below on page 8. Dividends to the Registrant from its insurance subsidiaries are subject to state regulation, as more fully described in MD&A.
Effective January 1, 2001, the Company adopted SFAS Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended.
Note: All share information has been restated to reflect the April 2001
Jefferson-Pilot Corporation is a holding company whose financial services and broadcasting subsidiaries provide products and services in four major businesses: 1) life insurance; 2) annuities and investment products; 3) group life, disability and dental insurance; and 4) broadcasting and sports programming production.
In our three financial services segments, effective investment management and asset/liability management are important to our financial position and results of operations. Interest spread, which represents the difference between interest earned on our investments and interest credited to policyholder funds, is a key component of our reportable segment results. The earned rate on our investments has declined in recent years as a result of a decline in the general interest rate environment. We establish credited rates within a highly competitive market for financial products. In establishing these rates, we start with an analysis of rates credited by other insurance companies and also compare rates offered by other financial services providers, such as bank certificates of deposit. These rates may impact the level of new sales or retention of existing customers. We believe that the historically low interest rate levels that we are currently experiencing will continue to challenge our earnings progression. Our operating results are also dependent on the level of mortality (death) and morbidity (disability and health) costs we incur. We attempt to address these conditions through underwriting risk selection and classification, by adjusting policyholder crediting rates to achieve desired spread performance, by monitoring claim and industry health care trend reports, and through a focus on conservative product designs. Also, we record substantial intangible asset balances because of commissions and expenses incurred in selling new policies, and because of acquisitions (DAC, VOBA, goodwill). The assumptions that we use in accounting for these intangible assets are important to our reported results.
For a more complete explanation of these important concepts, please see the Critical Accounting Policies, Financial Position, Investments and Market Risk Exposures sections of this report.
We use reportable segment results in assessing the performance of our business segments internally and believe it to be relevant and useful information. In the following discussion, “reportable segment results” and “total reportable segment results” include all elements of net income available to common stockholders except realized investment gains and losses. Reportable segment results as described above may not be comparable to similarly titled measures reported by other companies.
Our Individual Products segment sells life insurance on individuals, through which we underwrite the economic risks of mortality and provide vehicles for the accumulation of individual savings. We select and classify mortality risks, using actuarial science, within a competitive marketplace in accordance with various state and federal regulations. Because we earn revenues for accepting mortality risks, the growth in face amount of insurance in force is a key measure for a portion of our revenue growth. Because Individual Products operates under two distinct accounting models, we further analyze this segment by its two main product types: UL-type products and traditional products. UL-type products offered by this segment include universal life (UL) and variable universal life (VUL) products. UL-type product premiums may vary over the life of the policy at the discretion of the policyholder, so we do not recognize them as revenues when received, although UL-type premiums do increase assets and liabilities. We earn spreads between interest earned and credited to policyholders from aggregation and investment of policyholder funds. In managing these spreads, we develop and maintain systems and skills that are necessary to understand and mitigate credit and interest rate risks. We also recognize revenues on these products from mortality, expense and surrender charges earned (policy charges). Trends in policyholder fund balances and segment assets are important measures when analyzing the development of segment earnings. Due to competition from other financial services providers, it is important that we achieve continuing improvements in internal cost efficiencies in relation to policies administered and assets under management.
Traditional products require the policyholder to pay scheduled premiums over the life of the coverage. We recognize traditional premium receipts as revenues and profits are expected to emerge in relation thereto. Because of market preferences, we do not offer new traditional products except for some term life insurance.
Our Benefit Partners segment insures individuals for mortality, morbidity and dental costs under master group insurance contracts with employers. This segment offers various forms of contributory and noncontributory plans, as well as supplemental contracts. Most of our group contracts are sold to employers with fewer than 500 employees. We select and classify risks within a competitive marketplace based on group characteristics, applying actuarial science and group underwriting practices. We may adjust premiums charged for insuring group
statements requires management to use significant judgments and estimates concerning future results or other developments including the likelihood, timing or amount of one or more future transactions or amounts. Actual results may differ from these estimates under different assumptions or conditions. On an on-going basis, we evaluate our estimates, assumptions and judgments based upon historical experience and various other information that we believe to be reasonable under the circumstances. For a detailed discussion of other significant accounting policies, see Note 2.
We regularly monitor our investment portfolio to ensure that investments that may be other than temporarily impaired are identified in a timely fashion and properly valued, and that any impairments are charged against earnings in the proper period. Our methodology to identify potential other-than-temporary impairments, requires professional judgment and is further described in the Investments section and in Note 4.
The following tables illustrate our results before and after realized investment gains and losses, and reconcile reportable segment results to net income available to common stockholders, the most directly comparable GAAP financial measure:
Includes $1.5 relating to the cumulative effect of change in accounting for derivatives.
Includes $0.01 per share of income relating to the cumulative effect of change in accounting for derivatives.
organization. The 2002 results were primarily influenced by an increase in the accrual for pending litigation in our Corporate segment which offset growth in our AIP, Communications and Benefit Partners segments.
Earnings per share amounts for the reportable segments were more favorable than the absolute earnings amounts due to repurchases of 3,578,600 shares in 2003 and 7,881,300 shares in 2002.
