in Part I, Item 1 -
Business. Premiums from these core group employee benefit products increased 14% in 2007 and the combined ratio (loss ratio plus expense ratio) for group employee benefit products decreased to 92.4% in 2007 from 93.2% in 2006. Net investment income in 2007, which increased 6% from 2006, primarily reflects a 13% increase in average invested assets. The increase in interest expense was primarily due to interest payments on the 2007 Junior Debentures, which the Company issued in the second quarter of 2007.
Premiums from the Company’s other core group employee benefit products increased 16% to $951.7 million in 2007 from $821.6 million in 2006, primarily attributable to a 15% increase in premiums from the Company’s group disability products, new business production, improved retention of existing customers and a decrease in premiums ceded by the Company to reinsurers for these products. During 2007, premiums from the Company’s group disability products increased to $527.5 million from $458.1 million in 2006, primarily reflecting new business production. Premiums from the Company’s turnkey disability business were $49.8 million and $54.3 million in 2007 and 2006, respectively. New business production for the Company’s other core group employee benefit products increased 18% to $262.7 million in 2007 from $222.9 million in 2006 reflecting growth in the Company’s integrated employee benefits program and its suite of voluntary group insurance products, which includes, among others, its group limited benefit health insurance product. New business production includes only directly written business, and does not include premiums from the Company’s turnkey disability business. The level of production achieved from these other core group employee products also reflects the Company’s focus on the small case niche (insured groups of 10 to 500 individuals).
Net Investment Income. Net investment income in 2007 was $270.5 million as compared to $255.9 million in 2006, an increase of 6%. The level of net investment income in the 2007 period reflects a 13% increase in average invested assets to $4,555.2 million in 2007 from $4,038.7 million in 2006. The tax equivalent weighted average annual yield on invested assets was 6.2% and 6.6% in 2007 and 2006, respectively.
Loss on Redemption of Junior Subordinated Deferrable Interest Debentures. During 2007, the Company recognized a pre-tax loss of $2.2 million from the redemption of the Junior Debentures underlying the Capital Securities of Delphi Funding. On March 27, 2007, Delphi Funding redeemed the remaining $36.0 million liquidation amount of Capital Securities concurrently with the redemption by the Company of the underlying Junior Debentures held by Delphi Funding. The redemption price was $1,046.55 per Capital Security plus accrued dividends. As a result, the $103.1 million principal amount of the Junior Debentures ceased to be outstanding and dividends on the Capital Securities ceased to accrue.
Benefits and Expenses. Policyholder benefits and expenses were $1,310.6 million in 2007 as compared to $1,178.2 million in 2006, an increase of 11%. This increase primarily reflects the increase in premiums from the Company’s group employee benefit products discussed above, and also reflects additions to reserves for prior years’ claims and claim expenses in the amount of $11.6 million due to adverse loss experience, primarily arising from the Company’s excess workers’ compensation line, due principally to moderately increased claim frequency, relative to prior periods, relating to policies written during the period from 2000 to 2002. The combined ratio (loss ratio plus expense ratio) for the Company’s group employee benefits products decreased to 92.4% in 2007 from 93.2% in 2006. The weighted average annual crediting rate on the Company’s asset accumulation products, which reflects the effects of the first year bonus crediting rate on certain newly issued products, was 4.3% and 4.5% in 2007 and 2006, respectively.
Income Tax Expense. Income tax expense was $68.0 million in 2007 as compared to $63.0 million in 2006. The Company’s effective tax rate was 29.3% in 2007 and 30.3% in 2006.
In October 2006, the Company entered into an Amended and Restated Credit Agreement with Bank of America, N.A. as administrative agent, and a group of major banking institutions (the “Amended Credit Agreement”), which, among other things, increased the maximum borrowings available to $250 million, improved the pricing terms and extended the
Cash Flows. Operating activities increased cash by $396.3 million, $383.3 million and $402.9 million in 2008, 2007 and 2006, respectively. Net investing activities used $704.1 million of cash during 2008 primarily for the purchase of securities. Financing activities provided $320.3 million of cash during 2008, principally from the net increase in deposits to policyholder accounts and additional borrowings under the Amended Credit Agreement, partially offset by the redemption of the 2003 Junior Debentures and acquisition of treasury stock. During 2007, financing activities used $16.1 million of cash, principally for the repayment of outstanding borrowings under the Amended Credit Agreement, the redemption of the Junior Debentures held by Delphi Funding, and the repurchase of the Company’s Class A Common Stock, partially offset by proceeds from the issuance of the 2007 Junior Debentures.
