The Company owns the 41-story office building at One East Wacker Drive, Chicago, Illinois, that houses the executive offices of Kemper and the home office of its Kemper Direct operations, which together occupy approximately 58,000 square feet of the 527,000 rentable square feet in the building. In addition, Kemper’s subsidiaries together own and occupy 13 buildings located in seven states consisting of approximately 47,000 square feet in the aggregate. Kemper’s subsidiaries hold additional properties solely for investment purposes that are not utilized by Kemper or its subsidiaries.
Kemper Preferred leases facilities with an aggregate square footage of approximately 89,000 at 8 locations in eight states. The latest expiration date of the existing leases is in September of 2018. Kemper Specialty leases facilities with an aggregate square footage of approximately 20,000 at two locations in two states. The latest expiration date of the existing leases is in June of 2018. Kemper Direct leases facilities with an aggregate square footage of approximately 63,000 at five locations in four states. The latest expiration date of the existing leases is in October of 2016. Kemper Preferred, Kemper Specialty and Kemper Direct share leased facilities with an aggregate square footage of approximately 329,000 at 15 locations in 10 states. The latest expiration date of the existing leases is in September of 2018. Kemper’s Life and Health Insurance segment leases facilities with aggregate square footage of approximately 496,000 at 124 locations in 26 states. The latest expiration date of the existing leases is in October of 2019. Kemper’s corporate data processing operation leases facilities with aggregate square footage of approximately 36,000 square feet at two locations in two states. The latest expiration date of the existing leases is in September of 2018. Fireside leases facilities with an aggregate square footage of approximately 48,000 at one location in one state. The expiration date of the lease is in August of 2014.
Selected financial information as of and for the years ended December 31, 2012, 2011, 2010, 2009 and 2008 is presented below.
* Effective January 1, 2012, the Company adopted ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, and retrospectively applied its provisions to the prior periods presented. The retrospective application reduced Shareholders’ Equity by $77.9 million at January 1, 2008. See Note 2, “Summary of Accounting Policies and Accounting Changes,” to the Consolidated Financial Statements.
Catastrophe losses and LAE from continuing operations (excluding loss and LAE reserve development from prior accident years) were $124.5 million before tax for the year ended December 31, 2012, compared to $163.8 million in 2011, a decrease of $39.3 million. Kemper Preferred contributed $38.8 million to the decrease in catastrophe losses and LAE before tax, with the Life Health Insurance segment contributing $3.1 million to the decrease. The Company reported Income from Discontinued Operations of $11.6 million and $12.8 million for the years ended December 31, 2012 and 2011, respectively.
A reconciliation of Total Segment Net Operating Income to Net Income for the years ended December 31, 2012, 2011 and 2010 is presented below:
Ceded Catastrophe Reinsurance Premiums for the Life and Health Insurance segment for the year ended December 31, 2011 in the preceding table includes a reduction of $0.2 million in the Company’s estimate for reinsurance reinstatement premiums for certain hurricanes that occurred in prior years. Ceded Catastrophe Reinsurance Premiums for the Life and Health Insurance segment in the preceding table includes reinsurance reinstatement premiums of $0.6 million for the year ended December 31, 2010 to reinstate coverage following certain hurricanes that occurred in prior years.
Catastrophe losses and LAE (excluding loss and LAE reserve development from prior accident years) from continuing operations were $124.5 million, $163.8 million and $79.3 million for the years ended December 31, 2012, 2011 and 2010, respectively. Catastrophe losses and LAE (excluding loss and LAE reserve development) by business segment for the years ended December 31, 2012, 2011 and 2010 are presented below:
As shown in the preceding table, catastrophe losses and LAE decreased for the year ended December 31, 2012 due primarily to lower severity of losses below $5 million per event and lower frequency of losses in excess of $15 million per event, partially offset by higher frequency of losses ranging from $5 million to $10 million per event. The five events in the $5 million to $10 million range and one event in the $10 million to $15 million range for the year ended December 31, 2012 were related to hail or wind events in either Texas, Colorado or the Midwest and mid-Atlantic states. In the fourth quarter of 2012, the Company incurred claims related to one event in the greater than $25 million range which was Superstorm Sandy. Events below $5 million for the year ended December 31, 2011 are due primarily to spring storms. In the second quarter of 2011, the United States experienced a high volume of spring storms, including a record level of tornadoes in April resulting in two events in the $15 million to $20 million range and one event which was $32.1 million. In the third quarter of 2011, the Company incurred claims related to one event in the $20 million to $25 million range which was Hurricane Irene. Catastrophe losses and LAE for the year ended December 31, 2011 include $23.0 million related to Hurricane Irene.
Total Catastrophe loss and LAE reserves, net of reinsurance recoverables, developed favorably by $6.3 million, $6.4 million and $1.2 million for the years ended December 31, 2012, 2011 and 2010, respectively. See MD&A, “Loss and LAE Reserve Development,” of this 2012 Annual Report for catastrophe loss and LAE reserve development by business segment.
Increases (decreases) in the Company’s property and casualty loss and LAE reserves for the years ended December 31, 2012, 2011 and 2010 to recognize adverse (favorable) loss and LAE reserve development from prior accident years, hereinafter also referred to as “reserve development” in the discussion of segment results, is presented below:
Consolidated Net Operating Income is an after-tax, non-GAAP measure and is computed by excluding from Income from Continuing Operations the after-tax impact of 1) Net Realized Gains (Losses) on Sales of Investments, 2) Net Impairment Losses Recognized in Earnings related to investments and 3) other significant non-recurring or infrequent items that may not be indicative of ongoing operations. Significant non-recurring items are excluded when (a) the nature of the charge or gain is such that it is reasonably unlikely to recur within two years, and (b) there has been no similar charge or gain within the prior two years. The most directly comparable GAAP financial measure is Income from Continuing Operations.
The Company believes that Consolidated Net Operating Income provides investors with a valuable measure of its ongoing performance because it reveals underlying operational performance trends that otherwise might be less apparent if the items were not excluded. Net Realized Gains (Losses) on Sales of Investments and Net Impairment Losses Recognized in Earnings related to investments included in the Company’s results may vary significantly between periods and are generally driven by business decisions and external economic developments such as capital market conditions that impact the values of the Company’s investments, the timing of which is unrelated to the insurance underwriting process. Significant non-recurring items are excluded because, by their nature, they are not indicative of the Company’s business or economic trends.
A reconciliation of Consolidated Net Operating Income to Income from Continuing Operations for the years ended December 31, 2012, 2011 and 2010 is presented below:
There were no applicable significant non-recurring items that the Company excluded from the calculation of Consolidated Net Operating Income for the years ended December 31, 2012, 2011 and 2010.
Earned Premiums in the Kemper Preferred segment increased by $19.6 million for the year ended December 31, 2012, compared to the same period in 2011, due primarily to higher volume, and to a lesser extent, higher average premium. Earned premiums on automobile insurance increased by $4.6 million in 2012, compared to 2011, due primarily to higher volume, partially offset by lower average premium. Earned premiums on homeowners insurance increased by $13.6 million in 2012, compared to 2011, due primarily to higher volume and, to a lesser extent, higher average premium. Earned premiums on other personal insurance increased by $1.4 million in 2012, compared to 2011, due primarily to higher volume and, to a lesser extent, higher average premium.
Other personal insurance incurred losses and LAE were $30.8 million, or 55.6% of other personal insurance earned premiums, for the year ended December 31, 2012, compared to $26.7 million, or 49.4% of other personal insurance earned premiums, for the same period in 2011. Other personal insurance incurred losses and LAE increased by $4.1 million due primarily to lower levels of favorable loss and LAE reserve development and higher underlying losses and LAE, partially offset by lower catastrophe losses and LAE (excluding reserve development). Favorable loss and LAE reserve development was $2.7 million in 2012, compared to $5.0 million in 2011. Underlying losses and LAE were $28.6 million in 2012, compared to $26.1 million in 2011. Catastrophe losses and LAE (excluding development) were $4.9 million in 2012, compared to $5.6 million in 2011.
Earned Premiums in the Kemper Preferred segment decreased by $28.2 million for the year ended December 31, 2011 compared to 2010, due to lower volume, partially offset by higher average premium rates. Volume decreased due, in part, to Kemper Preferred’s decision to maintain its underwriting discipline and increase premium rates while facing increased competition in a soft personal lines insurance market. Also contributing to the decrease in volume was Kemper Preferred’s ongoing strategy to reduce its mix of non-package and non-target market business. Earned premiums from package policies (a package policy provides both automobile and homeowners insurance coverages in a single policy) comprised 55% of earned premiums in the Kemper Preferred segment in 2011, compared to 52% in 2010. Earned premiums on automobile insurance decreased by $33.8 million in 2011, compared to 2010, due to lower volume and, to a lesser extent, lower average premium rates. The weighted-average number of automobile insurance policies in force decreased by 7.2% in 2011, compared to 2010. Earned premiums on homeowners insurance increased by $4.9 million in 2011, compared to 2010, due primarily to higher average premium rates, partially offset by lower volume. The weighted-average number of homeowners insurance policies in force decreased by 2.5% in 2011, compared to 2010. Earned premiums on other personal insurance increased by $0.7 million in 2011, compared to 2010, due primarily to higher average premium rates, partially offset by lower volume.
