The Company's home office property consists of two connected office buildings totaling 840,000 square feet at 1 Fountain Square, Chattanooga, Tennessee. The office buildings and substantially all of the surrounding 25 acres of land, used primarily as parking lots, are owned by the Company in fee. With the acquisition of Paul Revere in 1997, the Company also has a large operations center and owns facilities in Worcester, Massachusetts comprised of two connected buildings totaling 438,000 gross square feet of office space and approximately 5.6 acres of land, used primarily as parking. In addition, approximately 36,000 square feet of space is leased in three buildings located in the Worcester area, and 15,000 square feet of office space is leased in Springfield, Massachusetts. Total rents are approximately $0.6 million annually.
The Company also leases other office space and minor storage space at approximately 65 locations in 33 states in the United States and 14 locations in 7 Canadian provinces for its sales and service force. The Company's real property lease payments for 1998 were approximately $9.2 million (net of rents received on subleased property).
The Company acquired GENEX Services, Inc. ("GENEX") and The Paul Revere Corporation ("Paul Revere") on February 28, 1997, and March 27, 1997, respectively. The financial information contained herein includes the accounts and operating results of GENEX and Paul Revere from the respective dates of acquisition. Since GENEX and Paul Revere are reflected in the results for 1998 and 1997, and not 1996, the difference in comparability of the years is frequently attributed to that fact.
The following discussion of operating results by segment excludes net realized investment gains and losses from revenue and income before taxes. The Company's investment focus has been on investment income to support its insurance liabilities as opposed to the generation of realized investment gains. Due to the nature of the Company's business, a long-term focus in necessary to maintain profitability over the life of the business. The realization of investment gains and losses will impact future earnings levels as the underlying business is long-term in nature and requires that the Company be able to sustain the assumed interest rates in its liabilities. However, income excluding realized investment gains and losses does not replace net income as a measure of the Company's profitability, and this discussion should be read in conjunction with the consolidated financial statements and notes thereto.
Income before net realized investment gains and losses and federal income taxes ("income") increased $3.6 million, or 1.0 percent, to $368.8 million in 1998 from $365.2 million in 1997. This increase resulted from
increased income in the Individual segment ($2.7 million), Employee Benefits segment ($45.6 million), and Voluntary Benefits segment ($8.1 million). This increase was partly offset by lower income in the Other segment ($6.1 million) and Corporate segment ($46.7 million).
Net income totaled $254.0 million in 1998, compared to $247.3 million in 1997 and $145.6 million in 1996. Net realized investment gains after federal income taxes were $22.3 million in 1998 and $9.8 million in 1997, compared to losses of $5.4 million in 1996.
Revenue in the Individual segment increased $351.3 million, or 18.5 percent, to $2,253.6 million in 1998 from $1,902.3 million in 1997. The increase was primarily the result of the acquisition of Paul Revere. Premium income in this segment increased $187.8 million, or 14.6 percent, to $1,474.4 million in 1998 from $1,286.6 million in 1997. Both the individual disability income and individual life lines of business produced increases in premium income. Also in this segment, net investment income increased $146.2 million, or 24.8 percent, to $736.0 million in 1998 from $589.8 million in 1997, primarily due to the acquisition of Paul Revere and increased capital allocation. Management expects that premium income in the Individual segment will begin to
grow on a year-over-year basis as the product transition in the individual disability income line of business begins to produce increasing levels of new sales of individual disability products.
In 1997, revenue in the Individual segment increased $877.3 million, or 85.6 percent, to $1,902.3 million from $1,025.0 million in 1996. The increase was primarily the result of the acquisition of Paul Revere, which contributed $851.9 million of revenue to this segment in 1997. Premium income in this segment increased $640.5 million, or 99.1 percent, to $1,286.6 million in 1997 from $646.1 million in 1996. The increase was primarily the result of the acquisition of Paul Revere, which contributed $636.5 million of premium income to this segment in 1997. Within this segment, revenue in the individual disability income line of business increased $840.1 million, or 94.1 percent, to $1,733.1 million in 1997 from $893.0 million in 1996. Revenue in the individual life line of business increased $37.2 million, or 28.2 percent, to $169.2 million in 1997 from $132.0 million in 1996. Both of these lines of business benefited from the Paul Revere acquisition.
In the fourth quarter of 1998, new annualized sales in the individual disability income line totaled $33.5 million, compared to $28.2 million in the third quarter of 1998 and $29.8 million in the fourth quarter of 1997, reflecting the continued product transition. On a pro forma basis, sales of individual disability income contracts declined in 1998 to $114.6 million from $127.3 million in 1997, reflecting the planned discontinuance of certain products and restructuring of others and, secondarily, with the consolidation of the Company's and Paul Revere's sales offices and related realignment of the field sales force.