We assess profitability by business segment and measure other operating statistics as detailed in the separate segment discussions that follow. We determine reportable segments in a manner consistent with the way we make operating decisions and assess performance. Sales are one of the statistics we use to track performance. Our sales, which are primarily of long-duration contracts in the Individual Products and AIP segments, have little immediate impact on revenues for these two segments as described in the segment discussions below.
Includes $1.5 relating to the cumulative effect of change in accounting for derivatives
Sales from our Individual markets excluding Community Banks and bank-owned life insurance (BOLI) grew in 2003 over 2002, and increased significantly in 2002 over 2001 due to new product introductions in 2002 and the strength of our Premier Partnering strategy. Sales in our core agency channels were up 7.5% in 2003 and were strongest in the latter part of the year as additional products were brought to market. With these new product offerings no single product comprised more than 30% of total sales in the fourth quarter of 2003. Sales to Community Banks and BOLI business declined in both 2003 and 2002. Community Bank and BOLI business will vary widely between periods as we respond to sales opportunities for these single premium products only when the market accommodates our required returns.
Interest margin on UL-type products grew in 2003, despite lower investment yields, due to growth in policyholder fund balances and an increase in average interest spread. The lower investment yield was due to the general interest rate environment and an increase in default charges paid from the Individual Products segment to the Corporate and Other segment of $6 as discussed under Corporate and Other. We actively manage interest spreads on our fixed UL-type products in response to changes in investment yields by adjusting the rates credited to policyholder fund balances while considering our competitive strategies as well. The average investment spread on fixed UL products increased 14 basis points to 2.03% in 2003 after having decreased 11 basis points in 2002. During 2003 and 2002, prepayments of mortgage backed securities significantly increased as a result of continued declines in long-term mortgage rates. Our mortgage backed securities portfolio is primarily a discount portfolio. The effect of prepayments in excess of expected levels increased effective investment yields by 20 and 15 basis points in 2003 and 2002. Prepayments were not significant in 2001. Of the 20 basis point investment yield impact in 2003, only a portion affected interest margin due to partial pass through of the higher yield to policyholders through crediting rates. DAC amortization and income taxes also reduce the earnings impact of excess accretion of discount. Our ability to manage interest crediting rates on fixed UL-type products is limited by minimum guaranteed rates provided in policyholder contracts. Therefore, continued low general market interest rates may impact future profitability, as the investment of cash flows at current interest rates reduces our average portfolio yield. At the end of 2003 and 2002, our crediting rates were approximately 49 and 79 basis points on average in excess of our minimum guaranteed rates, including some policies that were already at their minimum guaranteed rates.
Traditional premiums and other considerations declined in both 2003 and 2002 as we are focusing our sales efforts towards UL-type products and because in 2001 we began reinsuring 90% of our term life insurance sales. Net investment income from our traditional blocks declined in 2003 despite a favorable impact from prepayments of mortgage backed securities, due to the decline in investment yields and the decreasing size of the block.
Policy benefits on traditional business include death benefits, dividends, surrenders and changes in reserves, with the most significant being death benefits. Policy benefits as a percentage of premiums and other considerations were 114.3% in 2003, down slightly from 115.4% in 2002. The benefit ratio was 108.9% in 2001, reflecting favorable mortality experience in that year.
Expenses excluding amortization of DAC and VOBA were down in 2003 due to a reduction in the effective rate of premium taxes, and effective expense controls in our maintenance functions. The expense amounts we capitalize as DAC include first year commissions and deferrable acquisition expenses. We generally limit our capitalization of deferrable acquisition expenses to the lower of product specific pricing allowables or our actual deferrable acquisition costs. See further discussion of DAC and VOBA under the Financial Position section. The decline in expenses excluding amortization of DAC and VOBA in 2002 from 2001 was primarily a function of increased deferral of acquisition-related general and administrative expenses stemming from the significant increase in sales in 2002. Recent years’ sales growth combined with higher emergence of gross profits on UL-type products, particularly interest margin and expense charges in 2003, were the primary contributors to the increases in the amortization of DAC and VOBA. Unlocking of DAC assumptions reduced DAC amortization on fixed UL products by $20.5 and $17.2 in 2003 and 2002. The 2003 unlocking pertained primarily to assumptions regarding interest spreads and mortality, while the 2002 unlocking was related primarily to persistency assumptions. The 2002 unlocking was partially offset by a $16.6 increase in amortization on VUL products due to limitation of mean reversion techniques, as discussed in the Financial Position section.
The growth in average Individual Products assets in 2003 and 2002 was primarily due to growth in UL policyholder fund balances, partially offset by a decline in assets supporting our traditional block of business. In 2002, market values of separate account assets of variable products declined, which hindered the growth in average assets for this segment.
Our financial and operating risks for this segment include, among others, interest margin risks, mortality risks, variances between actual and underlying assumptions of DAC and VOBA, changes in taxation of our products and competing offerings, and the effects of unresolved litigation. We discuss these risks in more detail in the Financial Position, Capital Resources and Liquidity, and Market Risk Exposures sections. See Note 2 for a discussion of Statement of Position 03-1, a new accounting pronouncement that is effective January 1, 2004, which may significantly impact the timing of this segment’s earnings emergence in 2004 and beyond, depending on the outcome of evolving implementation guidance.