Operating results in the Kemper Preferred segment decreased by $107.5 million before taxes for the year ended December 31, 2011, compared to 2010, due primarily to higher incurred catastrophe losses and LAE (excluding development), higher homeowners insurance underlying losses and LAE as a percentage of earned premiums, the impact of lower favorable loss and LAE reserve development (including catastrophe development), higher insurance expenses as a percentage of earned premiums and lower net investment income.
Catastrophe losses and LAE (excluding development) were $144.2 million for the year ended December 31, 2011, compared to $70.1 million in 2010, an increase of $74.1 million. Favorable loss and LAE reserve development (including catastrophe development) was $19.1 million in 2011, compared to $23.8 million in 2010. Underlying losses and LAE as a percentage of earned premiums were 67.9% in 2011, compared to 66.2% in 2010.
Automobile insurance incurred losses and LAE were $389.5 million for the year ended December 31, 2011, compared to $399.1 million in 2010. Automobile insurance incurred losses and LAE decreased by $9.6 million due primarily to lower claim volume resulting principally from fewer automobile insurance policies in force and lower underlying losses and LAE as a percentage of automobile insurance earned premiums, partially offset by higher incurred catastrophe losses and LAE (excluding development) and the impact of lower favorable loss and LAE reserve development (excluding catastrophe development). Underlying losses and LAE as a percentage of automobile insurance earned premiums were 73.8% in 2011, compared to 74.1% in 2010. Underlying losses and LAE as a percentage of automobile insurance earned premiums decreased due primarily to lower average frequency of losses. Catastrophe losses and LAE (excluding development) were $14.1 million in 2011, compared to $7.2 million in 2010. Favorable loss and LAE reserve development (excluding catastrophe development) was $1.3 million in 2011, compared to favorable development of $11.6 million in 2010.
Homeowners insurance incurred losses and LAE were $293.5 million for the year ended December 31, 2011, compared to $210.0 million in 2010. Homeowners insurance incurred losses and LAE increased by $83.5 million in 2011, compared to 2010, due primarily to higher catastrophe losses and LAE (excluding development) and higher underlying losses and LAE, partially offset by the impact of higher favorable loss and LAE reserve development (excluding catastrophe development). Catastrophe losses and LAE (excluding development) on homeowners insurance were $124.5 million in 2011, compared to $61.4 million in 2010. The catastrophe losses and LAE in 2011 included losses from Hurricane Irene and several severe tornadoes and other storms throughout the United States. Underlying losses and LAE were $181.7 million in 2011, compared to $156.9 million in 2010. Underlying losses and LAE increased due primarily to higher average estimated frequency and severity of losses. Favorable loss and LAE reserve development (excluding catastrophe development) was $7.1 million in 2011, compared to $3.6 million in 2010.
Other personal insurance incurred losses and LAE were $26.7 million for the year ended December 31, 2011, compared to $24.5 million in 2010. Other personal insurance incurred losses and LAE increased by $2.2 million due primarily to higher catastrophe losses and LAE (excluding development), partially offset by the impact of higher favorable loss and LAE reserve development (excluding catastrophe development). Catastrophe losses and LAE (excluding development) on other personal insurance were $5.6 million in 2011, compared to $1.5 million in 2010. Favorable loss and LAE reserve development (excluding catastrophe development) was $5.2 million in 2011, compared to $3.7 million in 2010.
Insurance Expenses decreased by $3.5 million for the year ended December 31, 2011, compared to 2010, due primarily to lower acquisition expenses, partially offset by higher underwriting expenses, largely due to information technology expenses related to several new systems initiatives.
The Kemper Preferred segment reported Segment Net Operating Loss of $17.6 million for the year ended December 31, 2011, compared to Segment Net Operating Income of $52.9 million for the same period in 2010. The Kemper Preferred segment’s effective income tax rate differs from the federal statutory income tax rate due primarily to tax-exempt investment income and dividends received deductions. Tax-exempt investment income and dividends received deductions were $24.5 million in 2011, compared to $25.6 million in 2010.
Earned Premiums in the Kemper Specialty segment decreased by $25.4 million for the year ended December 31, 2012, compared to the same period in 2011, due primarily to lower earned premiums for personal automobile insurance, partially offset by higher earned premiums on commercial automobile insurance. Personal automobile insurance earned premiums decreased by $28.9 million in 2012, compared to 2011, due primarily to lower volume, partially offset by higher average premium. Personal automobile insurance policies in force were approximately 260,000 at December 31, 2012, compared to 302,000 at the beginning of 2012 and 329,000 at the beginning of 2011. Commercial automobile insurance earned premiums increased by $3.5 million in 2012, compared to 2011, due primarily to higher volume from an increase in new business production.
Insurance expenses as a percentage of earned premiums was 21.8% for the year ended December 31, 2012, compared to 20.6% in 2011. Insurance expenses as a percentage of earned premiums increased in 2012, compared to 2011, due primarily to higher expenses associated with information technology initiatives.
Net Investment Income in the Kemper Specialty segment decreased by $3.0 million for the year ended December 31, 2011, compared to 2010, due primarily to lower net investment income from Equity Method Limited Liability Investments. The Kemper Specialty segment reported net investment income of $3.7 million from Equity Method Limited Liability Investments in 2011, compared to $7.5 million in 2010.
Commercial automobile insurance operating profit increased by $4.3 million for the year ended December 31, 2011, compared to 2010, due primarily to the favorable effects of loss and LAE reserve development and lower underlying incurred losses and LAE as a percentage of commercial automobile insurance earned premiums. Favorable Loss and LAE reserve development on commercial automobile insurance was $6.1 million in 2011, compared to $1.1 million in 2010. Underlying incurred losses and LAE as a percentage of commercial automobile insurance earned premiums decreased in 2011, compared to 2010, due primarily to lower severity, partially offset by higher frequency of losses.
In the third quarter of 2012, the Company announced that it was reviewing strategic options for Kemper Direct and that it would cease direct-to-consumer marketing activities. In the fourth quarter of 2012, the Company concluded its evaluation and determined that, to optimize the value for the business, it would continue to solicit business for its worksite, affinity and renters programs and would place its direct-to-consumer operations in run-off. The Company expects positive earnings from the run-off as a result of premium rate increases and further optimization of operations. Kemper Direct expects that its policies in-force will decline 15% to 25% over the next twelve months as a result of this and other actions.
Net Investment Income in the Kemper Direct segment decreased by $3.5 million for the year ended December 31, 2012, compared to 2011, due primarily to lower net investment income from Equity Method Limited Liability Investments and lower levels of investments allocated to Kemper Direct. Net investment income from Equity Method Limited Liability Investments was $1.3 million in 2012, compared to $2.9 million in 2011.
The Kemper Direct segment reported an Operating Loss of $4.8 million for the year ended December 31, 2012, compared to an Operating Loss of $47.2 million in 2011. Operating results improved in the Kemper Direct segment in 2012, compared to 2011, due primarily to lower levels of unprofitable business, higher levels of favorable reserve development, the impact of the partial write-off in 2011 of an intangible asset from the acquisition of Direct Response Corporation (”Direct Response”) that did not recur in 2012 and lower underlying losses and LAE, partially offset by lower net investment income.
Incurred losses and LAE were $129.5 million, or 77.1% as a percentage of earned premiums, for the year ended December 31, 2012, compared to $197.6 million, or 88.7% as a percentage of earned premiums, in 2011. Incurred losses and LAE decreased in 2012, due primarily to the impact of lower earned premiums, higher levels of favorable loss and LAE reserve development and lower underlying losses and LAE as a percentage of earned premiums, partially offset by higher incurred catastrophe losses and LAE (excluding development). Underlying incurred losses and LAE exclude the impact of catastrophes and loss and LAE reserve development. Favorable loss and LAE reserve development was $17.8 million in 2012, compared to $3.9 million in 2011. Underlying losses and LAE as a percentage of earned premiums were 82.8% in 2012, compared to 87.5% in 2011. Underlying losses and LAE as a percentage of earned premiums decreased in both automobile and homeowners insurance. Catastrophe losses and LAE (excluding development) were $8.3 million in 2012, compared to $6.7 million in 2011.
Kemper Direct reported a Segment Net Operating Loss of $0.9 million for the year ended December 31, 2012, compared to a Segment Net Operating Loss of $27.5 million for the same period in 2011. The Kemper Direct segment’s effective income tax rate differs from the federal statutory income tax rate due primarily to tax-exempt investment income and dividends received deductions. Tax-exempt investment income and dividends received deductions were $6.2 million in 2012, compared to $8.7 million in 2011.