In 1997, revenue in the Employee Benefits segment increased $335.0 million, or 84.7 percent, to $730.5 million from $395.5 million in 1996. The increase was primarily the result of an increase in premium income in
In 1997, income in the Employee Benefits segment increased $9.2 million, or 29.9 percent, to $40.0 million from $30.8 million in 1996. This increase was primarily due to increased income in the group disability line of business, which increased $9.5 million to $15.3 million in 1997 from $5.8 million in 1996. This increase was primarily due to the acquisition of Paul Revere. Also within this segment, GENEX produced income of $2.0 million in 1997. These results were partly offset by lower income in the group life and accidental death and dismemberment lines of business, which produced income of $22.7 million in 1997, compared to $25.0 million in 1996.
Effective January 1, 1998, the Company entered into an agreement with Connecticut General Life Insurance Company ("Connecticut General") for Connecticut General to reinsure, on a 100% coinsurance basis, the Company's in-force medical stop-loss insurance coverages sold to clients of CIGNA Healthcare and its affiliates ("CIGNA"). This reinsured block constitutes substantially all of the Company's medical stop-loss insurance business. The small portion remaining consists of medical stop-loss coverages sold to clients other than those of CIGNA. These coverages will not be renewed. The medical stop-loss business produced revenue of $14.1 million, $38.0 million, and $50.6 million and income of $1.6 million, $6.6 million, and $10.2 million for the years ended 1998, 1997, and 1996, respectively.
On April 30, 1998, the Company closed the sale of its in-force individual and tax-sheltered annuity business to American General Annuity Insurance Company and The Variable Annuity Life Insurance Company, affiliates of American General Corporation ("American General"). The sale was effected by reinsurance in the form of 100% coinsurance agreements whereby the financial liability for the various annuity lines was transferred to American General. The responsibility for providing administrative services was also assumed by American General pursuant to various administrative services agreements with the American General affiliates. The in-force business sold consisted primarily of individual fixed annuities and tax-sheltered annuities in Provident Life and Accident Insurance Company ("Accident"), Provident National Assurance Company ("National"), The Paul Revere Life Insurance Company ("Paul Revere Life"), The Paul Revere Variable Annuity Insurance Company ("Paul Revere Variable")and The Paul Revere Protective Life Insurance Company ("Paul Revere Protective"). In addition, American General acquired a number of miscellaneous group pension lines of business sold in the 1970s and 1980s which were no longer actively marketed by the Company. Pursuant to an administrative services agreement, an affiliate of American General is providing administrative services to registered separate accounts
of Paul Revere Variable and National. The sale does not include the Company's block of guaranteed investment contracts ("GICs") or group single premium annuities ("SPAs"), which will continue in a run-off mode. In consideration for the transfer of the approximately $2.4 billion of statutory reserves, American General paid the Company a ceding commission of approximately $58.0 million. See "Note 14 of the Notes to Consolidated Financial Statements" for further discussion.
In 1997, the Company transferred its dental business to Ameritas Life Insurance Corp. The dental block, which was acquired in the Paul Revere acquisition, produced $39.2 million in premium income in 1997 and $48.3 million in 1996.
Income in the Other segment declined $6.1 million, or 6.6 percent, to $86.1 million in 1998 from $92.2 million in 1997. The decline in this segment was due in part to the sale of the individual annuity line and the reinsurance of the medical stop-loss line. Income in the group pension line of business also declined to $21.7 million in 1998 from $35.3 million in 1997 primarily due to the result of lower funds under management and lower income from a reduced amount of capital allocated to this line. In addition, the Company recorded an $8.0 million reserve strengthening for group SPAs during 1998. This decline was partly offset by improved income in the COLI line of business which increased to $27.9 million in 1998 from $19.4 million in 1997.
In 1997, income in the Other segment increased $13.4 million, or 17.0 percent, to $92.2 million from $78.8 million in 1996. This increase was primarily the result of higher income in the individual annuities line of business, which increased to $17.9 million in 1997 from $1.9 million in 1996, due to the acquisition of Paul Revere. This increase was partly offset by lower income in the group pension line of business, which produced income of $35.3 million in 1997, a decline of $12.3 million, or 25.8 percent, from $47.6 million in 1996. The medical stop-loss line also produced lower income in 1997, declining $3.6 million, or 35.3 percent, to $6.6 million in 1997 from $10.2 million in 1996.