Fixed annuity premium sales declined in 2003 and 2002 reflecting continued competition in the fixed annuity market and our unwillingness to match our competitors’ crediting rates, especially in the bank channel. Sales trends showed substantial improvement in late 2003 as approximately $321 of our total fixed annuity premium sales for 2003 came in the fourth quarter, following the introduction of a new product portfolio with fixed interest and equity-indexed components. We continue to develop differentiated annuity products designed to create new distribution opportunities and strengthen existing marketing relationships.
policyholders through crediting rates. DAC amortization and income taxes also reduce the earnings impact of excess accretion of discount.
Total expenses (including the net deferral and amortization of DAC and VOBA) were as follows:
Total AIP expenses increased in 2003, reflecting the increase in amortization of DAC and VOBA from overall growth in the business. Also, 2002 reflected a decrease in amortization of $13.0 due to lower lapse rates on fixed annuity products, partially offset by an $8.8 increase in amortization on variable annuity products using the mean reversion techniques discussed in the Financial Position section.
Risks in the annuity business other than those mentioned in our Overview are that equity market volatility could reduce demand for our products with interest credited rates indexed to those markets, increased lapses when interest rates rise, particularly in the portion of business subject to low or no surrender charges, and changes in taxation of our products and competing offerings. We discuss these risks in more detail in the Financial Position, Capital Resources and Liquidity, and Market Risk Exposures sections.
Total expenses increased in 2003 and 2002 in line with overall growth in the business.
In March 2004, we acquired Canada Life’s group life, disability and dental business. This transaction resulted in a commitment of approximately $200 of capital. This acquisition will enable us to expand our distribution network and further grow this business segment.
Earnings on investments increased $16.7 in 2003 driven by increases in earnings on equity investments and dividends on equity securities, resumed income on previously defaulted securities and an increase in default charges received from the operating segments. Default charges are received from the operating segments for this segment’s assumption of all credit related losses on the invested assets of those segments. These charges are calculated in part as a percentage of invested assets. In response to the recent default environment in the securities market, we increased default charges assessed to the other operating segments in 2003 resulting in default charge income of $31.3 compared to $21.9 and $20.0 for 2002 and 2001. Earnings on investments in this segment can fluctuate based upon opportunistic repurchases of common stock, the amount of excess capital generated by the operating segments and lost investment income on bonds defaulted or sold at a loss.
Interest expense on debt and Exchangeable Securities remained flat in 2003 and decreased $17.6, in 2002. The 2002 decline was primarily due to lower interest rates on borrowed money, the maturity of the Exchangeable Securities that were replaced with lower short-term floating rate borrowings in January 2002 and overall lower amounts outstanding. See Note 8 for details of our debt structure and interest costs. Operating expenses declined in 2003 as expenses for 2002 included an accrual for litigation of $23.1. Excluding this accrual for litigation, operating expenses increased $6.4 in 2003 and declined $9.0 in 2002. Operating expenses vary with the level of corporate activities and strategies. Goodwill amortization of $9.5, excluding JPCC, was included in operating expenses in this segment for 2001 but was eliminated in 2002 and 2003 under SFAS 142. The income tax benefit decreased $7.8 in 2003 and increased $7.3 in 2002, in line with the changes in pre-tax income.
Total assets increased $2,077 in 2003 and $1,613 in 2002 due to net policyholder contract deposits, growth in DAC, and unrealized gains on investments, which more than offset dividends, stock repurchases and impairment losses.
Our traditional individual and group insurance products are long-duration contracts. DAC and VOBA related to these products are amortized in proportion to premium revenue recognized. The DAC and VOBA balances on
these products were $199.5 or 7.9% of the gross balances (before adjustments for unrealized gains and losses) at December 31, 2003, and are generally subject to little volatility.
We also adjust the carrying value of DAC and VOBA to reflect changes in the unrealized gains and losses in available-for-sale securities backing UL-type and annuity products, since this impacts the timing of and possible realization of EGP’s. Note 6 contains roll forwards of DAC and VOBA including the amounts capitalized, amounts amortized and the effect of the unrealized gains.
At December 31, 2003, our capital structure consisted of short-term commercial paper, securities sold under repurchase agreements, long-term junior subordinated debentures, and stockholders’ equity. We also have bank credit agreements for unsecured revolving credit, under which we have the option to borrow at various interest
Our insurance subsidiaries have sold collateralized mortgage obligations and agency debentures under repurchase agreements involving various counterparties, accounted for as financing arrangements with maturities less than six months. We may use proceeds to purchase securities with longer durations as an asset/liability management strategy. At December 31, 2003 and 2002, repurchase agreements, including accrued interest, were $401 and $499. The securities involved had a fair value and amortized cost of $428 and $406 at December 31, 2003 versus $532 and $493 at December 31, 2002. The maximum principal amounts outstanding were $597 and $636 during 2003 and 2002.
On January 27, 2004, we issued $300 of 4.75% 10-year term notes and $300 of floating rate EXtendible Liquidity Securities® (EXLs) with an initial maturity of February 17, 2005 subject to periodic extension through 2011. The proceeds from the debt issuance were used to finance the Canada Life acquisition and to pay down commercial paper while rebalancing the mix of fixed and floating rate debt and short and long term maturities in our capital structure. We have received confirmation from both Fitch and S&P that the debt issuance will have no impact on our ratings or outlook.
