Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide information to assist you in better understanding and evaluating our financial condition and results of operations. We encourage you to read this MD&A in conjunction with our Consolidated Financial Statements included in Part II, Item 8 of this Annual Report on Form 10-K and the "Risk Factors" contained in Part I Item 1A of this Annual Report on Form 10-K.
We are a global health services organization with a mission to help our customers improve their health, well-being and sense of security. Our insurance subsidiaries are major providers of medical, dental, disability, life and accident insurance and related products and services, the majority of which are offered through employers and other groups (e.g. governmental and non-governmental organizations, unions and associations). We also offer Medicare and Medicaid products and health, life and accident insurance coverages primarily to individuals in the U.S. and selected international markets. In addition to our ongoing operations described above, we also have certain run-off operations, including a Run-off Reinsurance segment.
GO GLOBAL: We seek to deliver a range of differentiated products and superior service to meet the distinct needs of a growing global middle class and a globally mobile workforce through expansion in existing international markets and extension of our business model to new geographic areas.
long-term relationships with each of our customers and meet their needs throughout each stage of their lives regardless of the customer's plan type: employer-based, government-sponsored, or individual coverage.
As part of this strategy, we have focused our efforts on delivering innovative health and wellness solutions tailored to our employer and government customers, enhancing collaboration with physicians and hospitals to offer affordable, value-based high quality care to individuals and building deeper relationships with individual customers through the world. Through these efforts, we believe we can achieve better health outcomes for our global customers and improve employee productivity, all while lowering the costs of health care for all parties.
As of December 31, 2013, our consolidated shareholders' equity was $10.6 billion, assets were $54.3 billion and we reported revenues of $32.4 billion for the year then ended. Our revenues are derived principally from premiums on insured products, fees from self-insured products and services, mail-order pharmacy sales, and investment income.
Over the past two years, we have entered into a number of transactions that have helped us to achieve our strategic goals by: (1) repositioning the portfolio for growth in targeted geographies, product lines, buying segments and distribution channels; (2) improving our strategic and financial flexibility; and (3) pursuing additional opportunities in high growth markets with particular focus on individuals.
Run-off Operations. Prior to February 4, 2013, our Run-off Reinsurance segment had significant exposures, primarily from our guaranteed minimum death benefits ("GMDB" also known as "VADBe") and guaranteed minimum income benefits ("GMIB") business. Effective February 4, 2013, we entered into an agreement with Berkshire to reinsure future exposures for this business, net of existing retrocessional arrangements, up to a specified limit, for a payment of $2.2 billion. See Note 7 to the Consolidated Financial Statements and the Run-off Reinsurance section of this MD&A for additional information. As a result of this transaction, we recorded an after-tax charge of $507 million in the first quarter of 2013 that is reported as a special item.
In 2012, we completed three significant transactions targeting the seniors, individual and global supplemental benefits markets:
HealthSpring, Inc. We acquired HealthSpring, a Medicare Advantage provider, to assist us in serving individuals across their life stages and deepen our presence in a number of geographic markets. This acquisition brought us industry-leading physician partnership capabilities, deepened our existing client and customer relationships, and facilitated a broader deployment of our range of health and wellness capabilities and product offerings.
Great American Supplemental Benefits. We acquired Great American Supplemental Benefits to both strengthen our capabilities in the individual market and facilitate our expansion into the Medicare supplemental business.
We are constantly evaluating ways to deliver our products and services more efficiently and at a lower cost. During 2013 and 2012, we adopted specific plans to increase our organizational efficiency as follows.
2013 plan. During the fourth quarter of 2013, we committed to a plan to increase our organizational efficiency and reduce costs through a series of actions that includes employee headcount reductions. As a result, we recognized charges in other operating expenses of $60 million pre-tax ($40 million after-tax) in the fourth quarter of 2013, consisting mostly of severance costs. The Global Health Care segment reported $47 million pre-tax ($31 million after-tax). The remainder was reported as follows: $11 million pre-tax ($8 million after-tax) in the Global Supplemental Benefits segment and $2 million pre-tax ($1 million after-tax) in Group Disability and Life. We expect most of the severance to be paid by the end of 2015. We expect to realize annualized after-tax savings of approximately $45 million. A substantial portion of these savings will be realized in 2014.
2012 plan. During the third quarter of 2012, we committed to a series of actions to further improve our organizational alignment, operational effectiveness, and efficiency. As a result, we recognized charges in other operating expenses of $77 million pre-tax ($50 million after-tax) in the third quarter of 2012 consisting primarily of severance costs that are expected to be mostly paid by the end of the first quarter of 2014. We realized annualized after-tax savings of approximately $60 million, the majority of which was reinvested in the business to enhance our ability to provide superior service and affordable products to our customers.