The Other segment contains lines of business that are no longer actively marketed by the Company and are in run-off mode. It is expected that revenue and earnings in this segment will decline over time as these business lines wind down. The run-off of the group pension line results in a decline in assets under management and, in turn, a continued decline in the net investment income produced by the assets. Management expects to reinvest the capital supporting these lines of business in the future growth of the Individual and Employee Benefits segments.
The Corporate segment includes investment earnings on corporate assets not specifically allocated to a line of business, corporate interest expense, amortization of goodwill, and certain corporate expenses not allocated to a line of business.
The Corporate segment reported a loss of $61.1 million in 1998 compared to a loss of $14.4 million in 1997. Interest and debt expense increased to $62.1 million in 1998 from $39.9 million in 1997. Also, amortization of goodwill increased to $21.4 million in 1998 from $12.6 million in 1997, reflecting the acquisitions of Paul Revere and GENEX.
In 1997, the Corporate segment reported a loss of $14.4 million compared to a loss of $4.9 million in 1996. Interest and debt expense increased to $39.9 million in 1997 from $12.4 million in 1996. Also, amortization of goodwill increased to $12.6 million in 1997 as a result of the acquisition of Paul Revere and GENEX.
In July 1998, the Company completed a public offering of $200.0 million of 6.375% senior notes due July 15, 2005, and $200.0 million of 7.0% senior notes due July 15, 2018.
As a holding company, the Company is dependent upon payments from its wholly-owned insurance subsidiaries and GENEX to pay dividends to its stockholders and to pay its expenses. These payments by the Company's subsidiaries may take the form of either dividends or interest payments on amounts loaned to such subsidiaries by the Company or expense reimbursement. At December 31, 1998, the Company had outstanding from its insurance subsidiaries a $150.0 million surplus debenture due in 2006 with a weighted average interest rate during 1998 of 7.9% and a $100.0 million surplus debenture due in 2027 with a weighted average interest rate during 1998 of 8.3%. Semi-annual interest payments are conditional upon the approval by the insurance department of the state of domicile.
The Company's liquidity requirements are met primarily by cash flow provided from operations, principally in its insurance subsidiaries. Premium and investment income, as well as maturities and sales of invested assets, provide the primary sources of cash. Cash flow from operations was sufficient in 1998. Cash is applied to the payment of policy benefits, costs of acquiring new business (principally commissions) and operating expenses as well as purchases of new investments. The Company has established an investment strategy that management believes will provide for adequate cash flow from operations.
As a result of the release of capital generated by the run-off of the GIC portfolio, the sale of the commercial mortgage loans and other corporate actions, the Company has increased its available capital to support the growth of its businesses, including assisting in the financing of the acquisitions of Paul Revere and GENEX. Management continues to analyze potential opportunities to utilize the capital to further enhance stockholder value, including exploring options that would support the Company's growth initiatives.
interest rate risk management and net yields. Testing the asset and liability portfolios under various interest rate and economic scenarios allows management to choose the most appropriate investment strategy, as well as to prepare for disadvantageous outcomes. This analysis is the precursor to the Company's activities in derivative financial instruments. The Company uses interest rate swaps, interest rate forward contracts, exchange-traded interest rate futures contracts, and options to hedge interest rate risks and to match asset durations and cash flows with corresponding liabilities.
The following table provides certain investment information and results for the years indicated.
- -------- * Average yield is determined by dividing annualized net investment income by the average cash and invested assets for the year. Excluding net unrealized gains on securities, the yield is 8.2%, 8.0%, and 8.1% for 1998, 1997, and 1996, respectively. See "Note 3 of the Notes to Consolidated Financial Statements."
The Company's investment in mortgage-backed securities approximates $2.0 billion on an amortized cost basis at December 31, 1998 and $3.1 billion at December 31, 1997. At December 31, 1998, the mortgage-backed securities had an average life of 8.7 years and effective duration of 7.5 years. The mortgage- backed securities are valued on a monthly basis using valuations supplied by the brokerage firms that are dealers in these securities. The primary risk involved in investing in mortgage-backed securities is the uncertainty of the timing of cash flows from the underlying loans due to prepayment of principal. The Company uses models which incorporate economic variables and possible future interest rate scenarios to predict future prepayment rates. The Company has not invested in mortgage-backed derivatives, such as interest-only, principal-only or residuals, where market values can be highly volatile relative to changes in interest rates.