Insurance Expenses in the Kemper Direct segment were 34.3% of earned premiums for the year ended December 31, 2011, compared to 30.8% of earned premiums in 2010. Insurance Expenses as a percentage of earned premiums increased in 2011, compared to 2010, due primarily to higher amortization expense related to the acquisition of Direct Response, higher restructuring costs and higher consulting expenses.
In 2011, the Direct Response book of business was not improving at the rate that Kemper Direct had initially expected, and Kemper Direct determined that the customer relationships intangible asset related to the Direct Response acquisition was impaired at December 31, 2011 and recognized a charge of $13.5 million in 2011 to write down the asset to its estimated fair value.
Kemper believes that some of the health insurance products sold by its subsidiary, Reserve National, could be adversely impacted by some provisions of the Health Care Acts. In particular, a provision which sets minimum loss ratios for health insurance policies and a provision, beginning in 2014, establishing health insurance exchanges could adversely impact Reserve National’s business prospects. Such affected health insurance products (the “Affected Products”) accounted for $62.5 million, or 38%, of the Life and Health Insurance segment’s accident and health insurance earned premiums in 2012. Reserve National has been adapting its business model in response and suspended sales of the Affected Products at the end of 2011. In 2011, Reserve National began transitioning its sales to other health insurance products that are not expected to be as severely impacted by the Health Care Acts (the “Supplemental Products”). Supplemental Products accounted for $29.8 million, or 18%, of the Life and Health Insurance segment’s accident and health insurance earned premiums in 2012. Reserve National expects
The Life and Health Insurance segment continued to intentionally run off insurance policies providing dwelling coverage (”Dwelling Policies”) to reduce its exposure to catastrophe risks. Over the last several years, the Life and Health Insurance segment has halted new sales of Dwelling Policies in all markets and non-renewed Dwelling Policies in certain geographical, mainly coastal, areas while continuing to renew policies in other geographical areas. Accordingly, except for catastrophe reinsurance provided by the FHCF, the Life and Health Insurance segment did not renew its primary annual catastrophe reinsurance program for 2013. Earned premiums from dwelling coverage comprised 26%, 30% and 32% of the Life and Health Insurance segment’s earned premiums on property insurance in 2012, 2011 and 2010, respectively.
Operating Profit in the Life and Health Insurance segment was $140.4 million for the year ended December 31, 2012, compared to $152.3 million in 2011. Policyholders’ Benefits and Incurred Losses and LAE increased by $7.5 million in 2012 due primarily to higher policyholders’ benefits on life insurance and the impact of Loss and LAE reserve development on property insurance, partially offset by lower catastrophe losses and LAE and lower underlying losses on property insurance. Policyholders’ benefits on life insurance were $265.3 million in 2012, compared to $253.2 million in 2011, an increase of $12.1 million. Policyholder benefits on life insurance increased due primarily to reserve adjustments in 2011 associated with correcting expiry dates for certain extended term life insurance policies and a lower level of net lapse in 2012, partially offset by better mortality experience. Incurred accident and health insurance losses were $88.9 million, or 53.8% of accident and health insurance earned premiums, in 2012, compared to $88.9 million, or 53.4% of accident and health insurance earned premiums, in 2011. Incurred accident and health insurance losses were flat as higher average incurred claim costs for Medicare supplement insurance and, to a lesser extent, a higher average incurred claim cost for hospitalization and limited benefit insurance products, were offset by lower frequency of Medicare supplement insurance claims and, to a lesser extent, lower frequency of hospitalization and limited benefit insurance products. Incurred Losses and LAE on property insurance were $38.9 million in 2012, compared to $43.5 million in 2011. Underlying losses and LAE on property insurance were $33.2 million, or 40.8% of property insurance earned premium, in 2012, compared to $37.0 million, or 43.8% of property insurance earned premium, in 2011. Catastrophe losses and LAE (excluding development) were $6.0 million in 2012, compared to $9.1 million in 2011. Favorable loss reserve development on property insurance was $0.3 million (including adverse development of $0.1 million on catastrophes) in 2012, compared to favorable development of $2.6 million (including favorable development of $1.5 million on catastrophes) in 2011. Insurance Expenses in the Life and Health Insurance segment increased by $2.2 million in 2012, compared to 2011, due primarily to higher commission and fringe benefit expenses, partially attributable to an increase in the number of career agents employed, and higher amortization of deferred policy acquisition costs.
Certain state insurance regulators, legislators and treasurers are involved in an array of initiatives that could result in significant changes to unclaimed property laws and claims handling practices with respect to life insurance policies. These initiatives seek, in various ways, to impose a new duty on the part of life insurers to proactively search for deaths of their insureds. It is the Company's position that state officials lack authority to establish new procedures that change existing contracts. See Item 1A., Risk Factors,” under the caption “Changes in state enforcement of unclaimed property laws and related insurance claims handling practices could have a significant effect on (including an acceleration of) the payment and/or escheatment of life insurance death benefits relative to what is currently contemplated by Kemper and significantly increase claims handling costs,” Note 23, “Contingencies,” to the Consolidated Financial Statements and MD&A, “Liquidity and Capital Resources” for additional information about these matters.
Earned Premiums in the Life and Health Insurance segment increased by $1.8 million for the year ended December 31, 2011, compared to 2010, due primarily to higher accident and health insurance earned premiums. Earned premiums on accident and health insurance increased by $4.4 million in 2011, compared to 2010, due primarily to higher average premium rates, partially offset by lower volume of insurance. Net Investment Income decreased by $12.5 million in 2011, compared to 2010, due primarily to lower net investment income on Equity Method Limited Liability Investments, partially offset by higher levels of investments.
Segment Net Operating Income in the Life and Health Insurance segment was $98.9 million for the year ended December 31, 2011, compared to $87.4 million in 2010.
Net Investment Income for the years ended December 31, 2012, 2011 and 2010 was:
Net Investment Income decreased by $2.1 million for the year ended December 31, 2012, compared to the same period in 2011, due primarily to higher other investment expenses, partially offset by higher interest income from loans to policyholders and higher real estate net investment income. Interest income from loans to policyholders increased by $1.2 million in 2012, compared to 2011, due to a higher level of loans outstanding. Net investment income from real estate increased by $1.2 million in 2012, compared to 2011, due primarily to higher occupancy.
The Company regularly reviews its investment portfolio for factors that may indicate that a decline in the fair value of an investment is other than temporary. Losses arising from other-than-temporary declines in fair value are reported in the Consolidated Statements of Income in the period that the declines are determined to be other than temporary. Net Impairment Losses recognized in the Consolidated Statement of Income for the years ended December 31, 2012, 2011 and 2010 include other-than-temporary impairment (“OTTI”) losses of $6.9 million, $11.3 million and $16.5 million, respectively. OTTI losses recognized in the Consolidated Statement of Income for the years ended December 31, 2012 and 2011 included pre-tax losses of $3.1 million and $7.2 million, respectively, to write down real estate investments. OTTI losses recognized in the Consolidated Statement of Income for the year ended December 31, 2010 included pre-tax losses of $11.9 million due to the deterioration of the business prospects of a single issuer in the waste management business. OTTI losses recognized in the Consolidated Statement of Income for the year ended December 31, 2010 included pre-tax foreign currency losses of $2.1 million.
The Company’s fixed maturity investment portfolio is comprised primarily of high-grade municipal, corporate and agency bonds. At December 31, 2012, 93% of the Company’s fixed maturity investment portfolio was rated investment grade, which is defined as a security having a rating of AAA, AA, A or BBB from S&P; a rating of Aaa, Aa, A or Baa from Moody’s; a rating of AAA, AA, A or BBB from Fitch; or a rating from the NAIC of 1 or 2. The following table summarizes the credit quality of the fixed maturity investment portfolio at December 31, 2012 and 2011:
Gross unrealized losses on the Company’s investments in below-investment-grade fixed maturities were $4.3 million and $5.4 million at December 31, 2012 and 2011, respectively.
At December 31, 2012, the Company had $288.5 million of bonds issued by states and political subdivisions, commonly referred to as “municipal bonds,” that had been pre-refunded with U.S. Government and Government Agencies and Authorities obligations held in trust for the full payment of principal and interest (“Pre-refunded Municipal Bonds”). At December 31, 2012, the Company had $1,112.9 million of investments in municipal bonds that had not been pre-refunded, of which $103.5 million were enhanced with insurance from monoline bond insurers. The Company’s municipal bond investment credit-risk strategy is to focus on the underlying credit rating of the issuer and not to rely on the credit enhancement provided by the monoline bond insurer when making investment decisions. To that end, the underlying rating of nearly 96% of the Company’s entire municipal bond portfolio that has not been pre-refunded is AA or higher, half of which are direct obligations of states.