During the past three years, we have generated significant increases in revenues, adjusted income from operations and medical customers. This growth is largely due to the continued execution on our strategy, including the acquisition of HealthSpring, and continued business growth in targeted markets of all of our ongoing segments.
In 2013, we repurchased 13.6 million shares for $1.0 billion. From January 1, 2014 through February 26, 2014 we repurchased 5.0 million shares for $411 million. On February 26, 2014, the Company's Board of Directors increased share repurchase authority by $500 million. Accordingly, the total remaining share repurchase authorization as of February 26, 2014 was $901 million. Shareholders' equity increased in 2013, reflecting strong shareholders' net income in 2013 and the favorable effects of the pension plan, partially offset by the effects of share repurchase and unrealized losses on fixed maturities driven by rising interest rates.
On March 31, 2013, a sequestration order under the Budget Control Act of 2011 was issued that requires reductions in payments to Medicare Advantage ("MA") and Prescription Drug Program ("PDP") carriers. Effective April 1, 2013, payments to MA and PDP carriers were reduced by 2%, with the reduction scheduled to remain in place through 2023. The lower rates began impacting our revenue in the second quarter of 2013 and are expected to continue to reduce revenue into 2014 and beyond. The earnings impact is mitigated somewhat by reductions to medical cost reimbursements to health care professionals. Sequestration will continue to lower segment earnings in 2014 in the Global Health Care segment; however, the overall effect will depend on our ability to reduce medical cost reimbursements to health care professionals.
On April 1, 2013, the Centers for Medicare and Medicaid Services (CMS) issued the final Announcement of Calendar Year 2014 Medicare Advantage Benchmark Rates and Payment Policies. We submitted bids to CMS in the second quarter of 2013 that incorporated the 2014 rates and that continue to provide programs with attractive benefits to seniors. We expect 2014 earnings in our Government operating segment to be lower than prior years. The magnitude of this earnings impact will depend largely on our ability to manage medical costs.
Commercial minimum medical loss ratio ("MLR"). We record our rebate accrual based on estimated medical loss ratios calculated as prescribed by the U.S. Department of Health and Human Services ("HHS") using full-year premium and claim information by state and market segment for each legal entity that issues comprehensive medical coverage. In 2013, we accrued an estimated rebate of $12 million pre-tax ($8 million after-tax), compared with an accrual of $37 million pre-tax ($24 million after-tax) in 2012. We paid $15 million in 2013, lower than the estimated rebate accrual of $37 million, primarily due to refinements to the MLR rebate calculation, that also contributed to the lower 2013 rebate accrual when compared to 2012.
Health insurance industry fee. This fee, totaling $8 billion for the industry in 2014 and increasing to $13.9 billion by 2017, will not be tax deductible. Our effective tax rate is expected to increase beginning in 2014 as a result of this fee. Our share of this industry fee will be determined based on our proportion of premiums to the industry total. The amount of this fee is expected to be approximately $230 million in 2014: $130 million related to our commercial business and $100 million related to our Medicare business. For our commercial business, we anticipate recovering most of the industry fee through rate increases, resulting in an immaterial effect on shareholders' net income. For our Medicare business, although we expect to partially mitigate the effect of the fee through benefit changes and prices, we anticipate that the earnings impact will be more significant than it will be for our commercial business.
Reinsurance fee. Beginning in 2014, this fee will be a fixed dollar per customer levy on all commercial business, including ASO, and is tax deductible. It will be used to fund the reinsurance program for non-grandfathered individual business sold either on or off the public exchanges beginning in 2014. The amount of this fee is expected to be approximately $110 million in 2014. Because we anticipate recovering most of it through rate increases, the impact of this fee on shareholders' net income is not expected to be material.
Medicare Advantage and Medicare Part D requirements beginning in 2014. Under the rules proposed by HHS, if the MLR for a Medicare Advantage or Medicare Part D contract is less than the required 85% minimum, the contractor is required to pay a penalty to CMS and could be subject to additional sanctions if the MLR continues to be less than 85% for successive years. We currently expect that our Medicare Advantage and Medicare Part D plan offerings will meet these MLR requirements.
Public Health Exchanges. Beginning in 2014, we are offering coverage on five public health insurance exchanges (Arizona, Colorado, Florida, Tennessee, and Texas). The enrollment process began on October 1, 2013. Based on our preliminary enrollment data from the exchanges and the effect of the reinsurance, risk corridor and risk adjustment programs (see the "Regulation" section of this Form 10-K for additional information) we do not expect public exchange-based enrollments to have a material effect on our medical customer base, revenues, operating cash flows or results of operations in 2014.