In 2003 we repurchased 3,578,600 of our common shares at an average cost of $43.15 per share compared to 7,881,300 shares at an average cost of $43.69 in 2002. In February 2004, our board refreshed its share repurchase authorization to 5 million shares.
Cash and cash equivalents were $72, $67 and $139 at December 31, 2003, 2002 and 2001. The decrease in 2002 reflects the year-end 2001 build up of cash used to pay off the MEDS in January 2002. The parent company and non-regulated subsidiaries held equity and fixed income securities of $753, $424 and $542 at these dates. We consider the majority of these securities to be a source of liquidity to support our strategies.
Total debt and equity securities available-for-sale at December 31, 2003 and 2002 were $18,462 and $16,874.
Purchase obligations consist of JPCC commitments for purchases of syndicated television programming and commitments on other contracts and future sports programming rights of approximately $377 as of December 31, 2003, payable through the year 2011. We have commitments to sell a portion of the sports programming rights to other entities for $257 over the same period. These commitments are not reflected as an asset or liability in our balance sheets because the programs are not currently available for use. We expect advertising revenues that are sold on an annual basis to fund the purchase commitments.
We have no material off balance sheet arrangements of a financing nature.
at amortized cost, and accordingly there is a difference between fair value and carrying value for HTM securities. The following table shows the carrying values of our invested assets:
The majority of our unrealized gains and losses can be attributed to changes in interest rates and market changes in credit spreads.
These unrealized gains and losses do not necessarily represent future gains or losses that will be realized. Changing conditions related to specific bonds, overall market interest rates, credit spreads or equity securities markets as well as general portfolio management decisions might impact values we ultimately realize. Gross unrealized gains and losses at December 31, 2002 were $1,716 and $(290).
Limiting our bond exposure to any one creditor is another way we manage credit risk. The following table lists our ten largest exposures to an individual creditor in our bond portfolio as of December 31, 2003. As noted
At December 31, 2003 and 2002, below investment grade bonds were $1,452 or 7.1% and $1,287 or 6.6% of the carrying value of the bond portfolio, reflecting increases in market prices of below investment grade bonds that occurred in 2003.
In identifying “potentially distressed securities” we first screen for all securities that have a fair value to amortized cost ratio of less than 80%. However, as part of this identification process, management must make assumptions and judgments using the following information:
When this intensive review determines that the decline is other than temporary based on management’s judgment, the security is written down to fair value through a charge to realized investment gains and losses. We adjust the amortized cost for both AFS and HTM securities that have experienced other-than-temporary impairments to reflect fair value at the time of the impairment. We consider factors that lead to an other-than-temporary impairment of a particular security in order to determine whether these conditions have impacted other similar securities.
Of the $126 gross unrealized losses on debt securities at December 31, 2003, approximately $8 was included in our potentially distressed securities list mentioned above. Of this amount, $5 had been continuously included in our potentially distressed securities list for more than twelve months.
Information about unrealized gains and losses is subject to rapidly changing conditions. Securities with unrealized gains and losses will fluctuate, as will those securities that we have identified as potentially distressed. The recent volatility of financial markets and declines in market interest rates has led to an increase in both unrealized gains and losses. We consider all of the factors discussed earlier when we determine if an unrealized loss is other than temporary, including our ability and intent to hold the security until the value recovers. However, we may subsequently decide to sell certain of these securities in future periods within the overall context of our portfolio management strategies. If we make the decision to dispose of a security with an unrealized loss, we will write down the security to its fair value if we have not sold it by the end of the reporting period.
$19.8 write down of manufactured housing debt that was secured by long term mortgages on mobile homes and a corporate guarantee from the manufacturer and underwriter of the underlying collateral. The manufacturer filed for Chapter 11 bankruptcy protection rendering the corporate guarantee essentially worthless. In addition, we concluded that projected cash flows of the underlying collateral may be insufficient based on third-party valuations. This had no impact on other holdings in our portfolio.
$19.8 write down of manufactured housing debt that was secured by long term mortgages on mobile homes and a corporate guarantee from the manufacturer and underwriter of the underlying collateral. The manufacturer filed for Chapter 11 bankruptcy protection, which left us unable to collect under the corporate guarantee. Again, we concluded that projected cash flows of the underlying collateral may be insufficient based on third-party valuations. This had no impact on other holdings in our portfolio.
$19.6 write down on debt of WorldCom, Inc., which filed for bankruptcy in July. This issuer had specific problems with accounting restatements and potentially questionable business practices. The entire telecommunications sector has been under pressure due to overcapacity. We then sold these securities in 2002. We specifically looked at other creditors in this sector including several on our potentially distressed security list and determined that at this point, the unrealized losses on securities we hold of other material creditors are temporary.
Our investment strategy with respect to mortgage backed securities (MBS) portfolio focuses on actively traded issues with less volatile cash flows. The majority of the MBS holdings are sequential and planned amortization class tranches of federal agency issuers. The MBS portfolio has been constructed with underlying mortgage collateral characteristics and structure in order to mitigate cash flow volatility over a range of interest rates.