The Company's exposure to below-investment-grade fixed maturity securities at December 31, 1998, was $1,366.4 million, representing 7.9 percent of invested assets, below the Company's internal limit of 10.0 percent of invested assets for this type of investment. The Company's exposure to below- investment-grade fixed maturities totaled $1,297.1 million at December 31, 1997, representing 6.6 percent of invested assets.
As are many other businesses in this country and abroad, the Company is affected in numerous ways, both by its own computer information systems and by third parties with which it has business relationships, in the processing of date data relating to the year 2000 and beyond. Failure to adequately address and substantially resolve year 2000 issues could, and as to mission critical systems in certain circumstances would, have a material adverse effect on the Company's business, results of operations, or financial condition. While there can be no assurance as to its success, the Company has a project underway which is intended and designed to avoid and/or mitigate any such material adverse effect from year 2000 issues.
In 1996 the Company completed the significant aspects of the planning phase of a project designed to modify its computer information systems to enable proper processing of date data relating to the year 2000. This project has a number of phases, including (i) planning; (ii) inventory (ascertaining the various internal systems and external relationships potentially affected by year 2000 issues); (iii) analysis (determining the extent to which the system or remediation or conversion to a compliant alternative); (iv) construction (remediating the system in order to be compliant); (v) testing (subjecting the integrated testing to validate interconnected and future date processing in the date forward year 2000 environment); and (vi) completion. The Company defines year 2000 "compliant" or "compliance" to mean that software will have the ability to (i) accept input and provide output of data involving dates or portions of dates correctly and without ambiguity as to the twentieth or twenty-first centuries; (ii) manage, store, manipulate, sort, sequence, and perform calculations with respect to data involving dates or portions of dates before, during and after January 1, 2000 (including single-century or multi- century date formulas) without malfunction, abends, aborts; and (iii) manage the leap year occurring in the year 2000 and any Special Dates. The term "Special Dates" means dates used by programmers to create exceptions where no date could be determined as specified to serve as end-of-file indicators or to facilitate sort routines. The Company's approach has primarily been one of modifying or remediating systems to make them compliant since there are not generally compliant replacements available in the market that will meet the Company's operational needs. In some instances non-compliant systems have been replaced with available and usable compliant systems where that approach is both cost and time effective.
There are numerous instances in which third parties having a relationship with the Company have year 2000 issues to address and resolve. These include primarily vendors of hardware and software, holders of group insurance policies, issuers of investment securities, financial institutions, governmental agencies, and suppliers. An aspect of the project has been to identify these third parties and generally to contact them seeking written assurance as to the third party's expectancy to be year 2000 compliant. Written requests have been sent to more than 925 third parties. The nature of the Company's follow up depends upon its assessment of the response and of the materiality of the effect of non-compliance by the third party on the Company. For example, the Company follows up with additional written requests and telephonic inquiries depending upon the circumstances and in some instances determines that it is appropriate to test third party systems about which it has received written assurance. Project personnel have identified primary business areas which, based on the status of current responses from third parties and their risk assessments, have the potential for year 2000 problems. In instances in which the effect of non-compliance may be deemed materially adverse to the Company's business, results of operations, or financial condition, the project personnel have determined alternatives for contingent arrangements, and project personnel are considering appropriate documentation of potential procedural changes by the Company or third party providers. At this time these include various plans for investments and cash management, underwriting, client services, workplace management, and claims. With regard to material relationships, contingency plans are expected to be ready for execution by the end of second quarter, 1999.
Since inception of the project, the Company has expensed $6.5 million through December 31, 1998, in connection with incremental cost of the year 2000 project and estimates an additional $1.5 million to complete the project.
The effort of the information systems personnel and others devoted to the project has been considerable. Temporary personnel in varying numbers have been retained to assist full time personnel in some phases or aspects of the project. The Company has utilized compensation programs to retain project personnel in order to keep the project on schedule. While the project has required systems management to more closely scrutinize the prioritization of information technology projects, it is not believed that any deferral of information technology projects has had a material impact on the Company. At various stages during the project, the Company has used consultants on some particular aspects of the project. The Company has also had occasional contact with certain peer companies comparing approaches to year 2000 issues. The Company has not sought and does not currently expect to obtain independent verification of its processes for dealing with year 2000.