The following table summarizes the fair value of the Company’s investments in governmental fixed maturities at December 31, 2012 and 2011:
The Company’s short-term investments primarily consist of overnight repurchase agreements and money market funds. At December 31, 2012, the Company had $183.7 million invested in overnight repurchase agreements primarily collateralized by securities issued by the U.S. government and $111.8 million invested in money market funds which primarily invest in U.S. Treasury securities. At the time of borrowing, the repurchase agreements generally require the borrower to provide collateral to the Company at least equal to the amount borrowed from the Company. The Company bears some investment risk in the event that a borrower defaults and the value of collateral falls below the amount borrowed. The Company does not have any investments in sovereign debt securities issued by foreign governments.
Seventy-four companies comprised over 75% of the Company’s fixed maturity exposure to the Manufacturing industry at December 31, 2012, with the largest single exposure, Merck & Co. Inc., comprising 3.2%, or $43.5 million, of the Company’s fixed maturity exposure to such industry. Thirty-three companies comprised over 75% of the Company’s exposure to the Finance, Insurance and Real Estate industry at December 31, 2012, with the largest single exposure, Citigroup Inc., comprising 4.6%, or $36.1 million, of the Company’s exposure to such industry.
The Company owns investments in various limited liability investment companies and limited partnerships that primarily invest in distressed debt, mezzanine debt and secondary transactions. The Company’s investments in these limited liability investment companies and limited partnerships are reported either as Equity Method Limited Liability Investments, or Other Equity Interests and included in Equity Securities depending on the accounting method used to report the investment. See Note 2, “Summary of Accounting Policies and Accounting Changes,” to the Consolidated Financial Statements. Additional information pertaining to these investments at December 31, 2012 and 2011 is presented below:
Interest and Other Expenses was $85.5 million, $83.9 million and $68.3 million for the years ended December 31, 2012, 2011 and 2010, respectively. Interest expense, excluding interest on a mortgage note payable included in real estate investment expense, was $37.6 million, $36.9 million and $32.2 million for the years ended December 31, 2012, 2011 and 2010, respectively. Other Corporate Expenses were $47.9 million, $47.0 million and $36.1 million for the years ended December 31, 2012, 2011 and 2010, respectively. Other Corporate Expenses increased by $0.9 million for the year ended December 31, 2012, compared to 2011, due primarily to higher postretirement benefit costs and salaries. Other Corporate Expenses increased by $10.9 million for the year ended December 31, 2011, compared to 2010, due primarily to higher postretirement benefit costs, costs incurred with changing the Company’s name and other corporate initiatives.
The Company’s effective income tax rate from discontinued operations differs from the Federal statutory income tax rate due primarily to the net effects of state income taxes. State income tax, net of federal taxes, from discontinued operations was $0.7 million of expense, $0.3 million of benefit, and $1.1 million of expense for the years ended December 31, 2012, 2011 and 2010, respectively. State income tax includes changes in the state deferred tax asset valuation allowance related to Fireside and is net of a $0.2 million benefit, $2.3 million benefit, and $0.5 million expense for the years ended December 31, 2012, 2011 and 2010, respectively.
In 2003, Kemper issued $200 million of its 4.875% senior notes due November 1, 2010 (the “2010 Senior Notes”) for an effective yield of 5.04%. The 2010 Senior Notes were repaid and retired in 2010. Interest expense under the 2010 Senior Notes was $8.4 million for the year ended December 31, 2010.
On March 31, 2012, Kemper’s subsidiary, Fireside Bank, converted from an industrial bank to a general business corporation and changed its name to Fireside Auto Finance. Accordingly, Fireside is no longer regulated by the Federal Depository Insurance Corporation or the California Department of Financial Institutions and may pay dividends or make other distributions without prior regulatory approval. On April 5, 2012, FAF distributed $20 million of its capital to its then parent company, Fireside Securities Corporation, who then, in turn, distributed the same amount to its parent company, Kemper. In October 2011, Fireside Bank distributed $250 million of its capital to its then parent company, Fireside Securities Corporation, who then, in turn, distributed the same amount to its parent company, Kemper.
Net Cash Provided by Operating Activities increased by $90.7 million for the year ended December 31, 2012, compared to 2011. Net Cash Provided by Operating Activities decreased by $83.5 million for the year ended December 31, 2011, compared to 2010.
Net Cash Used by Financing Activities decreased by $291.2 million for the year ended December 31, 2012, compared to the same period in 2011. The Company did not use cash for the Repayments of Certificates of Deposits for the year ended December 31, 2012, compared to net cash used of $321.8 million in 2011. Kemper used $60.7 million of cash during 2012 to repurchase shares of its common stock, compared to $27.4 million of cash used to repurchase shares of its common stock in 2011. Kemper used $56.9 million of cash to pay dividends for the year ended December 31, 2012, compared to $58.2 million of cash used to pay dividends in the same period of 2011. The quarterly dividend rate was $0.24 per common share for each quarter of 2012 and 2011.
Cash available for investment activities in total is dependent on cash flow from Operating Activities and Financing Activities and the level of cash the Company elects to maintain. Net Cash Provided by Investing Activities decreased by $670.8 million for the year ended December 31, 2012, compared to the same period of 2011. Sales of Fixed Maturities exceeded Purchases of Fixed Maturities by $41.8 million for the year ended December 31, 2012. Purchases of Fixed Maturities exceeded Sales of Fixed Maturities by $13.1 million in 2011. Purchases of Equity Securities exceeded Sales of Equity Securities by $66.9 million for the year ended December 31, 2012. Sales of Equity Securities exceeded Purchases of Equity Securities by $49.1 million for the year ended December 31, 2011. Net cash used by acquisitions of short-term investments was $80.0 million for the year ended December 31, 2012, compared to net cash of $155.5 million provided by dispositions of short-term investments in 2011. Net proceeds from the sale of Fireside’s inactive portfolio of automobile loan receivables provided $16.7 million of cash for the year ended December 31, 2012. Net proceeds from the sale of Fireside’s active loan portfolio provided $220.7 million of cash for the year ended December 31, 2011. Receipts from Automobile Loan Receivables provided $2.0 million of cash for the year ended December 31, 2012, compared to $166.5 million of cash provided in 2011.
The reported value of the Company’s investments was $6,460.1 million at December 31, 2012, of which $5,386.6 million, or 83%, was reported at fair value, $253.0 million, or 4%, was reported under the equity method of accounting, $266.3 million, or 4%, was reported at unpaid principal balance and $554.2 million, or 9%, was reported at cost or depreciated cost. Investment securities, in general, are exposed to various risks, such as interest rate risk, credit risk, and overall market volatility risk. Accordingly, it is reasonably possible that changes in the fair values of the Company’s investments reported at fair value will occur in the near term and such changes could materially affect the amounts reported in the financial statements. Also, it is reasonably possible that changes in the carrying values of the Company’s Equity Method Limited Liability Investments will occur in the near term and such changes could materially affect the amounts reported in the financial statements because these issuers follow specialized industry accounting rules which require that they report all of their investments at fair value.
In estimating the Company’s Property and Casualty Insurance Reserves, the Company’s actuaries exercise professional judgment and must consider, and are influenced by, many variables that are difficult to quantify. Accordingly, the process of estimating and establishing the Company’s Property and Casualty Insurance Reserves is inherently uncertain and the actual ultimate net cost of claims may vary materially from the estimated amounts reserved. The reserving process is particularly imprecise for claims involving asbestos, environmental matters, construction defect and other emerging and/or long-tailed exposures which may not be discovered or reported until years after the insurance policy period has ended. Property and Casualty Insurance Reserves related to the Company’s Discontinued Operations are predominantly long-tailed exposures, $45.2 million of which was related to asbestos, environmental matters and construction defect exposures at December 31, 2012.
For each accident quarter, the point estimate selected by the Company’s actuaries is not necessarily one of the points produced by any particular one of the methodologies utilized, but often is another point selected by the Company’s actuaries, using their professional judgment, that takes into consideration each of the points produced by the several loss reserving estimation methodologies used. In some cases, for a particular product, the current accident quarter may not have enough paid claims data to rely upon, leading the Company’s actuaries to conclude that the incurred loss development methodology provides a better estimate than the paid loss development methodology. Therefore, the Company’s actuaries may give more weight to the incurred loss development methodology for that particular accident quarter. As an accident quarter ages for that same product, the actuary may gain more confidence in the paid loss development methodology and begin to give more weight to the paid loss development methodology. The Company’s actuaries’ quarterly selections are summed by product and/or coverage levels to create the actuarial indication of the ultimate losses. More often than not, the actuarial indication for a particular product line and accident quarter is most heavily weighted towards the incurred loss development methodology, particularly for short-tail lines such as personal automobile insurance. Historically, the incurred loss development methodology has been more reliable in predicting ultimate losses for short-tail lines, especially in the more recent accident quarters, compared with the paid loss development methodology. However, in some circumstances changes can occur which impact numerous variables, including, but not limited to, those variables identified below that are difficult to quantify and/or impact the predictive value of prior
The final step in the quarterly loss and LAE reserving process involves a comprehensive review of the actuarial indications by the Company’s corporate actuary and corporate management who apply their collective judgment and determine the appropriate estimated level of reserves to record. Numerous factors are considered in this determination process, including, but not limited to, the assessed reliability of key loss trends and assumptions that may be significantly influencing the current actuarial indications, changes in claim handling practices or other changes that affect the timing of payment or development patterns, changes in the mix of business, the maturity of the accident year, pertinent trends observed over the recent past, the level of volatility within a particular line of business, the improvement or deterioration of actuarial indications in the current period as
compared to prior periods, and the amount of reserves related to third party pools for which the Company does not have access to the underlying data and, accordingly, relies on calculations provided by such pools.