Because of the decline in interest rates during 2002 and early 2003, the mortgage market experienced record levels of refinancings and the structural protection of our MBS portfolio eroded. We experienced MBS prepayments totaling $2,656 or 64.1% and $1,277 or 22.8% of the average carrying value of the MBS portfolio in 2003 and 2002. Our MBS portfolio is primarily a discount portfolio; therefore, prepayments accelerate the accretion of discount into income. The excess accretion of discount increased investment income in 2003 by $49.8 compared to $28.0 in 2002, on a pre-tax basis. Prepayments were not material in 2001. These prepayments are reinvested at yields that are lower than our current portfolio yields, producing less investment income going forward. As shown above, our MBS portfolio declined substantially in 2003, and we reinvested most of the proceeds in investment grade corporate bonds.
Since our assets and liabilities are largely monetary in nature, our financial position and earnings are subject to risks resulting from changes in interest rates at varying maturities, changes in spreads over U.S. Treasuries on new investment opportunities, changes in the yield curve, and equity price risks. During 2003, 10 year U.S. Treasury rates increased 44 basis points from 3.81% to 4.25%.
We employ various methodologies to manage our exposure to interest rate risks. Our asset/liability management process focuses primarily on the management of interest rate risk of our insurance operations. We monitor the duration of insurance liabilities compared to the duration of assets backing the insurance lines, measuring the optionality of cash flows. Our goal in this analysis is to prudently balance profitability and risk for each insurance product category, and for us as a whole. At December 31, 2003 and 2002, 89% of policy liabilities related to interest-sensitive portfolios.
We have derived the estimated incremental loss amounts below by modeling estimated cash flows of our market risk sensitive instruments and insurance portfolios. Incremental income or loss is net of taxes at 35%. The model also assumes that all floating rate debt, including reverse repurchase agreements, is replaced with similar instruments. Estimated cash flows produced in the model assume reinvestments representative of our current investment strategy, and calls/prepayments include scheduled maturities as well as those expected to occur when borrowers can benefit financially based on the difference between prepayment penalties and new money rates under each scenario. Assumed lapse rates within insurance portfolios consider the relationships expected between crediting rates and market interest rates, as well as the level of surrender charges inherent in individual contracts. The illustrated incremental income or loss also includes the expected impact on amortization of DAC and VOBA. The model is based on our existing business in force as of December 31, 2003 and does not consider new sales of life and annuity products or the potential impact of interest rate fluctuations on sales.
The following table shows our estimate of the impact that various hypothetical interest rate scenarios would have on our earnings for a single year, based on the assumptions in our model. We believe that, based upon historically low current interest rates, a symmetrical change in interest rates is not reasonably possible. Our model shows the effect on income with an increase of up to 300 basis points and a decrease of 100 basis points. We believe that the 300 basis point increase or 100 basis point decrease, graded pro-rata over four quarters, reflects reasonably possible near term changes in interest rates as of December 31, 2003. The incremental loss for a year derives primarily from differences in the yield curves and in the sensitivities they introduce to our model.
These estimated impacts are incremental to potential earnings impacts from trends and/or environmental factors already in existence, such as an expected reduction in the level of prepayments on mortgage backed securities. The model assumes that changes in our crediting rates will occur correspondingly with increases or declines in investment yields, subject to the impact of minimum rate guarantees. As discussed previously, as of year end our crediting rates on blocks of business that are on an annual reset basis were approximately 49 basis points and 39 basis points on average in excess of minimum guaranteed rates for Individual Products and AIP.
The incremental income or loss for shifts in excess of those shown or that occur more quickly than quarterly grading does not have a linear relationship to the values shown above. The incremental loss resulting from a higher change in interest rates would be proportionally greater due to the optionality of our interest-sensitive assets and liabilities. Similarly, the incremental loss resulting from a greater decrease in interest rates would be proportionally greater due to the effect of minimum rate guarantees in our interest-sensitive liabilities. A significant change in the slope of the yield curve could also affect our results. For example, competing products such as bank CDs could become relatively more attractive than our longer duration annuities under an inverted yield curve, resulting in higher policyholder withdrawals. An anticipated increase in interest rates could also suggest that we would term out more of our floating rate debt, which the model does not take into consideration.
We are exposed to equity price risk on our equity securities (other than trading). We hold common stock with a fair value of $754; approximately $411 is in a single issuer, Bank of America Corporation (BankAmerica). We believe that a hypothetical 20% decline in the equity market is possible. If the market value of the S&P 500 Index®, and of BankAmerica common stock specifically, decreased 20%, the fair value of our common stock as of December 31, 2003 would change as follows:
Certain information in our SEC filings and in any other written or oral statements made by us or on our behalf, involves forward looking statements. We have used appropriate care in developing this information, but any forward looking statements may turn out to be wrong. They can be affected by inaccurate assumptions or by known or unknown risks and uncertainties that could significantly affect our actual results or financial condition.
We have audited the accompanying consolidated balance sheets of Jefferson-Pilot Corporation and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2003. Our audits also included the financial statement schedules listed in the Index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Jefferson-Pilot Corporation and subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As discussed in Note 2 to the financial statements, in 2002 the Company changed its method of accounting for goodwill.
The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (GAAP). The insurance subsidiaries also submit financial statements to insurance industry regulatory authorities. Those financial statements are prepared on the basis of statutory accounting practices (SAP) and are significantly different from financial statements prepared in accordance with GAAP. See Note 11.