Given the range of possibilities that may occur in connection with non- compliance with year 2000 that could affect the Company, particularly as a consequence of third parties, the Company is unable to provide an estimate of the impact of such non-compliance on its business, results of operations, or financial condition. With regard to non-compliance resulting from the Company's systems, which the Company believes to be less likely than that resulting from third parties, the Company would devote its financial and personnel resources, which include approximately 250 systems personnel who would be available, to remediate the problem as soon as possible. With regard to non-compliance resulting from third party failure, the Company is trying to determine through responses and other appropriate action where there is any material likelihood of non-compliance having a potentially material impact. In these instances it is seeking to develop an appropriate contingency arrangement that will minimize such impact; however, given the range of possibilities, no assurance can be given that the Company's efforts will be successful.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Provident Companies, Inc. and Subsidiaries at December 31, 1998 and 1997, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. 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.
Operations: The Company does business in the United States and Canada. The Company operates principally in the life and health insurance business. Individual disability and life products are reported in the Individual segment and are marketed primarily through brokerage offices, independent agents, financial planners, and corporate marketing arrangements. The Employee Benefits segment contains products that are sold to corporate customers, including group life, disability, and accidental death and dismemberment protection. Individual products marketed through sponsoring employers are reported in the Voluntary Benefits segment. The Other segment includes results from products no longer actively marketed, including corporate-owned life insurance, group pension, medical stop-loss, medical and dental, and individual annuities. The Corporate segment reports corporate results, primarily investment earnings not specifically allocated to a line of business, corporate interest expense, goodwill amortization, and certain corporate expenses not allocated to a line of business. The operating segment information located in the tables on pages 18 through 25 is incorporated herein by reference.
Use of Estimates: The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein.
Fixed maturity securities include bonds and redeemable preferred stocks. Equity securities include common stocks and nonredeemable preferred stocks. Fixed maturity and equity securities not bought and held for the purpose of selling in the near term but for which the Company does not have the positive intent and ability to
Changes in the fair value of available-for-sale fixed maturity securities and equity securities are reported as other comprehensive income. These amounts are net of deferred federal income taxes and valuation adjustments to deferred policy acquisition costs, value of business acquired, and reserves for future policy and contract benefits which would have been recorded had the related unrealized gains or losses on these securities been realized.
Interest Rate Swap Agreements are agreements in which two parties agree to exchange, at specified intervals, interest payment streams calculated on an agreed-upon notional principal amount with at least one stream based on a specified variable rate. The underlying notional principal is not exchanged between the parties. The Company has certain forward interest rate swap agreements where the exchange of interest payments does not begin until a specified future date. The Company intends to settle the forward interest rate swap agreements prior to the commencement of the exchange of interest payment streams.
Futures and Forward Contracts are commitments to either purchase or sell a financial instrument at a specific future date for a specified price. The Company invests only in futures and forward contracts which have U.S. Treasury securities as the underlying investments. Changes in the market value of contracts are generally settled on a daily basis. The notional amounts of futures and forward contracts represent the extent of the Company's involvement but not the future cash requirements, as the Company intends to close out open positions prior to settlement. All of the Company's futures and forward contracts are accounted for as hedges.
The fair values of futures and forwards which hedge available-for-sale securities are reported in the consolidated statements of financial condition as a component of fixed maturity securities. The fair values of open futures and forwards which hedge liabilities are reported in the consolidated statements of financial
condition as a component of other liabilities. Gains or losses realized on the termination of futures and forward contracts are accounted for in the same manner as interest rate swap agreements.
Deferred Policy Acquisition Costs: Certain costs of acquiring new business which vary with and are primarily related to the production of new business have been deferred. Such costs include commissions, other agency compensation, certain selection and policy issue expenses, and certain field expenses. Deferred policy acquisition costs are subject to recoverability testing at the time of policy issue and loss recognition testing subsequent to the year of issue.
Property and Equipment: Property and equipment is depreciated on the straight-line method over its estimated useful life. The accumulated depreciation for property and equipment was $128.8 million and $115.7 million as of December 31, 1998 and 1997, respectively.
Disabled lives reserves for future policy and contract benefits on disability income policies are calculated based upon assumptions as to interest and claim termination rates that are currently appropriate. The interest rate assumptions used for discounting claim reserves are based on projected portfolio yield rates, after consideration for defaults and investment expenses, for the assets supporting the liabilities for the various product lines. The assets for each product line are selected according to the specific investment strategy for that product line to produce asset cash flows that follow similar timing and amount patterns to those of the anticipated liability payments. Claim termination rate assumptions are based upon industry standards adjusted as appropriate to reflect actual Company experience. The assumptions vary by year of claim incurral and may include a provision for adverse deviation.