At December 31, 2008, municipal fixed maturity securities represented approximately 26% of the Company’s total invested assets, of which approximately 75% were insured by third-party financial guarantors. See Note B to the Consolidated Financial Statements included herein. As part of its investment portfolio repositioning discussed above, the Company has recently been increasing the portfolio’s allocation to municipal securities. See “Introduction”. Due in particular to the impacts that the current economic recession has had and may in the future have on the finances of state and local governments, and the uncertainties associated with the abilities of the financial guarantors to meet their insurance obligations, these securities subject the Company to a degree of credit risk. The extent of this risk may increase in the future if the recessionary environment continues or worsens. The Company’s municipal securities had a weighted average credit rating of “AA” at December 31, 2008. For insured municipal fixed maturity securities having ratings by nationally recognized statistical rating organizations without giving effect to the credit enhancement provided by the insurance the weighted average credit rating at December 31, 2008 by such organizations was “AA”.
The types and amounts of investments made by the Company’s insurance subsidiaries are subject to the insurance laws and regulations of their respective states of domicile. Each of these states has comprehensive investment regulations. In addition, the Company’s Amended Credit Agreement also contains limitations, with which the Company is currently in compliance in all material respects, on the composition of the Company’s investment portfolio. The Company also continually monitors its investment portfolio and attempts to ensure that the risks associated with concentrations of investments in either a particular sector of the market or a single entity are limited.
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 assist the Company in estimating 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 $68.0 million at December 31, 2008 as compared to a decline of approximately $89.7 million at December 31, 2007. 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 indicated by these analyses 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, its and its insurance subsidiaries’ current and future capital requirements, the interest rate environment and other market conditions. At December 31, 2008, a hypothetical 10% decrease in market interest rates would cause a corresponding $1.5 million increase in the fair value of the Company’s fixed-rate corporate debt which matures in 2033 as compared to an increase of $7.6 million at December 31, 2007. Because interest expense on the Company’s floating-rate corporate debt that was outstanding at December 31, 2008 would have fluctuated as prevailing interest rates changed, changes in market interest rates would not have materially affected its fair value.
The most significant assumptions made in the estimation process for future policy benefits and unpaid claims and claim expenses for the Company’s disability and accident products relate to mortality, morbidity, claim termination and discount rates. Mortality and morbidity assumptions are based on various actuarial tables that are generally utilized in the industry, modified as believed to be necessary for possible variations. The claim termination rate represents the probability that a disability claim will close or change due to maximum benefits being paid under the policy, the recovery or death of the claimant, or a change in status in any given period. Establishing claim termination rates is complex and involves many factors, including the cause of disability, the claimant’s age and the type of contractual benefits provided. The Company uses its extensive claim experience database to develop its claim termination rate assumptions, which are applied as an average to its large population of active claims. A one percent increase or decrease in the group long-term disability claim termination rate established by the Company, which the Company believes is a reasonable range of variance in this regard, would have decreased or increased, respectively, the reserves established for claims incurred in 2008 by approximately $1.1 million, which would in turn have increased or decreased, respectively, its 2008 net income by $0.7 million. Disability reserves are discounted using interest rate assumptions based upon projected portfolio yield rates for the assets supporting the liabilities. The Company’s discount rate assumptions are discussed in further detail below.
The primary actuarial methods used to establish the Company’s reserves for unpaid claims and claim expenses for its property and casualty insurance products are the incurred loss development method and the Bornhuetter-Ferguson expected loss method. Under the incurred loss development method, various mathematic tools are utilized in order to project future loss experience based on the Company’s historical loss experience. This method is utilized for accident years as to which management believes a sufficient level of historical loss experience exists. For more recent years for which this level of experience does not exist, management utilizes the Bornhuetter-Ferguson expected loss method to establish loss reserves. Under this method, in addition to historical loss experience, the Company also takes into account an expected loss ratio based on information determined during the initial pricing of the business, including, among other factors, changes in rates and terms and conditions.