Summarized below are our results of operations on a GAAP basis.
Consolidated Results of Operations: 2013 Compared to 2012 and 2012 Compared to 2011
Mail Order Pharmacy Revenues. Increases in each of 2013 and 2012 compared with the prior year, primarily reflected higher prescription volume for specialty medications (injectibles).
Other Revenues. Prior to the February 4, 2013 reinsurance transaction with Berkshire, other revenues included the results of a hedge program in the Run-off Reinsurance segment related to the GMDB and GMIB businesses. Other revenues included pre-tax losses of $39 million in 2013, $119 million in 2012 and $4 million in 2011 associated with the hedge program. Excluding the impact of the hedge program, other revenues were flat in 2013, compared with 2012, and decreased 3% in 2012 compared with 2011.
Realized Investment Results. The significant increase in 2013, compared with 2012, primarily resulted from gains on the sales of real estate joint ventures and higher gains on sales of fixed maturities largely to fund the February 4, 2013 reinsurance transaction. In 2012 realized investment results were lower than in 2011, primarily due to the absence of gains on sales of real estate held in joint ventures reported in 2011. See Note 14 to the Consolidated Financial Statements for additional information
Benefits and expenses. The increase in 2013 compared with 2012 reflected continued business growth in the ongoing segments and the charge associated with the reinsurance transaction. In 2012, the increase compared with 2011 reflected the acquisition of HealthSpring and continued business growth in the ongoing segments.
Shareholders' net income. The decrease in 2013, compared with 2012 primarily reflects the $507 million after-tax charge associated with the February 4, 2013 reinsurance agreement with Berkshire, partially offset by an increase in adjusted income from operations. In 2012, the increase in shareholders' net income compared with 2011, resulted primarily from substantially higher adjusted income from operations.
Adjusted income from operations. The increase in 2013 compared with 2012 was largely attributable to earnings growth in all of our ongoing business segments (Global Health Care, Global Supplemental Benefits, and Group Disability and Life). See the segment discussions later in this MD&A for further information. In 2012, adjusted income from operations increased 27% compared with 2011, largely attributable to earnings contributions from HealthSpring, as well as overall revenue growth in the other ongoing operating segments and lower charges related to the GMDB business.
The increase in short-term investments in 2013 compared with 2012 was driven by investment of increased cash levels in liquid commercial paper and United States Government obligations.
Cash flows from financing activities are generally comprised of issuances and re-payment of debt at the parent company level, proceeds on the issuance of common stock resulting from stock option exercises, and stock repurchases. In addition, the subsidiaries report net deposits and withdrawals to and from investment contract liabilities (that include universal life insurance liabilities) because such liabilities are considered financing activities with policyholders.
In 2013 we repurchased 13.6 million shares for $1.0 billion. From January 1, 2014 through February 26, 2014 we repurchased 5.0 million shares for $411 million. On February 26, 2014, the Company's Board of Directors increased share repurchase authority by $500 million. Accordingly, the total remaining share repurchase authorization as of February 26, 2014 was $901 million. In 2012 the Company repurchased 4.4 million shares for $208 million and in 2011 repurchased 5.3 million shares for $225 million.
The increase in interest expense in 2012 was primarily due to the issuance of $2.1 billion of long-term debt in the fourth quarter of 2011 to fund the acquisition of HealthSpring, partially offset by a lower weighted average interest rate reflecting the more favorable rates of this debt issued. The weighted average interest rate for outstanding short-term debt (primarily commercial paper) was 0.41% at December 31, 2013 and .47% at 2012.
Unfunded Pension Plan Liability. As of December 31, 2013, our unfunded pension liability was $611 million, a decrease of approximately $1.0 billion from December 31, 2012, reflecting an increase in the assumed discount rate of 100 basis points, strong asset returns, and pension contributions of $195 million in 2013. We expect to make pension contributions in 2014 required under the Pension Protection Act of 2006 of approximately $100 million. As a result of the improved funding position, we do not expect to make voluntary contributions in 2014. In addition, during 2013, we increased our asset allocation to fixed income investments and reduced our allocation to domestic stocks in order to reduce the investment risk in the pension plan.