The preparation of financial statements requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities and the disclosures of contingent assets and liabilities as of the date of the financial statements, and the reported amounts of revenue and expenses for the reporting period. Those estimates are inherently subject to change and actual results could differ from those estimates. Included among the material (or potentially material) reported amounts and disclosures that require extensive use of estimates are: fair value of certain invested assets, asset valuation allowances, deferred policy acquisition costs, goodwill, value of business acquired, policy liabilities, and the potential effects of resolving litigated matters.
The Company includes with cash and cash equivalents its holdings of highly liquid investments that mature within three months of the date of acquisition.
Deferred policy acquisition costs and the value of business acquired for variable life and annuity products are amortized utilizing mean reversion techniques. In calculating the estimated gross profits for these products the Company utilizes a long-term total net return on assets of 8.25% and a five-year reversion period. The reversion period is a period over which a short-term return assumption is utilized to maintain the model’s overall long-term rate of return. The Company caps the reversion rate of return at 8.25% for one year and 10% for years two through five. Mean reversion techniques result in the application of reasonable yield assumptions to trend the long-term rate of return back to the assumed rate over a period of time following a historical deviation from the assumed long-term rate.
The carrying amounts of deferred policy acquisition costs and value of business acquired are adjusted for the effect of non-credit related realized gains and losses, credit related gains, and the effects of unrealized gains and losses on debt securities classified as available for sale. Deferred policy acquisition costs and value of business acquired are not adjusted for the effect of credit related losses, rather as a part of the investment income allocation process a charge, referred to as a default charge, is made against the investment income allocated to the Individual Products, Annuity and Investment Products, and Benefit Partner segments. The default charge is based upon the credit quality of the assets supporting each segment and is meant to replicate the expected credit losses that will emerge over an economic cycle. Through this mechanism, the Individual Products, Annuity and Investment Products, and Benefit Partner segments pay a relatively level charge to the corporate segment and in return are reimbursed when credit related losses actually occur. See Note 6 for further discussion.
Separate account assets and liabilities represent funds segregated for the benefit of certain policyholders who bear the investment risk. The separate account assets and liabilities, which are equal, are recorded at fair value. Policyholder account deposits and withdrawals, investment income and realized investment gains and losses are excluded from the amounts reported in the consolidated statements of income. Fees charged on policyholders’ deposits are included in other considerations.
Concession income of the broker/ dealer subsidiaries is recorded as earned and is presented in other revenue.
Benefits and expenses, other than deferred policy acquisition costs, related to traditional life, accident and health, disability and dental insurance products are recognized when incurred in a manner designed to match them with related premiums and to spread income recognition over expected policy lives. For universal life-type and annuity products, benefits include interest credited to policyholders’ accounts, which is recognized as it accrues.
The liability for policy and contract claims consists of the estimated amount payable for claims reported but not yet settled and an estimate of claims incurred but not reported, which is based on historical experience,
The Company accounts for stock incentive awards in accordance with APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and accordingly, recognizes no compensation expense for stock option awards to employees or directors when the option price is not less than the market value of the stock at the date of award. The Company recognizes expense utilizing the fair value method in accordance with SFAS 123 for stock options granted to non-employees, specifically agents.
goodwill and intangible assets subsequent to their acquisition. In accordance with the statements, the Company no longer amortizes goodwill nor certain other intangible assets (primarily Federal Communication Commission Licenses), but rather tests these intangible assets for impairment at least on an annual basis. During 2001, the Company recognized $13 of amortization expense related to these assets. The Company did not recognize any impairment losses upon adoption of SFAS 142. Further, the Company completed its annual test of impairment in the second quarter of 2003 and concluded that there had been no impairments. No subsequent events have occurred that would have led to impairment of goodwill and other intangibles.
Following is a reconciliation of reported earnings to adjusted earnings as if SFAS 142 had been in effect for all periods presented. In connection with the implementation of SFAS 142, the Company did not change the life on any intangible that was subject to amortization:
In April 2003, the FASB issued Statement of Financial Accounting Standards No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities” (SFAS 149), which is effective for contracts entered into or modified after June 30, 2003, with certain exceptions. The adoption of SFAS 149 did not impact the Company’s financial position or results of operations.
In its securities lending program, the Company generally receives cash collateral in an amount that is in excess of the market value of the securities loaned. Market values of securities loaned and collateral are monitored daily, and additional collateral is obtained as necessary. The market value of securities loaned and collateral received amounted to $637 and $659 at December 31, 2003 and $533 and $555 at December 31, 2002.
Investments in debt and equity securities include 1,773 issuers. Debt and equity securities include investments in Bank of America of $494 and $471 as of December 31, 2003 and 2002. No other corporate issuer represents more than one percent of investments.
The Company’s mortgage loan portfolio is comprised of conventional real estate mortgages collateralized primarily by retail (33%), office (20%), industrial (20%), apartment (16%), and hotel (11%) properties. Mortgage loan underwriting standards emphasize the credit status of a prospective borrower, quality of the underlying collateral and conservative loan-to-value relationships. Approximately 32% of stated mortgage loan balances as of December 31, 2003 are due from borrowers in South Atlantic states, approximately 18% are due from borrowers in West South Central states, approximately 14% are due from borrowers in Pacific states and approximately 10% are due from borrowers in Mountain states. No other geographic region represents as much as 10% of December 31, 2003 mortgage loans.