Separate Accounts: The separate account amounts shown in the accompanying financial statements represent contributions by contract holders to variable- benefits and fixed-benefits pension plans. The contract purchase payments and the assets of the separate accounts are segregated from other Company funds for both investment and administrative purposes. Contract purchase payments received under variable annuity contracts are subject to deductions for sales and administrative fees. Also, the sponsoring company of the separate accounts receives management fees which are based on the net asset values of the separate accounts.
Statement of Financial Accounting Standards No. 130 (SFAS 130), Reporting Comprehensive Income. In 1998, the Company adopted the provisions of SFAS 130 which establish standards for reporting and presentation of comprehensive income and its components. SFAS 130 requires foreign currency translation adjustments and unrealized holding gains and losses on the Company's available-for-sale fixed maturity and equity securities, which prior to adoption were reported separately in stockholders' equity, to be reported as components of comprehensive income (see Note 10). Prior periods have been reclassified to conform to the requirements of SFAS 130. The adoption of SFAS 130 had no impact on the Company's net income or stockholders' equity.
Statement of Financial Accounting Standards No. 125 (SFAS 125), Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities. In 1997, the Company adopted the provisions of SFAS 125 which provide accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. Those standards are based on consistent application of a financial-components approach that focuses on control. SFAS 125 also establishes new rules for determining whether a transfer of financial assets constitutes a sale and, if so, the determination of any resulting gain or loss. The adoption of SFAS 125 did not have a material effect on the Company's financial position or results of operations.
Statement of Financial Accounting Standards No. 128 (SFAS 128), Earnings Per Share. In 1997, the Company adopted the provisions of SFAS 128 which establish computation and reporting standards for earnings per share. SFAS 128 simplifies the standards for computing earnings per share and makes them comparable to international earnings per share standards. SFAS 128 requires dual presentation on the face of the income statement of earnings per share and earnings per share assuming dilution and requires a reconciliation of the numerator and denominator of the earnings per share computation to the numerator and denominator of the earnings per share assuming dilution computation (see Note 10). Earnings per share is computed using the weighted average number of common shares outstanding and does not consider any potential dilution. Earnings per share assuming dilution reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Historical earnings per common share amounts have been restated in accordance with the provisions of SFAS 128.
Statement of Financial Accounting Standards No. 133 (SFAS 133), Accounting for Derivative Instruments and Hedging Activities. In 1998, the Financial Accounting Standards Board issued SFAS 133 which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives), and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial condition and measure those instruments at fair value. SFAS 133 specifies a special method of accounting for certain hedging transactions, prescribes the type of items and transactions that may be hedged, and provides the criteria which must be met in order to qualify for hedge accounting.
Fair value hedge. Changes in the fair value of both the derivative and the hedged item attributable to the risk being hedged are recognized in income.
For a derivative not designated as a hedging instrument, the gain or loss is recognized in income in the period of change.
The Company plans to adopt the provisions of SFAS 133 in 2000. At this time, the Company has not determined the effects that adoption of SFAS 133 will have on its financial statements.
Statement of Position 97-3 (SOP 97-3), Accounting by Insurance and Other Enterprises for Insurance-Related Assessments. In 1997, the AICPA issued SOP 97-3 which provides guidance for determining when an entity should recognize a liability or an asset for insurance-related assessments and how to measure these items. The adoption of SOP 97-3 will not have a material effect on the Company's financial position or results of operations. The Company will adopt the provisions of SOP 97-3 effective January 1, 1999.
Fixed Maturity Securities: Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services or, in the case of private placements, are estimated by discounting expected future cash flows using a current market rate applicable to the yield, credit quality, and maturity of the investments. See Note 3 for the amortized cost and fair values of securities by security type and by maturity date.
Short-term Debt: The carrying amounts for short-term debt approximate fair value.
At December 31, 1998, the total investment in below-investment-grade fixed maturity securities (securities rated below Baa3 by Moody's Investors Service or an equivalent internal rating) was $1,366.4 million or 7.9 percent of invested assets. The amortized cost of these securities was $1,376.9 million.
To help limit the credit exposure of the derivatives, the Company has entered into master netting agreements with its counterparties whereby contracts in a gain position can be offset against contracts in a loss position. The Company also typically enters into bilateral, cross- collateralization agreements with its counterparties to help limit the credit exposure of the derivatives. These agreements require the counterparty in a loss position to submit
The following table summarizes the timing of anticipated settlements of interest rate swaps outstanding at December 31, 1998, and the related weighted average interest receive rate or pay rate assuming current market conditions.