Insurance liabilities. Contractual cash obligations for insurance liabilities, excluding unearned premiums and fees, represent estimated net benefit payments for health, life and disability insurance policies and annuity contracts. Recorded contractholder deposit funds reflect current fund balances primarily from universal life customers. Contractual cash obligations for these universal life contracts are estimated by projecting future payments using assumptions for lapse, withdrawal and mortality. These projected future payments include estimated future interest crediting on current fund balances based on current investment yields less the estimated cost of insurance charges and mortality and administrative fees. Actual obligations in any single year will vary based on actual morbidity, mortality, lapse, withdrawal, investment and premium experience. The sum of the obligations presented above exceeds the corresponding insurance and contractholder liabilities of $19 billion recorded on the balance sheet because the recorded insurance liabilities reflect discounting for interest and the recorded contractholder liabilities exclude future interest crediting, charges and fees. We manage our investment portfolios to generate cash flows needed to satisfy contractual obligations. Any shortfall from expected investment yields could result in increases to recorded reserves and adversely impact results of operations. The amounts associated with the sold retirement benefits and individual life insurance and annuity businesses, as well as the reinsured workers' compensation, personal accident and supplemental benefits businesses, are excluded from the table above as net cash flows associated with them are not expected to impact us. The total amount of these reinsured reserves excluded is approximately $6 billion.
Estimated payments of $82 million for deferred compensation, non-qualified and international pension plans and other postretirement and postemployment benefit plans are expected to be paid in less than one year. Our best estimate is that contributions to the qualified domestic pension plans during 2014 will be approximately $100 million. We expect to make payments subsequent to 2014 for these obligations, however subsequent payments have been excluded from the table as their timing is based on plan assumptions that may materially differ from actual activities. See Note 9 to the Consolidated Financial Statements for further information on pension and other postretirement benefit obligations.
The preparation of Consolidated Financial Statements in accordance with GAAP requires management to make estimates and assumptions that affect reported amounts and related disclosures in the Consolidated Financial Statements. Management considers an accounting estimate to be critical if:
changes in the estimate or different estimates that could have been selected could have a material effect on our consolidated results of operations or financial condition.
Consistent with prior years, fair value of a reporting unit was estimated using models and assumptions that we believe a hypothetical market participant would use to determine a current transaction price. The significant assumptions and estimates used in determining fair value include the discount rate and future cash flows. A range of discount rates was used, corresponding with the reporting unit's weighted average cost of capital, consistent with that used for investment decisions considering the specific and detailed operating plans and strategies within the reporting units. Projections of future cash flows were consistent with our annual planning process for revenues, claims, operating expenses, taxes, capital levels and long-term growth rates.
The fair value estimates of our remaining reporting units could decrease by approximately 25% to 85% before an indication of impairment of goodwill occurs. These outcomes were derived by determining the magnitude of changes to certain assumptions and estimates necessary for the estimated fair value of reporting units to approach their carrying values.
Our Cigna-HealthSpring business (reported in the Government operating segment that is also the reporting unit) contracts with CMS and various state governmental agencies to provide managed health care services, including Medicare Advantage plans and Medicare-approved prescription drug plans. Estimated future cash flows for this business incorporated the potential effects of sequestration and the Medicare Advantage reimbursement rates for 2014 and beyond as discussed in the "Overview" section of this MD&A. Revenues from the Medicare programs are dependent, in whole or in part, upon annual funding from the federal government through CMS. Funding for these programs is dependent on many factors including general economic conditions, continuing government efforts to contain health care costs and budgetary constraints at the federal level and general political issues and priorities. Goodwill as of December 31 was as follows (in millions):
See Notes 2(H) and 8 to the Consolidated Financial Statements for additional discussion of our goodwill.
the accrued pension benefit liability would increase by approximately $185 million as of December 31, 2013 resulting in an after-tax decrease to shareholders' equity of approximately $120 million as of December 31, 2013.
annual pension costs for 2014 would decrease by approximately $5 million, after-tax; and
If the December 31, 2013 fair values of domestic qualified plan assets decreased by 10%, the accrued pension benefit liability would increase by approximately $405 million as of December 31, 2013 resulting in an after-tax decrease to shareholders' equity of approximately $265 million.
An increase in these key assumptions would result in impacts to annual pension costs, the accrued pension liability and shareholders' equity in an opposite direction, but similar amounts.
The impact of this favorable prior year development was an increase to shareholders' net income of $77 million after-tax ($119 million pre-tax) in 2013. The change in the amount of the incurred claims related to prior years in the medical claims payable liability does not directly correspond to an increase or decrease in shareholders' net income as explained in Note 5 to the Consolidated Financial Statements.
Fair value is defined as the price at which an asset could be exchanged in an orderly transaction between market participants at the balance sheet date.
Global Health Care's segment earnings and adjusted income from operations increased significantly in 2012, as compared with 2011. This increase reflected the timing of the HealthSpring acquisition in 2012 and Commercial revenue growth driven by a higher ASO customer base.
The table below shows premiums and fees for the Global Health Care segment:
Net investment income increased in 2013, compared with 2012, reflecting higher assets and higher income from partnership investments. In 2012, net investment income decreased compared with 2011 reflecting lower yields, partially offset by the impact of the HealthSpring acquisition and higher income from partnership investments.