At December 31, 2003 and 2002, the recorded investment in mortgage loans that are considered to be potentially impaired was $62 and $66. Delinquent loans outstanding as of December 31, 2003 and 2002 totaled $4 and $12. The related allowance for credit losses on all mortgage loans was $36 at December 31, 2003 and 2002. The average recorded investment in potentially impaired loans was $64, $77 and $67 during the years ended December 31, 2003, 2002 and 2001, on which interest income of $6, $6 and $7 was recognized.
One statistic we pay particular attention to with respect to debt securities is the Fair Value to Amortized Cost ratio. Securities with a fair value to amortized cost ratio in the 90%-99% range are typically securities that have been impacted by increases in market interest rates or credit spreads. Securities in the 80%-89% range are typically securities that have been impacted by increased market yields, specific credit concerns or both. These securities are monitored to ensure that the impairment is not other than temporary. Securities with a fair value to amortized cost ratio less then 80% are considered to be “potentially distressed securities,” and are subjected to rigorous review. The following factors are considered: the length of time a security’s fair value has been below amortized cost, industry factors or conditions related to a geographic area that are negatively affecting the security, downgrades by rating agencies, the valuation of assets specifically pledged to support the credit, the overall financial condition of the issuer, past due interest or principal payments, and our intent and ability to hold the security for a sufficient time to allow for a recovery in value.
As of December 31, 2003 we held nine securities that were “potentially distressed.” Four of these securities are equipment trust securities secured by passenger aircraft. We have evaluated both the underlying collateral and the health of the passenger airlines that are leasing these aircraft, and have concluded that these securities are not other than temporally impaired. The remaining five securities have been “potentially distressed” for less than six months and, based on our review of the factors delineated above, are not considered to be other than temporarily impaired.
The Company uses interest rate swaps to convert floating rate investments to fixed rate investments. Interest is exchanged periodically on the notional value, with the Company receiving the fixed rate and paying various short-term LIBOR rates on a net exchange basis. For the years ended December 31, 2003, 2002 and 2001 the ineffective portion of the Company’s cash flow hedging instruments, which is recognized in realized investment gains, was not significant. At December 31, 2003 and 2002 the maximum term of interest rate swaps that hedged floating rate investments was ten years.
The Company also uses interest rate swaps to hedge anticipated purchases of assets that support the annuity line of business. As assets are purchased, the interest rate swap is unwound resulting in a realized gain/(loss) which effectively offsets the change in the cost of the assets purchased to back annuities issued. The gain/(loss) is amortized into income over time, resulting in an overall yield that is consistent with the Company’s pricing assumptions.
For the years ended December 31, 2003 and 2002, the Company recognized other comprehensive income related to cash flow hedges, net of taxes, of $(5) and $9.
For the years ended December 31, 2003, 2002 and 2001 the Company recognized $4, $0 and $0 in previously deferred losses as a result of sales of securities purchased through the use of cash flow hedges. The Company does not expect to reclassify a significant amount of net gains (losses) on derivative instruments from accumulated other comprehensive income to earnings during the next twelve months.
The Company markets equity-indexed annuities. These contracts have an equity market component, where interest credited to the contracts is linked to the performance of the S&P 500® index. The Company has historically managed this risk by purchasing call options that mirrored the interest credited to the contracts. These call options act as an economic hedge, as changes in their fair values are recognized in net investment income. For the year ended December 31, 2003, activity reflected in net investment income related to these options was $18. Such amounts were insignificant for 2002 and 2001.
The Company also invests in debt securities with embedded options, which are considered to be derivative instruments under SFAS 133. These derivatives are marked to market through realized investment gains and were insignificant for the years ended December 31, 2003, 2002 and 2001.
As discussed in Note 2, investment income allocated to the Individual Products, AIP and Benefit Partners segments are reduced by a default charge intended to replicate expected credit losses over an economic cycle. In 2003, the Company unlocked its deferred policy acquisition cost and VOBA models with respect to the default charge assumption, resulting in a favorable adjustment of $16 to realized gains and losses.
Credited interest rates for universal life-type products ranged from 3.0% to 9.0% in 2003 and from 4.0% to 7.5% in 2002 and 2001. The average credited interest rates for universal life-type products were 5.0% for 2003 and 5.6% for years 2002 and 2001. For annuity products, credited interest rates generally ranged from 3.0% to 7.6% in 2003, 3.0% to 7.8% in 2002 and 4.0% to 9.8% in 2001.
For immediate annuities, the 71 IAM table is used for issues prior to 1992, the 83a table is used for issues between 1992 and 1999, and issues after 1999 use the 2000a table.
The junior subordinated debentures were issued in 1997 and consist of $206 at an interest rate of 8.14% and $103 at an interest rate of 8.285%. Interest is paid semi-annually. These debentures mature in 2046, but are redeemable prior to maturity at the option of the Company beginning January 15, 2007, two-thirds subject to a call premium of 4.07% and the remainder subject to a call premium of 4.14% that grades to zero as of January 15, 2017.