In 1998, 1997, and 1996, the Company amortized into net investment income $1.9 million, $0.6 million, and $0.1 million, respectively, of the deferred gains from this program. Realized investment gains and losses from this program during 1998, 1997 and 1996 were immaterial.
Gains or losses on termination of these forwards and futures are deferred and reported as an adjustment of the carrying amount of the hedged asset or liability and amortized into earnings over the lives of the hedged items. The net deferred gain associated with this activity was $28.9 million and $30.2 million at December 31, 1998 and 1997, respectively.
At December 31, 1998, the Company had no open contracts under this program.
The estimated net amortization of value of business acquired for each of the next five years is as follows (in millions of dollars):
Changes in the liability for unpaid claims and claim adjustment expenses were as follows:
A reconciliation of the income tax attributable to continuing operations computed at U.S. federal statutory tax rates to the income tax expense as included in the consolidated statements of income follows:
Under the Life Insurance Company Tax Act of 1959, life companies were required to maintain a policyholders' surplus account containing the accumulated portion of current income which had not been subjected to income tax in the year earned. The Deficit Reduction Act of 1984 requires that no future amounts
Federal income taxes paid during 1998, 1997, and 1996 were $78.4 million, $122.7 million, and $92.5 million, respectively.
During 1998, the Company repaid the $725.0 million outstanding borrowing under its revolving credit facility. The interest rate on the revolving credit facility was variable based upon a London Interbank Offered Rate (LIBOR) plus a margin.
Interest costs related to these securities are reported in the consolidated statements of income as a component of interest and debt expense. Interest paid on these securities during 1998 was $11.1 million.
The following table provides the components of the net periodic benefit cost (credit) for the plans during 1998, 1997, and 1996.
When securities are reported at fair value, adjustments are made to deferred policy acquisition costs, value of business acquired, and reserves for future policy and contract benefits as if the unrealized investment gains and losses on the securities had been realized.
The components of other comprehensive income (loss) and the related deferred tax are as follows:
The deferred tax (credit) for other comprehensive items is computed at the federal statutory income tax rate.
Options to purchase approximately 1,022,000 common shares in 1998 were not considered dilutive because the options' exercise prices were greater than the average market price. These options were excluded from the calculation of earnings per common share assuming dilution. Nondilutive options excluded from the calculation of earnings per common share assuming dilution for 1997 and 1996 were immaterial.
In accordance with stock option plan provisions, outstanding stock options would become immediately exercisable in the event of a change in control of the Company.
Compensation cost for the Company's management incentive compensation plan and employee stock purchase plan under the fair value approach was estimated as of the grant date using the Black-Scholes option pricing model with the following weighted average assumptions:
Reinsurance activity is accounted for on a basis consistent with the terms of the reinsurance contracts and the accounting used for the original policies issued. Premium income, policy and contract benefits, and changes in reserves for future policy and contract benefits and policyholders' funds are presented in the consolidated statements of income net of reinsurance ceded. The total amounts deducted for reinsurance ceded are as follows:
Premium income assumed was $204.4 million, $174.4 million, and $51.5 million during 1998, 1997, and 1996, respectively.
On March 27, 1997, the Company acquired The Paul Revere Corporation (Paul Revere), a provider of life and disability insurance products, at a price of approximately $1.2 billion. The transaction was financed through common equity issued to Zurich Insurance Company, a Swiss insurer, and its affiliates in the amount of $300.0 million (19,047,620 shares of common stock), common equity of $437.5 million (23,340,000 shares of common stock) and cash of $2.5 million issued to Paul Revere shareholders, internally generated funds of $145.0 million, and borrowings on the Company's revolving credit facility of $305.0 million. The acquisition was accounted for by the purchase method. The fair values of the assets acquired and liabilities assumed were $6,680.0 million and $6,675.4 million, respectively. The purchase price has been allocated principally to the value of business acquired with the remainder being allocated to goodwill. The interest rate used to determine the value of business acquired for traditional products was the reserve discount rate. The interest rate used for interest-sensitive products was based on the current interest rate credited on account values. The value of business acquired will be amortized with interest based on premium income for the traditional individual life and disability income products and on the estimates of future gross profits for interest-sensitive individual life products. Goodwill will be amortized on a straight-line basis over a 40 year period. The consolidated financial statements include the operating results of Paul Revere from April 1, 1997.