Global Health Care segment benefits and expenses consist of the following:
Medical claims expense increased 12% in 2013 compared with 2012, primarily due to medical cost inflation, the timing of the HealthSpring acquisition, and customer growth. Higher Medicare Advantage inpatient and outpatient medical costs also contributed to the increase.
Medical claims expense increased 56% in 2012 compared with 2011, primarily reflecting the acquisition of HealthSpring, conversion of Vanbreda business from service to risk, and medical cost inflation.
The operating expense ratio, calculated as total operating expenses divided by segment revenues, is one measure of the segment's overall operating efficiency.
Medical claims payable increased 10% in 2013 compared with 2012, primarily driven by growth in the stop loss and HealthSpring books of business. Medical claims payable increased 42% in 2012 compared with 2011, primarily reflecting the acquisition of HealthSpring.
is covered under an insurance policy or service agreement issued by the Company;
Medical customers increased 11% in 2012 compared to 2011, primarily reflecting ASO customer growth driven by strong retention and sales in targeted market segments, the impact of the HealthSpring acquisition, and growth in the international health care business.
The key factors affecting segment earnings and adjusted income from operations for this segment are:
As described in Note 3 to the Consolidated Financial Statements, the Global Supplemental Benefits segment acquired two businesses during the second half of 2012: Great American Supplemental Benefits and Finans Emeklilik (also referred to as the "Turkey JV"). Collectively, throughout this discussion these two transactions are referred to as "the acquisitions".
The increase in segment earnings (as well as the increase in adjusted income from operations) was primarily driven by business growth, primarily in South Korea, lower acquisition costs in Europe reflecting a decision to cease selling activities in certain markets, and earnings of the acquisitions during the second half of 2012, partially offset by higher acquisition and benefits expenses.
The increase in segment earnings (as well as the increase in adjusted income from operations) was primarily driven by strong revenue growth, primarily in South Korea and, to a lesser extent, margin improvement largely attributable to disciplined management of solicitation spending.
Premiums and fees increased in both 2013 and 2012 compared with the comparable prior year. When applying actual 2013 currency exchange rates to 2012 and 2011 results, premiums and fees increased by 25% in 2013 and 32% in 2012. These increases are primarily attributable to the acquisitions, and to a lesser extent, strong persistency, and new sales growth, particularly in South Korea.
The increase in the effective tax rate in 2013 compared with 2012 and the decrease in 2012 compared with 2011 are largely due to implementing a capital management strategy in 2013 and 2012. Excluding those effects, the Global Supplemental Benefits segment's effective tax rate was 24.0% in 2013, 24.6% in 2012, and 27.3% in 2011. The continued decline in these rates reflects the favorable effects of our capital management strategy.
Segment earnings and adjusted income from operations decreased, primarily attributable to a higher disability loss ratio and higher expense ratio, partially offset by a lower life loss ratio and higher net investment income. Results in 2012 include the $43 million after-tax favorable impact of reserve reviews. Results in 2011 include the $39 million after-tax favorable impact of reserve reviews offset by a $7 million after-tax litigation accrual.
On February 4, 2013, we effectively exited our Run-off GMDB and GMIB business by entering into an agreement with Berkshire Hathaway Life Insurance Company of Nebraska ("Berkshire") to reinsure 100% of our future exposures for these businesses, net of existing retrocession arrangements, up to a specified limit. See Note 7 to the Consolidated Financial Statements and the Introduction section of this MD&A for additional information.
Segment results for 2013 were significantly lower than 2012, primarily due to the after-tax charge of $507 million related to the reinsurance transaction with Berkshire. See Note 7 to the Consolidated Financial Statements for further information around the loss on reinsurance.
Net investment income decreased substantially in 2013 compared with 2012, primarily attributable to selling or reallocating investment assets as a result of the reinsurance transaction with Berkshire.
Other revenues consisted of gains and (losses) from futures and swap contracts used in the GMDB and GMIB equity and interest rate hedge programs that were discontinued beginning February 4, 2013. The components were as follows:
GMIB fair value (gain) loss. GMIB fair value results in 2013 reflected gains through February 4, 2013 from increases in underlying account values and interest rates fully offset by the charge related to the February 4, 2013 reinsurance transaction.
Results of GMDB hedging programs. Results in 2013 and 2012 reflected favorable equity market performance. The result in 2011 was due to turbulent conditions in an overall declining equity market. Results for 2013 are limited to market activity prior to the hedge program's discontinuance resulting from the reinsurance transaction with Berkshire.
Other, including operating expenses increased in 2013 primarily due to expenses associated with the reinsurance transaction of February 4, 2013. The decrease in 2012 compared with 2011 was due to the favorable impact of reserve studies and lower operating expenses.