The principal differences between SAP and GAAP are (1) policy acquisition costs are expensed as incurred under SAP, but are deferred and amortized under GAAP, (2) the value of business acquired is not capitalized under SAP, but is under GAAP, (3) amounts collected from holders of universal life-type and annuity products are recognized as premiums when collected under SAP, but are initially recorded as contract deposits under GAAP, with cost of insurance recognized as revenue when assessed and other contract charges recognized over the periods for which services are provided, (4) the classification and carrying amounts of investments in certain securities are different, (5) the criteria for providing asset valuation allowances, and the methodologies used to determine the amounts thereof, (6) the timing of establishing certain reserves, and the methodologies used to determine the amounts thereof, and (7) certain assets are not admitted for purposes of determining surplus under SAP.
Some states require life insurers to maintain a certain value of securities on deposit with the state in order to conduct business in that state. Our insurance subsidiaries had securities totaling $25 and $27 on deposit with various states in 2003 and 2002.
Under prior federal income tax law, one-half of the excess of a life insurance company’s income from operations over its taxable investment income was not taxed, but was set aside in a special tax account designated as “Policyholders’ Surplus.” The Company has approximately $107 of untaxed “Policyholders’ Surplus” on which no payment of federal income taxes will be required unless it is distributed as a dividend, or under other specified conditions. No related deferred tax liability has been recognized for the potential tax, which would approximate $37.
The assumption for long-term rate of return on assets is derived from historical returns on investments of the types in which pension assets are invested. A range of assumptions for long-term rate of return is made for benchmarks representing each asset class. The upper and lower range limits are based on optimistic and pessimistic assumptions, respectively, and reflect historical returns that are adjusted to reflect factors that might cause future experience to differ from the past, differences between the benchmarks and the Plans’ assets, and the effects of asset smoothing. The adjusted rates of return are weighted by target allocations for each asset class to derive limits for a range of overall long-term gross rates of return. Within this range, one rate of return is selected as the best estimate. From that rate the Company subtracts an estimate of expenses, and the result is the basis for the assumed long-term rate of return on assets.
The Company’s pension plans weighted-average asset allocations at December 31, 2003 and 2002 by asset category are as follows based on fair value:
The overall investment objective of the Plans is to meet or exceed the actuarial assumptions of each Plan. The Plans are assumed to exist in perpetuity; therefore, the investment portfolio is managed to provide stable and growing income, as well as to achieve growth in principal equal to the rate of inflation. Allocation of Plan assets
is reviewed at least annually. As of December 31, 2003, the guidelines were: equity securities, a range of 40% to 70% of the total portfolio’s value, with no more than 20% of the total equity exposure in non-U.S. equities; fixed income, a range of 30% to 60% of the total portfolio’s value; cash, up to 5% of the portfolio’s value. Late in 2003, increases in the market value of equity securities caused the percentage of the portfolio invested in debt securities to be 29% at year end. Guidelines subsequent to December 31, 2003 allow an allocation of up to 75% to equity securities and an allocation to fixed income securities of no less than 25%, to accommodate fluctuations in market value. The portfolio may be invested in individual securities, mutual funds, or co-mingled funds of various kinds. In order to achieve a prudent level of portfolio diversification, the securities of any one company or issuer, other than the U.S. Treasury, should not exceed 5% of the portfolio’s value and no more than 20% of the fund should be invested in any one industry. Without specific written instructions from the Plan Administrator, a Plan will not be invested in short sales of individual securities, put or call options on individual securities or commodities, or commodity futures.
The Company sponsors contributory health care and life insurance benefit plans for eligible retired employees, qualifying retired agents and certain surviving spouses. The Company contributes to a welfare benefit trust from which future benefits will be paid. The Company accrues the cost of providing postretirement benefits other than pensions during the employees’ active service period. The non-pension postretirement expense was $2 in 2003, $2 in 2002 and $1 in 2001.
Defined contribution retirement plans cover most employees and full time agents. The Company matches a portion of participant contributions and makes profit sharing contributions to a fund that acquires and holds shares of the Company’s common stock. Most plan assets are invested under a group variable annuity contract issued by JP Life. Expenses were $2, $4 and $4 during 2003, 2002 and 2001.
The insurance subsidiaries attempt to reduce exposure to significant individual claims by reinsuring portions of certain individual life insurance policies and annuity contracts written. They reinsure the portion of an individual life insurance risk in excess of their retention, which ranges from $0.4 to $2.1 for various individual life and annuity products. They also attempt to reduce exposure to losses that may result from unfavorable events or circumstances by reinsuring certain levels and types of accident and health insurance risks underwritten. They assume portions of the life and accident and health risks underwritten by certain other insurers on a limited basis, but amounts related to assumed reinsurance are not significant to the consolidated financial statements.
As of December 31, 2003 and 2002, JPFIC also had a reinsurance recoverable of $76 and $79 from a single reinsurer, pursuant to a 50% coinsurance agreement. JPFIC and the reinsurer are joint and equal owners in $153 and $144 of securities and short-term investments as of December 31, 2003 and 2002, 50% of which is included in investments in the consolidated balance sheets.
The components of other comprehensive income, along with related tax effects, are as follows:
The Company routinely enters into commitments to extend credit in the form of mortgage loans and to purchase certain debt instruments for its investment portfolio in private placement transactions. The fair value of outstanding commitments to fund mortgage loans and to acquire debt securities in private placement transactions, which are not reflected in the consolidated balance sheets, approximates $86 at December 31, 2003.