Development in the Kemper Preferred segment comprised the largest portion of the Company’s development reported in continuing operations in 2011 and 2010. Additional information regarding the Kemper Preferred development is discussed below. Development in the Kemper Direct segment comprised the largest portion of the Company’s development reported in continuing operations in 2012. Development in the Kemper Direct segment in 2012 is due primarily to claims developing more favorably than expected for liability and PIP coverages. Development in the Life and Health Insurance segment in 2011 and 2010 is due primarily to development on certain hurricanes. See MD&A, “Life and Health Insurance.”
loss development factors and, in turn, future loss reserve development. Significant favorable changes in one or more factors will lead to favorable future loss reserve development, which could result in the actual loss developing closer to, or even below, the lower end of the Company’s estimated reserve variability. Significant unfavorable changes in one or more factors will lead to unfavorable loss reserve development, which could result in the actual loss developing closer to, or even above, the higher end of the Company’s estimated reserve variability. Accordingly, due to these factors and the other factors enumerated throughout the MD&A and the inherent limitations of the loss reserving estimation methodologies, the estimated and illustrated reserve variability may not necessarily be indicative of the Company’s future reserve variability, which could ultimately be greater than the estimated and illustrated variability. In addition, as previously noted, development will emerge in all of the Company’s product lines over time. Accordingly, the Company’s future reserve variability could ultimately be greater than the illustrated variability.
While the Company believes that none of its reporting units with material goodwill are at risk of failing step one of the goodwill impairment test, the process of determining whether or not an asset, such as Goodwill, is impaired or recoverable relies on projections of future cash flows, operating results and market conditions. Such projections are inherently uncertain and, accordingly, actual future cash flows may differ materially from projected cash flows. In evaluating the recoverability of Goodwill, the Company performs a discounted cash flow analysis for each of the Company’s reporting units carrying Goodwill. The discounted cash value may be different from the fair value that would result from an actual transaction between a willing buyer and a willing seller. Such analyses are particularly sensitive to changes in discount rates and investment rates. Changes to these rates might result in material changes in the valuation and determination of the recoverability of Goodwill. For example, an increase in the rate used to discount cash flows will decrease the discounted cash value. There is likely to be a similar, but not necessarily as large as, increase in the investment rate used to project the cash flows resulting from investment income earned on the Company’s investments. Accordingly, an increase in the investment rate would increase the discounted cash value.
Consolidated Statements of Cash Flows for the Years Ended December 31, 2012, 2011 and 2010
Consolidated Statements of Shareholders’ Equity for the Years Ended December 31, 2012, 2011 and 2010
As discussed in Note 2, “Summary of Accounting Policies and Accounting Changes,” to the Consolidated Financial Statements, on January 1, 2012, the Company adopted Accounting Standards Update (“ASU”) 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts, and retrospectively adjusted its financial statements for prior periods for the impact of the adoption. On January 1, 2012, the Company also implemented a new model for allocating capital and net investment income to its business segments. Accordingly, the Company has also reclassified certain amounts in its segment results in the retrospectively adjusted financial statements to conform to the current presentation. The Company accounts for Kemper’s subsidiary, Fireside, and the Company’s former Unitrin Business Insurance operations as discontinued operations. See Note 3, “Discontinued Operations,” to the Consolidated Financial Statements.
The preparation of financial statements in conformity with GAAP requires the use of estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could materially differ from those estimates and assumptions.
The fair values of the Company’s Investments in Fixed Maturities, Investments in Equity Securities, Short-term Investments and Notes Payable are estimated using a hierarchal framework which prioritizes and ranks market price observability. The carrying amounts reported in the Consolidated Balance Sheets approximate fair value for Cash, Short-term Investments and certain other assets and other liabilities because of their short-term nature. The actual value at which financial instruments could actually be sold or settled with a willing buyer or seller may differ from estimated fair values depending on a number of factors, including, but not limited to, current and future economic conditions, the quantity sold or settled, the presence of an active market and the availability of a willing buyer or seller.
The process of estimating and establishing reserves for losses and LAE for property and casualty insurance is inherently uncertain and the actual ultimate net cost of a claim may vary materially from the estimated amount reserved. The reserving process is particularly imprecise for claims involving long-tailed exposures, which may not be discovered or reported until years after the insurance policy period has ended. Management considers a variety of factors, including, but not limited to, past claims experience, current claim trends and relevant legal, economic and social conditions, in estimating reserves. A change in any one or more factors is likely to result in the ultimate net claim cost to differ from the estimated reserve. Changes in such estimates may be material and would be recognized in the Consolidated Financial Statements when such estimates change.
Investments in Equity Securities include common and non-redeemable preferred stocks and other equity interests and are reported at fair value. Investments in common and non-redeemable preferred stocks with readily determinable fair values are classified as available for sale. Dividend income on investments in common and non-redeemable preferred stocks is recognized on the ex-dividend date. Other equity interests primarily consist of exchange traded funds and partnership interests in limited liability partnerships in which the Company’s interests are deemed minor. The Company’s share of distributed earnings from other equity interests is recognized as dividend income when received.
Costs directly associated with the successful acquisition of business, principally commissions and certain premium taxes and policy issuance costs, are deferred. On January 1, 2012, the Company retrospectively adopted ASU 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. See discussion below under the caption “Adoption of New Accounting Standards” regarding the adoption of the new standard. Costs deferred on property and casualty insurance products and health insurance products are amortized over the period in which premiums are earned. Costs deferred on traditional life insurance products are primarily amortized over the anticipated premium-paying period of the related policies in proportion to the ratio of the annual premiums to the total premiums anticipated, which is estimated using the same assumptions used in calculating policy reserves.
The Company accounts for the present value of the future profits embedded in Property and Casualty Insurance customer relationships acquired (“P&C Customer Relationships”) based on the present value of estimated future cash flows from the customer relationships acquired. P&C Customer Relationships was $18.7 million and $20.8 million at December 31, 2012 and 2011, respectively. P&C Customer Relationships is amortized using the effective interest method. P&C Customer Relationships are tested for recoverability using undiscounted projections of future cash flows and written down to estimated fair value if the carrying value exceeds the sum of such projections of undiscounted cash flows. The Company recorded a loss of $13.5 million before tax for the year ended December 31, 2011 to write down the carrying value of P&C Customer Relationships related to the acquisition of Direct Response to its estimated fair value.
The following line items in the Consolidated Statements of Cash Flows for the years ended December 31, 2012, 2011 and 2010 were affected by the adoption of the new accounting standard:
In May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure
in the first quarter of 2012 and, except for the additional disclosure requirements, the initial application of the standard did
interim or annual period beginning on or after December 15, 2011. The standard amends ASC Topic 350, “Intangibles” -
likely than not that the fair value of a reporting unit is less than its carrying amount. The Company adopted the standard in the first quarter of 2012 and the initial application of the standard did not have an impact on the Company.
Income, related to the presentation of reclassification adjustments but also required companies to report comprehensive income
either in a single continuous financial statement or in two separate but consecutive financial statements. The Company adopted
In 2008, the Company sold its Unitrin Business Insurance operations. The Company retained Property and Casualty Insurance Reserves for unpaid insured losses that occurred prior to the date of the sale. Property and Casualty Insurance Reserves reported in the Company’s Consolidated Balance Sheets include $99.2 million and $125.6 million at December 31, 2012 and 2011, respectively, for the retained liabilities. In accordance with GAAP, changes in the Company’s estimate of such retained liabilities after the sale are reported as a separate component of the results of discontinued operations. See Note 6, “Property and Casualty Insurance Reserves,” to the Consolidated Financial Statements.
Included in the fair value of Mortgage and Asset-backed investments at December 31, 2011 are $2.9 million of collateralized debt obligations, $1.7 million of non-governmental residential mortgage-backed securities, $0.4 million of other asset-backed securities and $0.1 million of commercial mortgage-backed securities.