The increase in segment earnings and adjusted income from operations in 2013, compared with 2012, primarily resulted from a lower effective tax rate due to the $14 million favorable impact of completing the 2009-2010 IRS examinations during the third quarter of 2013. See Note 19 to the Consolidated Financial Statements for additional information on the IRS examinations.
Premiums and fees reflect revenue primarily on universal and whole life insurance policies in the COLI business. Premiums and fees increased in 2013, compared with 2012, primarily due to strong persistency, lower policyholder mortality credits and higher transaction fees. Premiums and fees decreased in 2012, compared with 2011 due to lower policyholder death benefit exposures.
Benefits and expenses increased in 2013 compared with 2012, primarily due to scheduled lump sum annuity payments and the expense to settle a tax sharing agreement with the buyer of the retirement benefit business as a result of completing of the 2009 and 2010 IRS examinations. Also contributing to the increase was higher amortization of deferred acquisition costs and higher claims experience in COLI. Benefits and expenses decreased in 2012 compared with 2011 primarily due to favorable COLI claims experience and lower policyholder death benefit coverage and the absence of a charge recorded in the first quarter of 2011 to reimburse the buyer of the retirement benefits business with a portion of the tax benefits resulting from the completion of the 2007 and 2008 IRS examination as required under a tax sharing agreement.
Corporate reflects amounts not allocated to operating segments, such as net interest expense (defined as interest on corporate debt less net investment income on investments not supporting segment operations), interest on uncertain tax positions, certain litigation matters,
In 2012, segment loss for Corporate was significantly higher than in 2011, primarily reflecting higher interest expense due to the $2.1 billion of long-term debt issued in the fourth quarter of 2011 to fund the HealthSpring acquisition, and costs associated with litigation matters.
The following table presents our invested asset portfolio as of December 31, 2013 and 2012. Overall invested assets have declined during the year, reflecting the funding of the Berkshire reinsurance transaction and the impact of increased market yields on asset valuations. These investments do not include separate account assets.
Investments in fixed maturities include publicly traded and privately placed debt securities, mortgage and other asset-backed securities, preferred stocks redeemable by the investor and hybrid and trading securities. These investments are generally classified as available for sale and are carried at fair value on our balance sheet. Additional information regarding valuation methodologies, key inputs and controls is included in Note 10 of the Consolidated Financial Statements.
As of December 31, 2013, $14.6 billion, or 88%, of the fixed maturities in our investment portfolio were investment grade (Baa and above, or equivalent), and the remaining $1.9 billion were below investment grade. The majority of the bonds that are below investment grade are rated at the higher end of the non-investment grade spectrum. These quality characteristics have not materially changed during the year.
Corporate fixed maturities include private placement investments of $4.5 billion that are generally less marketable than publicly-traded bonds. However, yields on these investments tend to be higher than yields on publicly-traded bonds with comparable credit risk. We perform a credit analysis of each issuer, diversify investments by industry and issuer and require financial and other covenants that allow us to monitor issuers for deteriorating financial strength and pursue remedial actions, if warranted. At December 31, 2013, corporate fixed maturities include $383 million of investments in companies that are domiciled or have significant business interests in European countries with significant political or economic concerns (Portugal, Italy, Ireland, Greece and Spain). These investments have an average quality rating of Baa3 and are diversified by industry sector, including approximately 2% invested in financial institutions.
As of December 31, 2013, we had no direct investments in monoline bond insurers. Guarantees provided by various monoline bond insurers for certain of our investments in state and local governments and other asset-backed securities as of December 31, 2013 were:
As summarized above, $121 million or 5% of the commercial mortgage loan portfolio is comprised of subordinated notes that were fully underwritten and originated by us using our standard underwriting procedures and are secured by first mortgage loans. Senior interests in these first mortgage loans were then sold to other institutional investors. This strategy allowed us to effectively utilize our origination capabilities to underwrite high quality loans, limit individual loan exposures, and achieve attractive risk adjusted yields. In the event of a default, we would pursue remedies up to and including foreclosure jointly with the holders of the senior interest, but would receive repayment only after satisfaction of the senior interest.
The commercial mortgage loan portfolio contains approximately 120 loans, including five impaired loans with a carrying value totaling $112 million that are classified as problem or potential problem loans. Two of these loans totaling $31 million are current based on restructured terms and three loans totaling $81 million, net of $8 million in reserves, are current. All of the remaining loans continue to perform under their contractual terms. We have $177 million of loans maturing in the next twelve months. Given the quality and diversity of the underlying real estate, positive debt service coverage and significant borrower cash investment averaging 30%, we remain confident that the vast majority of borrowers will continue to perform as expected under the contract terms.