Two alleged class action lawsuits have been filed in Superior Court in Worcester, Massachusetts (the Court) against the Company--one purporting to represent all career agents of Paul Revere whose employment relationships ended on June 30, 1997 and were offered contracts to sell insurance policies as independent producers, and the other purporting to represent independent brokers who sold certain Paul Revere individual disability income policies with benefit riders. Motions filed by the Company to dismiss most of the counts in the complaints, which allege various breach of contract and statutory claims, have been denied, but the cases remain at a preliminary stage. To date, no class has been certified in either lawsuit. The Company has filed a conditional
counterclaim in each action which requests a substantial return of commissions should the Court agree with the plaintiff's interpretation of the contract. The Company has strong defenses to both lawsuits and will vigorously defend its position and resist certification of the classes. In addition, the same plaintiff's attorney who has filed the purported class action lawsuits has filed 42 individual lawsuits on behalf of current and former Paul Revere sales managers alleging various breach of contract claims. The Company has filed a motion in federal court to compel arbitration for 16 of the plaintiffs who are licensed by the National Association of Securities Dealers and have executed the Uniform Application for Registration or Transfer in the Securities Industry (Form U-4). The Company has strong defenses and will vigorously defend its position in these cases as well. Although the alleged class action lawsuits and the 42 individual lawsuits are in the early stages, management does not currently expect these suits to materially affect the financial position or results of operations of the Company.
Various lawsuits against the Company have arisen in the normal course of business. Contingent liabilities that might arise from litigation are not deemed likely to materially affect the financial position or results of operations of the Company.
The Company's insurance subsidiaries' statutory net income, as reported in conformity with statutory accounting practices prescribed by state regulatory authorities, for the years ended December 31, 1998, 1997, and 1996, was $161.1 million, $76.1 million, and $104.9 million, respectively. Statutory capital and surplus at December 31, 1998 and 1997, was $1,252.1 million and $1,128.2 million, respectively.
The Company's insurance subsidiaries prepare their statutory-basis financial statements in accordance with accounting practices prescribed or permitted by the National Association of Insurance Commissioners (NAIC) and the applicable state regulatory authorities. Prescribed statutory accounting practices include state laws, regulations, and general administrative rules, as well as a variety of publications of the NAIC. Permitted statutory accounting practices encompass all accounting practices that are not prescribed; such practices may differ from state to state, may differ from company to company within a state, and may change in the future. At December 31, 1998, the Company had not applied any permitted accounting practices that differed from prescribed statutory accounting practices that had a material impact on the financial position or results of operations of the insurance subsidiaries.
At December 31, 1998, the Company's insurance subsidiaries had on deposit with regulatory authorities securities with a book value of $1,002.6 million held for the protection of policyholders.
In November 1998, the Company announced its plans to merge with UNUM Corporation (UNUM), a leading provider of disability products and other employee benefits, in a transaction that will create UNUMProvident Corporation (UNUMProvident). In the merger, each share of UNUM common stock issued and outstanding immediately prior to the effective time of the merger will be converted into one share of UNUMProvident common stock. Each share of the Company's common stock issued and outstanding immediately prior to the effective time of the merger will remain an issued and outstanding share of UNUMProvident common stock after the merger. However, as a result of the Provident Reclassification Amendment, which will become effective immediately prior to the effective time of the merger, each share of the Company's common stock issued and outstanding immediately prior to the effective time of the Provident Reclassification Amendment will be reclassified and converted into 0.73 of a validly issued, fully paid, and nonassessable share of UNUMProvident common stock. The reclassification will not apply to UNUMProvident common stock issued to UNUM stockholders in the merger. The merger is subject to regulatory and UNUM stockholder and Company stockholder approval. The transaction is expected to be completed by mid-1999 and is expected to be accounted for as a pooling of interests.
On the date the merger is completed or on an earlier date if required by generally accepted accounting principles, UNUMProvident will record an expense for merger related expenses of approximately $210.0 million. These expenses consist of employee-related expenses, exit activities related to duplicate facilities and redundant systems, and investment banking, legal, and accounting fees. Since the incurral of the merger related expenses is related to and primarily dependent upon the completion of the transaction, which will occur in the future, the merger related expenses will be recognized as a charge to earnings at the time of the transaction closing. The estimated merger related expenses represent management's best estimates based on available information at this time. Actual charges will differ from these estimates.
The pro forma financial statements are presented for comparative purposes only and are not necessarily indicative of the results of operations that would have been realized had the merger been completed during the years or as of the date for which the pro forma financial statements are presented, nor are they necessarily indicative of the results of operations in future periods or the future financial position of UNUMProvident.
Provident Companies, Inc. and UNUM Corporation Unaudited Pro Forma Combined Condensed Balance Sheet As of December 31, 1998