Unrealized losses on fixed maturities, which the Company has determined to be temporary at December 31, 2012, were $8.1 million, of which $2.6 million was related to fixed maturities that were in an unrealized loss position for 12 months or longer. Included in the preceding table under the heading “Less Than 12 Months” there were unrealized losses of $0.3 million at December 31, 2012 related to securities for which the Company has recognized credit losses in earnings. There were no unrealized losses at December 31, 2012 related to securities for which the Company has recognized credit losses in earnings in the preceding table under the heading “12 Months or Longer.” Included in the preceding table under the heading “12 Months or Longer” are unrealized losses of $0.1 million at December 31, 2012 related to securities for which the Company has previously recognized foreign currency losses in earnings. Investment-grade fixed maturity investments comprised $3.8 million and below-investment-grade fixed maturity investments comprised $4.3 million of the unrealized losses on investments in fixed maturities at December 31, 2012. Unrealized losses for below-investment-grade fixed maturities included unrealized losses totaling $0.1 million for one issuer that the Company previously recognized foreign currency impairment losses in earnings. For the other remaining below-investment-grade fixed maturity investments in an unrealized loss position, the unrealized loss amount, on average, was less than 3% of the amortized cost basis of the investment. At December 31, 2012, the Company did not have the intent to sell these investments and it was not more likely than not that the Company would be required to sell these investments before recovery of its amortized cost basis, which may be at maturity. Based on the Company’s evaluation at December 31, 2012 of the prospects of the issuers, including, but not limited to, the credit ratings of the issuers of the investments in the fixed maturities, and the Company’s intention to not sell and its determination that it would not be required to sell before recovery of the amortized cost of such investments, the Company concluded that the declines in the fair values of the Company’s investments in fixed maturities presented in the preceding table were temporary at the evaluation date.
during the twelve-month period preceding the evaluation date. The Company concluded that the declines in the fair values of these perpetual preferred stocks were temporary in nature, largely driven by market conditions, and since the Company intends to hold the securities until recovery, these investments were not considered to be other-than-temporarily impaired at December 31, 2011. The Company concluded that the unrealized losses on its investments in common stocks at December 31, 2011 were temporary based on the relative short length and magnitude of the losses. The Company’s investments in other equity interests include investments in limited liability partnerships that primarily invest in distressed debt, mezzanine debt and secondary transactions. By the nature of their underlying investments, the Company believes that its investments in the limited liability partnerships also exhibit debt-like characteristics which, among other factors, the Company considers when evaluating these investments for impairment. Based on evaluations of the factors described above that the Company considers when determining whether a decline in the fair value of an investment in equity securities is other than temporary, the Company concluded that the declines in the fair values of the Company’s investments in equity securities were temporary at December 31, 2011.
The following table sets forth the pre-tax amount of OTTI credit losses, recognized in Retained Earnings for Investments in Fixed Maturities held by the Company as of December 31, 2012, 2011 and 2010, for which a portion of the OTTI loss has been recognized in Accumulated Other Comprehensive Income, and the corresponding changes in such amounts.
Method Limited Liability Investments in which the Company invested totaled $3,643.6 million and $4,086.9 million as of December 31, 2012 and 2011, respectively. Aggregate total liabilities of the Equity Method Limited Liability Investments in which the Company invested totaled $421.0 million and $440.2 million as of December 31, 2012 and 2011, respectively. Aggregate net income (loss) of the Equity Method Limited Liability Investments in which the Company invested totaled $134.6 million, $(13.8) million and $401.6 million for the years ended December 31, 2012, 2011 and 2010, respectively. As of, and for the year ended, December 31, 2012, the aggregated summarized financial data reflects the latest available financial information. The Company’s maximum exposure to loss at December 31, 2012 is limited to the total carrying value of $253.0 million. In addition, the Company had outstanding commitments totaling approximately $52.8 million to fund Equity Method Limited Liability Investments at December 31, 2012.
The Company tests goodwill for recoverability on an annual basis at the beginning of the first quarter and, if circumstances or events indicate that the fair value of a reporting unit may have declined below its carrying value, such tests are performed at intervening interim periods. Accordingly, the Company tested goodwill associated with each of its reporting units for recoverability on January 1, 2012 and January 1, 2011. However, no goodwill was associated with, and, accordingly, no testing was required for the Kemper Direct segment. The Company principally used projections of discounted future cash flows to estimate the fair values of the reporting units tested. For each reporting unit tested, the estimated fair value exceeded the carrying value of the reporting unit, and the Company concluded that the associated goodwill was recoverable at the aforementioned dates tested.
development on certain catastrophes. Commercial lines insurance loss and LAE reserves included favorable development of $12.6 million from continuing operations and $6.3 million from discontinued operations. Commercial lines insurance losses and LAE reserves developed favorably from continuing operations due primarily to the emergence of more favorable loss patterns than expected for the four most recent accident years. Commercial lines insurance loss and LAE reserves developed favorably from discontinued operations due primarily to the commutation of certain insurance liabilities that had been previously assumed.
Interest Expense, including facility fees, accretion of discount and write-off of unamortized credit agreement issuance costs for the years ended December 31, 2012, 2011 and 2010 was:
Interest Paid on Notes Payable, including facility fees, for the years ended December 31, 2012, 2011 and 2010 was:
On March 7, 2012, Kemper entered into the 2016 Credit Agreement, a four-year, $325.0 million, unsecured, revolving credit agreement, expiring March 7, 2016, with a group of financial institutions. The 2016 Credit Agreement replaced Kemper’s Former Credit Agreement, a $245.0 million, unsecured, revolving credit agreement which was scheduled to expire on October 30, 2012 and was terminated on March 7, 2012. There were no borrowings under the Former Credit Agreement at either December 31, 2011 or at its termination. The 2016 Credit Agreement provides for fixed and floating rate advances for periods up to six months at various interest rates. The 2016 Credit Agreement contains various financial covenants, including limits on total debt to total capitalization, consolidated net worth and minimum risk-based capital ratios for Kemper’s largest insurance subsidiaries, United Insurance and Trinity. Proceeds from advances under the 2016 Credit Agreement may be used for general corporate purposes, including repayment of existing indebtedness. There were no outstanding borrowings under the 2016 Credit Agreement at December 31, 2012, and accordingly, $325.0 million was available for future borrowings.
During the third quarter of 2011, Kemper borrowed $95.0 million under the Former Credit Agreement. The proceeds from the borrowing were used, in part, to make a voluntary contribution of $83.7 million to fully fund the Company’s defined benefit pension plan under the funding requirements of Employee Retirement Income Security Act of 1974, as amended (”ERISA”). The contribution consisted of cash of $32.2 million and 7,309,764 shares of Intermec common stock purchased from Kemper’s subsidiary, Trinity (see Note 17, “Pension Benefits,” to the Consolidated Financial Statements). Kemper repaid $30.0 million and $65.0 million of the borrowing in September and October of 2011, respectively. Kemper had no outstanding advances under the Former Credit Agreement at December 31, 2011.
Kemper used a portion of the proceeds from the sale of the 2015 Senior Notes to repay borrowings of $140 million under the Former Credit Agreement and to make a capital contribution of $60 million to its subsidiary, United Insurance.
In 2003, Kemper issued $200 million of its 4.875% senior notes due November 1, 2010 for an effective yield of 5.04%. The 2010 Senior Notes were repaid and retired on November 1, 2010.
The Company leases certain office space under non-cancelable operating leases, with initial terms typically ranging from one to ten years, along with options that permit renewals for additional periods. The Company also leases certain equipment under non-cancelable operating leases, with initial terms typically ranging from one to five years. Minimum rent is expensed on a straight-line basis over the term of the lease.
Kemper’s insurance subsidiaries are also required to hold minimum levels of statutory capital and surplus to satisfy regulatory requirements. The minimum statutory capital and surplus, or company action level risk-based capital (“RBC”), necessary to satisfy regulatory requirements for the Company’s life and health insurance subsidiaries collectively was $118.6 million at December 31, 2012. The minimum statutory capital and surplus necessary to satisfy regulatory requirements for the Company’s property and casualty insurance subsidiaries collectively was $300.0 million at December 31, 2012. Company action level RBC is the level at which a company is required to file a corrective action plan with its regulators and is equal to 200% of the authorized control level RBC.
For equity-based compensation awards with a graded vesting schedule, the Company recognizes compensation expense on a straight-line basis over the requisite service period for each separately-vesting portion of the awards as if each award were, in substance, multiple awards. Compensation expense is recognized only for those awards expected to vest, with forfeitures estimated at the date of grant based on the Company’s historical experience and future expectations. Equity-based compensation expense was $5.8 million, $5.3 million and $4.2 million for the years ended December 31, 2012, 2011 and 2010, respectively. Total unamortized compensation expense related to nonvested awards at December 31, 2012 was $5.3 million, which is expected to be recognized over a weighted-average period of 1.4 years.