Our other long-term investments include $1,169 million in security partnership and real estate funds as well as direct investments in real estate joint ventures. The funds typically invest in mezzanine debt or equity of privately held companies (securities partnerships) and equity real estate. Given our subordinate position in the capital structure of these underlying entities, we assume a higher level of risk for higher expected returns. To mitigate risk, investments are diversified across approximately 95 separate partnerships, and approximately 60 general partners who manage one or more of these partnerships. Also, the funds' underlying investments are diversified by industry sector or property type, and geographic region. No single partnership investment exceeds 7% of our securities and real estate partnership portfolio.
We recognize interest income on problem bonds and commercial mortgage loans only when payment is actually received because of the risk profile of the underlying investment. The amount that would have been reflected in net income if interest on non-accrual investments had been recognized in accordance with the original terms was not significant for 2013 or 2012.
Net problem and potential problem investments representing approximately 1% of total investments, excluding policy loans at December 31, 2013, decreased by $96 million from December 31, 2012, primarily reflecting payoff activity.
Included in after-tax realized investment gains (losses) were increases in valuation reserves related to commercial mortgage loans and other-than-temporary impairments on fixed maturities and partnership investments as follows:
Investment/liability matching. We generally select investment assets with characteristics (such as duration, yield, currency and liquidity) that correspond to the underlying characteristics of our related insurance and contractholder liabilities so that we can match the investments to our obligations. Shorter-term investments support generally shorter-term life and health liabilities. Medium-term, fixed-rate investments support interest-sensitive and health liabilities. Longer-term investments generally support products with longer pay out periods such as annuities and long-term disability liabilities.
Use of local currencies for foreign operations. We generally conduct our international business through foreign operating entities that maintain assets and liabilities in local currencies. While this technique does not reduce foreign currency exposure on our net assets, it substantially limits exchange rate risk to those net assets.
a hypothetical increase in market interest rates, primarily for fixed maturities and commercial mortgage loans, partially offset by liabilities for long-term debt; and
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, comprehensive income and changes in total equity and cash flows present fairly, in all material respects, the financial position of Cigna Corporation and its subsidiaries at December 31, 2013 and 2012, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2013 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework 1992 issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Annual Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
These Consolidated Financial Statements were prepared in conformity with accounting principles generally accepted in the United States of America ("GAAP"). Amounts recorded in the Consolidated Financial Statements necessarily reflect management's estimates and assumptions about medical costs, investment valuation, interest rates and other factors. Significant estimates are discussed throughout these Notes; however, actual results could differ from those estimates. The impact of a change in estimate is generally included in earnings in the period of adjustment. Certain reclassifications have been made to prior year amounts to conform to the current presentation.
Variable interest entities. As of December 31, 2013 and 2012 the Company determined it was not a primary beneficiary in any material variable interest entities.
Investment Company Accounting (ASU 2013-08). The FASB issued accounting guidance to change the criteria for reporting as an investment company, clarify the fair value measurement used by an investment company and require additional disclosures. This guidance also confirms that parent company accounting for an investment company should reflect fair value accounting and is effective beginning on January 1, 2014. Adoption of this standard is not expected to have a material impact on the Company's financial statements.
Fees Paid to the Federal Government by Health Insurers (ASU 2011-06). In 2011, the FASB issued accounting guidance for the health insurance industry assessment (the "fee") mandated by the Patient Protection and Affordable Care Act of 2010 ("Health Care Reform"). The fee will be levied on health insurers beginning in 2014 based on a ratio of an insurer's net health insurance premiums written for the previous calendar year compared to the U.S. health insurance industry total. In addition, because these fees will generally not be tax deductible, the Company's effective tax rate is expected to increase beginning in 2014. Under the guidance, the liability for the fee will be estimated and recorded in full each year beginning in 2014 when health insurance is first provided. A corresponding deferred cost will be recorded and amortized over the calendar year. The fee is expected to be approximately $230 million in 2014: $130 million related to the commercial business and $100 million related to the Medicare business. The Company anticipates recovering most of the industry fee related to our commercial business through rate increases. For the Company's Medicare business, although we expect to partially mitigate the effect of the fee through 2014 benefit changes and prices,
the Company anticipates that its impact on earnings will be more significant than it will be for our commercial business.
Deferred acquisition costs. Effective January 1, 2012, the Company adopted the FASB's amended guidance (ASU 2010-26) on accounting for costs to acquire or renew insurance contracts. This guidance requires certain sales compensation and telemarketing costs related to unsuccessful efforts and any indirect costs to be expensed as incurred. The Company's deferred acquisition costs arise from sales and renewal activities primarily in its Global Supplemental Benefits segment. This amended guidance was implemented in 2012 through retrospective adjustment of comparative prior periods.