Deferred acquisition costs related to group life, disability and accident products, which totaled $125.8 million at December 31, 2008, are amortized over the anticipated premium-paying period of the related policies in proportion to the ratio of the present value of annual expected premium income to the present value of the total expected premium income. Persistency, which measures the rate at which the Company’s policyholders elect to renew their insurance policies (taking into account the effect of internal replacements pursuant to SOP 05-1), was the sole key assumption used in calculating the amortization of deferred acquisition costs for the Company’s group life, disability and accident products in 2008, 2007 and 2006. The actual persistency of these products has not fluctuated significantly in recent years, nor has the level of future persistency of these products assumed by the Company for purposes of such calculations. Deferred acquisition costs related to casualty insurance products, which totaled $14.0 million at December 31, 2008, are amortized ratably over the period in which the related premium is earned, which is generally one year.
Deferred acquisition costs related to annuity products, which totaled $124.5 million at December 31, 2008, are amortized over the anticipated lives of the annuity policies in relation to the expense margins. The amortization is a constant percentage of estimated future gross profits based on the ratio of the present value of amounts deferred as compared to the present value of estimated future gross profits. The key assumptions utilized in the Company’s estimates of future gross profits in 2008, 2007 and 2006 relate to the underlying annuity policies’ future crediting rates and persistency, the Company’s future yield on investments supporting the policies and level of expense necessary to maintain the policies over their entire lives. Adjustments are made, generally on an annual basis, to reflect the actual gross profits to date as
compared to assumed experience and any changes in the remaining expected future gross profits. As a result of this process, known as “unlocking”, the Company records an adjustment to its deferred acquisition costs balance, which may be positive or negative, in order to reflect any changes in the amounts reflected in its key assumptions. A negative adjustment results in a corresponding benefit to the Company’s net income, while a positive adjustment results in a corresponding charge to net income. Changes in the Company’s deferred acquisition cost balance due to unlocking were $10.9 million, $1.5 million and $(1.6) million for the 2008, 2007 and 2006 years. If significant changes in the levels of the Company’s key assumptions relating to its deferred acquisition costs balance were to occur in the future, such changes could result in a large unlocking event that would materially affect the Company’s results of operations and financial condition. If estimated gross profits for all future years on business in force at December 31, 2008 were to increase or decrease by 10%, the deferred policy acquisition costs balance at December 31, 2008 would increase, in the first case, by $0.8 million or decrease, in the second case, by $5.8 million.
The Company also invests in certain investment funds organized as limited partnerships and limited liability companies which invest in various financial instruments. For a discussion of the Company’s repositioning of its investment portfolio during 2008 to reduce the level of investments of this type, see “Introduction”. 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. The Company believes that its estimates reasonably reflect the values of its investments in these fund entities; however, there can be no assurance that such values will ultimately be realized upon liquidation of such investments, which generally can occur only through a redemption or withdrawal from the various fund entities, since no trading market exists for these investments. Such redemptions and withdrawals are generally available only at specified intervals upon the giving of specified prior notice to the applicable entity.
Forward-Looking Statements And Cautionary Statements Regarding Certain Factors That May Affect Future Results
In connection with, and because it desires to take advantage of, the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, the Company cautions readers regarding certain forward-looking statements in the above “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Form 10-K and in any other statement made by, or on behalf of, the Company, whether in future filings with the Securities and Exchange Commission or otherwise. Forward-looking statements are statements not based on historical information and which relate to future operations, strategies, financial results, prospects, outlooks or other developments. Some forward-looking statements may be identified by the use of terms such as “expects,” “believes,” “anticipates,” “intends,” “judgment,” “outlook” “effort,” “attempt,” “achieve,” “project” or other similar expressions. Forward-looking statements are necessarily based upon estimates and assumptions that are inherently subject to significant business, economic, competitive and other uncertainties and contingencies, many of which are beyond the Company’s control and many of which, with respect to future business decisions, are subject to change. Examples of such uncertainties and contingencies include, among other important factors, those affecting the insurance industry generally, such as the economic and interest rate environment, federal and state legislative and regulatory developments, including but not limited to changes in financial services, employee benefit and tax laws and regulations, changes in accounting rules and interpretations thereof,
market pricing and competitive trends relating to insurance products and services, acts of terrorism or war, and the availability and cost of reinsurance, and those relating specifically to the Company’s business, such as the level of its insurance premiums and fee income, the claims experience, persistency and other factors affecting the profitability of its insurance products, the performance of its investment portfolio and changes in the Company’s investment strategy, acquisitions of companies or blocks of business, and ratings by major rating organizations of the Company and its insurance subsidiaries. These uncertainties and contingencies can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. Certain of these uncertainties and contingencies are described in more detail in Part I, Item 1A - Risk Factors. The Company disclaims any obligation to update forward-looking information.