The Compensation Committee of the Board of Directors, or the Board’s authorized designee, has sole discretion to determine the persons to whom awards under the Omnibus Plan are granted, and the material terms of the awards. For stock options, material terms include the number of shares covered by such options and the exercise price, vesting and expiration dates of such options. Options are non-transferable and are exercisable in installments. Options to purchase Kemper’s common stock are granted at prices equal to the fair value of Kemper’s common stock on the date of grant. Prior to 2003, only non-qualified stock options had been granted. Beginning in 2003, options granted to employees were coupled with tandem stock appreciation rights (“SARs”), settled in Kemper common stock. Employee options generally vest over a period of three and one-half years and expire ten years from the date of grant. Each new member of the Board of Directors who is not employed by the Company (“Non-Employee Director”) receives an initial option to purchase 4,000 shares of Kemper common stock immediately upon becoming a director. Thereafter, on the date of each annual meeting of Kemper’s shareholders, eligible Non-Employee Directors automatically receive annual grants of options to purchase 4,000 shares of common stock for so long as they remain eligible directors. Such options granted to Non-Employee Directors are exercisable one year from the date of grant at an exercise price equal to the fair market value of Kemper’s common stock on the date of grant and expire 10 years from the date of grant.
The Company uses the Black-Scholes option pricing model to estimate the fair value of each option on the date of grant. The expected terms of options are developed by considering the Company’s historical share option exercise experience, demographic profiles, historical share retention practices of employees and assumptions about their propensity for early exercise in the future. Further, the Company aggregates individual awards into relatively homogenous groups that exhibit similar exercise behavior to obtain a more refined estimate of the expected term of options. Expected volatility is estimated using weekly historical volatility. The Company believes that historical volatility is currently the best estimate of expected volatility. For original option grants made in 2010, the dividend yield assumed was the annualized continuous dividend yield on Kemper common stock on the date of grant. The dividend yield in 2012 and 2011 was calculated by taking the natural logarithm of the annualized yield divided by the Kemper common stock price on the date of grant. The Company believes that basing the dividend yield on the current annualized yield is likely to be more consistent with the actual yield during the expected life of the option. The risk free interest rate was the yield on the grant date of U.S. Treasury zero coupon issues with a maturity comparable to the expected term of the option.
Information pertaining to options outstanding at December 31, 2012 is presented below:
The grant date fair values of the performance-based restricted stock awards are determined using the Monte Carlo simulation method. The Monte Carlo simulation model produces a risk-neutral simulation of the daily returns on the common stock of Kemper and each of the other companies included in the Peer Group. Returns generated by the simulation depend on the risk-free interest rate used and the volatilities of, and the correlation between, these stocks. The model simulates stock prices and dividend payouts to the end of the three-year performance period. Total shareholder returns are generated for each of these stocks based on the simulated prices and dividend payouts. The total shareholder returns are then ranked, and Kemper’s simulated ranking is converted to a payout percentage based on the terms of the performance-based restricted stock awards. The payout percentage is applied to the simulated stock price at the end of the performance period, reinvested dividends are added back, and the total is discounted to the valuation date at the risk-free rate. This process is repeated approximately ten thousand times, and the grant date fair value is equal to the average of the results from these trials.
Activity related to nonvested performance-based restricted stock for the year ended December 31, 2012 was as follows:
The number of additional shares that would be granted if the Company were to meet or exceed the maximum performance levels related to the outstanding performance-based shares for the 2012 and 2011 three-year performance periods was 68,275 common shares and 63,725 common shares, respectively, (as “full value awards,” the equivalent of 204,825 shares and 191,175 shares, respectively, under the Share Authorization) at December 31, 2012. For the 2010 three-year performance period, the Company exceeded target performance levels with a payout percentage of 114%. Accordingly, an additional 6,996 shares of stock were issued to award recipients on February 2, 2013. For the 2009 three-year performance period, the Company exceeded target performance levels with a payout percentage of 183%. Accordingly, an additional 40,727 shares of stock were issued to award recipients on January 31, 2012 (the “2009 Additional Shares”).
The Company’s awards of restricted common stock contain a right to receive non-forfeitable dividends and participate in the undistributed earnings with common shareholders. Accordingly, the Company is required to apply the two-class method of computing basic and diluted earnings per share.
A reconciliation of the numerator and denominator used in the calculation of Basic Income from Continuing Operations Per Unrestricted Share and Diluted Income from Continuing Operations Per Unrestricted Share for the years ended December 31, 2012, 2011 and 2010 is as follows:
The dilutive effect of Investee Equivalent Shares on Income from Continuing Operations was not significant for the year ended December 31, 2010.
The components of Accumulated Other Comprehensive Income at December 31, 2012 and 2011 were:
The components of Net Impairment Losses Recognized in Earnings reported in the Consolidated Statements of Income for the years ended December 31, 2012, 2011 and 2010 were:
Income taxes paid were $52.2 million in 2012. Income taxes refunded, net of income tax paid of $57.1 million, were $4.1 million in 2011, and income taxes paid were $65.1 million in 2010, respectively.
Changes in Fair Value of Plan Assets and Changes in Projected Benefit Obligation for the years ended December 31, 2012 and 2011 were:
The measurement dates of the assets and liabilities at end of year presented in the preceding table under the headings, “2012” and “2011” were December 31, 2012 and December 31, 2011, respectively.
For one of the plans, the accumulated benefit obligation exceeded the value of plan assets at December 31, 2011. The Projected Benefit Obligation, Accumulated Benefit Obligation and Fair Value of Plan Assets was $496.8 million, $478.1 million and $438.7 million, respectively, at December 31, 2011 for such plan.
The investment objective of the Pension Plan is to produce current income and long-term capital growth through a combination of equity and fixed income investments which, together with appropriate employer contributions and any required employee contributions, is adequate to provide for the payment of the benefit obligations of the Pension Plan. The assets of the Pension Plan may be invested in both fixed income and equity investments. Fixed income investments may include cash and short-term instruments, U.S. Government securities, corporate bonds, mortgages and other fixed income investments. Equity investments may include various types of stock, such as large-cap, mid-cap and small-cap stocks, and may also include investments in investment companies and Kemper common stock (subject to Section 407 and other requirements of ERISA). The Pension Plan has not invested in Kemper common stock.
Additional information pertaining to the changes in the fair value of the Pension Plans’ assets classified as Level 3 for the year ended December 31, 2012 is presented below:
Fair value measurements for the Pension Plans’ assets at December 31, 2011 are summarized below:
Additional information pertaining to the changes in the fair value of the Pension Plans’ assets classified as Level 3 for the year ended December 31, 2011 is presented below:
The components of Comprehensive Pension Expense for the years ended December 31, 2012, 2011 and 2010 were:
On September 14, 2011, the Company made a voluntary contribution of $83.7 million to its defined benefit pension plan. The contribution consisted of $32.2 million in cash and 7,309,764 shares of Intermec common stock with a fair value of $51.5 million on the date of contribution. On May 23, 2011, the Company requested a waiver from the U.S. Department of Labor (“DOL”) related to the prohibited transaction rules under ERISA and the Internal Revenue Code for the one-time in-kind contribution of the shares of Intermec common stock. On January 19, 2012, the DOL granted relief, from the prohibited transaction rules retroactive to September 1, 2011.
The Company also sponsors a non-qualified supplemental defined benefit pension plan (the “Supplemental Plan”). The unfunded liability related to the Supplemental Plan was $24.0 million and $21.7 million at December 31, 2012 and 2011, respectively. Pension expense for the Supplemental Plan was $1.8 million, $3.3 million and $3.1 million in 2012, 2011 and 2010, respectively. An actuarial loss of $1.3 million before tax and an actuarial gain of $2.9 million before tax is included Other Comprehensive Income for the years ended December 31, 2012 and 2011, respectively.
The Company sponsors an other than pension postretirement employee benefit plan (“OPEB”) that provides medical, dental and/or life insurance benefits to approximately 600 retired and 400 active employees (the “OPEB Plan”). The Company generally is self-insured for the benefits under the OPEB Plan. The medical plan generally provides for a limited number of years of medical insurance benefits at retirement based on the participant’s attained age at retirement and number of years of service until specified dates and generally requires participant contributions, with most contributions adjusted annually.
The actuarial assumptions used to develop the components of the Accumulated Benefit Obligation at December 31, 2012 and 2011 were:
The Company estimates that OPEB Expense for the year ended December 31, 2013 will include income of $1.0 million resulting from the amortization of the related accumulated actuarial gain included in Accumulated Other Comprehensive Income at December 31, 2012.
The Company is engaged, through its subsidiaries, in the property and casualty insurance and life and health insurance businesses. The Company conducts its operations through four operating segments: Kemper Preferred, Kemper Specialty, Kemper Direct and Life and Health Insurance.
Segment Operating Profit for the years ended December 31, 2012, 2011 and 2010 was:
Segment Net Operating Income for the years ended December 31, 2012, 2011 and 2010 was:
Amortization of Deferred Policy Acquisition Costs by Operating Segment for the years ended December 31, 2012, 2011 and 2010 was:
Earned Premiums by product line for the years ended December 31, 2012, 2011 and 2010 were:
The catastrophe reinsurance program for the Kemper Preferred segment in 2012 also included reinsurance coverage for catastrophe losses in North Carolina at retentions lower than those described above. The catastrophe reinsurance program for the Life and Health Insurance and Kemper Direct segments in 2012 also included reinsurance coverage from FHCF for hurricane losses in Florida at retentions lower than those described above.
The catastrophe reinsurance program for the Kemper Preferred segment in 2010 also included reinsurance coverage for catastrophe losses in North Carolina at retentions lower than those described above. The catastrophe reinsurance program for the Life and Health Insurance and Kemper Direct segments in 2010 also included reinsurance coverage from FHCF for hurricane losses in Florida at retentions lower than those described above.
In the event that the Company’s incurred catastrophe losses and LAE covered by any of its catastrophe reinsurance programs presented in the three preceding tables exceed the retention for that particular layer, each of the programs required one reinstatement of such coverage. In such an instance, the Company is required to pay a reinstatement premium to the reinsurers to reinstate the full amount of reinsurance available under such layer. The reinstatement premium is a percentage of the original premium based on the ratio of the losses in excess of the Company’s retention to the reinsurers’ coverage limit.
Reinsurance premiums for the Company’s primary catastrophe reinsurance programs, the Kemper Preferred NC Program and the FHCF Program reduced earned premiums for the years ended December 31, 2012, 2011 and 2010 by the following:
Total Catastrophe loss and LAE reserves, net of reinsurance recoverables, developed favorably by $6.3 million, $6.4 million and $1.2 million for the years ended December 31, 2012, 2011 and 2010, respectively. The Kemper Preferred segment reported favorable catastrophe reserve development of $6.2 million, $5.5 million and $4.9 million for the years ended December 31, 2012, 2011 and 2010, respectively. The Life and Health Insurance segment reported adverse catastrophe reserve development of $0.1 million and $3.4 million for the years ended December 31, 2012 and 2010, respectively and favorable catastrophe reserve development of $1.5 million for the year ended December 31, 2011.
For the year ended December 31, 2010, compared to 2009, the Kemper Preferred segment experienced a higher severity of catastrophe losses, due in part to a catastrophe loss of $12.9 million resulting from damage caused by hail in the state of Arizona in the fourth quarter of 2010. No major hurricanes that significantly impacted the Company made landfall in the United States during 2010.
The process of estimating and establishing reserves for catastrophe losses is inherently uncertain and the actual ultimate cost of a claim, net of actual reinsurance recoveries, may vary materially from the estimated amount reserved. The Company’s estimates of direct catastrophe losses are generally based on inspections by claims adjusters and historical loss development experience for areas that have not been inspected or for claims that have not yet been reported. The Company’s estimates of direct catastrophe losses are based on the coverages provided by its insurance policies. The Company’s homeowners and dwellings insurance policies do not provide coverage for losses caused by floods, but generally provide coverage for physical damage caused by wind or wind driven rain. Accordingly, the Company’s estimates of direct losses for homeowners and dwellings insurance do not include losses caused by flood. Depending on the policy, automobile insurance may provide coverage for losses caused by flood. Estimates of the number and severity of claims ultimately reported are influenced by many variables, including, but not limited to, repair or reconstruction costs and determination of cause of loss that are difficult to quantify and will influence the final amount of claim settlements. All these factors, coupled with the impact of the availability of labor and material on costs, require significant judgment in the reserve setting process. A change in any one or more of these factors is likely to result in an ultimate net claim cost different from the estimated reserve. The Company’s estimates of indirect losses from residual market assessments are based on a variety of factors, including, but not limited to, actual or estimated assessments provided by or received from the assessing entity, insurance industry estimates of losses, and estimates of the Company’s market share in the assessable states. Actual assessments may differ materially from these estimated amounts.
Trinity and Capitol are parties to a quota share reinsurance agreement whereby Trinity assumes 100% of the business written by Capitol. Capitol is a mutual insurance company and, accordingly, is owned by its policyholders. In the second quarter of 2012, Capitol requested regulatory approval to amend such agreement with Trinity, effective April 1, 2012, whereby ceded losses for dwelling coverage were capped. In the third quarter of 2012, Capitol received such regulatory approval. Incurred losses and LAE assumed by Trinity were reduced by $2.6 million in the third quarter of 2012 in conjunction with such amendment. Trinity and ORCC, a subsidiary of Capitol, are also parties to a quota share reinsurance agreement whereby Trinity assumes 100% of the business written by ORCC.
The Company investigates significant differences related to the values provided. On completion of its investigation, management exercises judgment to determine the price selected and whether adjustments, if any, to the price obtained from the Company’s primary pricing provider would warrant classification of the price as Level 3. In instances where a measurement cannot be obtained from either pricing provider, the Company generally will evaluate bid prices from one or more binding quotes obtained from market makers to value investments in inactive markets and classified by the Company as Level 2. The Company generally classifies securities when it receives non-binding quotes or indications as Level 3 securities unless the Company can validate the quote or indication against recent transactions in the market. For securities classified as Level 3, the Company either uses valuations provided by third party fund managers, third party appraisers, the Company’s own internal valuations or net asset values provided for Limited Liability Companies and Limited Partnerships. These valuations typically employ valuation techniques, including earnings multiples based on comparable public securities, comparable yields as well as industry specific non-earnings based multiples or discounted cash flow models. Valuations classified as Level 3 by the Company generally consist of investments in various private placement securities of non-rated entities. In rare cases, if the private placement security has only been outstanding for a short amount of time, the Company, after considering the initial assumptions used in acquiring an investment, considers the original purchase price as representative of the fair value.
For an investment in a fixed maturity security, an increase in the yield used to determine the fair value of the security will decrease the fair value of the security. A decrease in the yield used to determine fair value will increase the fair value of the security, but the fair value increase is generally limited to par if the security is currently callable.
The Company’s policy is to recognize transfers between levels as of the end of the reporting period. There were no transfers between Levels 1 and 2 for the year ended December 31, 2012. The transfers into Level 3 and out of Level 3 for the year ended December 31, 2012 were due to changes in the availability of market observable inputs.
The fair value of Notes Payable is estimated using quoted prices for similar liabilities in markets that are not active. The inputs
In the ordinary course of its businesses, the Company is involved in legal proceedings, including lawsuits, regulatory examinations and inquiries. Except with regard to the matter discussed below, based on currently available information, the Company does not believe that it is reasonably possible that any of its pending legal proceedings will have a material effect on the Company’s financial statements.
Kemper’s life insurance companies are currently the subject of an unclaimed property compliance examination by a private firm retained by the treasurers of thirty-eight states. One state insurance regulator has also commenced a market conduct exam of Kemper’s life insurance companies for the purpose of verifying such companies’ compliance with relevant regulations governing life insurance claims handling and escheatment practices. It is the Company’s position that state officials lack authority to establish new procedures that change existing contracts. In November 2012, the Company filed a declaratory judgment action in state court in Kentucky asking the court to construe the Kentucky Unclaimed Life Insurance Benefit Act (the “Kentucky Act”) such that it would only apply prospectively, i.e., only with respect to those life insurance policies issued on or after the effective date of the Kentucky Act, consistent with the requirements of applicable Kentucky statutory law and Kentucky and federal constitutional provisions. The case is currently in the discovery phase.
FS&C also provides investment management services with respect to certain funds of the Company’s defined benefit pension plans. The Company’s defined benefit pension plans had $120.7 million, $107.1 million and $98.3 million in assets managed by FS&C at December 31, 2012, 2011 and 2010, respectively. The Company’s defined benefit pension plans incurred, in the aggregate, expenses of $0.3 million, $0.3 million and $0.3 million to FS&C for the years ended December 31, 2012, 2011 and 2010, respectively.
With respect to the Company’s defined contribution plans, one of the alternative investment choices afforded to participating employees is the Dreyfus Appreciation Fund, an open-end, diversified managed investment fund. FS&C provides investment management services to the Dreyfus Appreciation Fund as a sub-investment advisor. According to published reports filed by FS&C with the SEC, the Dreyfus Appreciation Fund pays monthly fees to FS&C according to a graduated schedule computed at an annual rate based on the value of the Dreyfus Appreciation Fund’s average daily net assets. The Company does not compensate FS&C for services provided to the Dreyfus Appreciation Fund. Participants in the Company’s defined contribution plans had allocated $20.4 million, $19.3 million and $18.2 million for investment in the Dreyfus Appreciation Fund at December 31, 2012, 2011 and 2010, respectively, representing 7%, 7% and 6% of the total amount invested in the Company’s defined contribution plans at such dates.
We have audited the accompanying consolidated balance sheets of Kemper Corporation and subsidiaries (the “Company”) as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2012. Our audits also included the financial statement schedules listed in Item 15. We also have audited the Company’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements and financial statement schedules, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control. Our responsibility is to express an opinion on these financial statements and financial statement schedules and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kemper Corporation and subsidiaries as of December 31, 2012 and 2011, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth herein. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
As discussed in Note 2 to the consolidated financial statements, the Company changed its accounting for costs associated with acquiring or renewing insurance contracts in 2012.