Fixed maturities and equity securities. Most fixed maturities (including bonds, mortgage and other asset-backed securities and preferred stocks redeemable by the investor) and some equity securities are classified as available for sale and are carried at fair value with changes in fair value recorded in accumulated other comprehensive income (loss) within shareholders' equity. The Company records impairment losses in net income for fixed maturities with fair value below amortized cost that meet either of the following conditions:
If the Company intends to sell or determines that it is more likely than not to be required to sell these fixed maturities before their fair values recover, an impairment loss is recognized for the excess of the amortized cost over fair value.
If the net present value of projected future cash flows of a fixed maturity (based on qualitative and quantitative factors, including the probability of default, and the estimated timing and amount of recovery) is below the amortized cost basis, that difference is recognized as an impairment loss. For mortgage and asset-backed securities, estimated future cash flows are also based on assumptions about the collateral attributes including prepayment speeds, default rates and changes in value.
Commercial mortgage loans. These loans are made exclusively to commercial borrowers at a fixed rate of interest. Commercial mortgage loans are carried at unpaid principal balances or, if impaired, the lower of unpaid principal or fair value of the underlying real estate. If the fair value of the underlying real estate is less than unpaid principal of an impaired loan, a valuation reserve is recorded and adjusted each period for changes in fair value. Commercial mortgage loans are considered impaired when it is probable that the Company will not collect amounts due according to the terms of the original loan agreement. The Company monitors credit risk and assesses the impairment of loans individually and on a consistent basis for all loans in the portfolio. The Company estimates the fair value of the underlying real estate using internal valuations generally based on discounted cash flow analyses. Certain commercial mortgage loans without valuation reserves are considered impaired because the Company will not collect all interest due according to the terms of the original agreements; however, the Company expects to recover the unpaid principal because it is less than the fair value of the underlying real estate.
Real estate. The Company carries investment real estate at depreciated cost less any write downs to fair value due to impairment and assesses impairment when cash flows indicate that the carrying value may not be recoverable. Depreciation is generally recorded using the straight-line method based on the estimated useful life of each asset. Investment real estate as of December 31, 2013 and 2012 is expected to be held longer than one year and includes real estate acquired through the foreclosure of commercial mortgage loans.
Other long-term investments. Other long-term investments include investments in unconsolidated entities. These entities include certain limited partnerships and limited liability companies holding real estate, securities or loans. These investments are carried at cost plus the Company's ownership percentage of reported income or loss in cases where the Company has significant influence, otherwise the investment is carried at cost. Income from certain entities is reported on a one quarter lag depending on when their financial information is received. Also included in other long-term investments are loans to unconsolidated real estate entities secured by the equity interests of these entities and carried at unpaid principal balances (mezzanine loans). Other long-term investments are considered impaired, and written down to their fair value, when cash flows indicate that the carrying value may not be recoverable. Fair value is generally determined based on a discounted cash flow analysis.
Changes in the fair value of a derivative instrument may not always equal changes in the fair value of the hedged item (referred to as "hedge ineffectiveness"). The Company generally reports hedge ineffectiveness in realized investment gains and losses.
Cash equivalents consist of short-term investments with maturities of three months or less from the time of purchase. These instruments are classified as held to maturity and carried at amortized cost. The Company reclassifies cash overdraft positions to accounts payable, accrued expenses and other liabilities when the legal right of offset does not exist.
Acquisition costs eligible for deferral include incremental, direct costs of acquisition of new or renewal insurance contracts and other costs directly related to successful contract acquisition. Examples of deferrable costs include commissions, sales compensation and benefits, policy issuance and underwriting costs and premium taxes. The Company records acquisition costs differently depending on the product line. Acquisition costs for:
Supplemental health, life and accident insurance (primarily individual products) and group health and accident insurance products are deferred and amortized, generally in proportion to the ratio of periodic revenue to the estimated total revenues over the contract periods.
Deferred policy acquisition costs also include the value of business acquired with the supplemental benefits business in 2012. See Note 3 for additional information.
Each year, deferred policy acquisition costs are tested for recoverability. For universal life and other individual products, management estimates the present value of future revenues less expected payments. For group health and accident insurance products, management estimates the sum of unearned premiums and anticipated net investment income less future expected claims and related costs. If management's estimates of these sums are less than the deferred costs, the Company reduces deferred policy acquisition costs and records an expense. The Company recorded amortization for policy acquisition costs of $255 million in 2013, $218 million in 2012 and $259 million in 2011 in other operating expenses.
The Company calculates depreciation and amortization principally using the straight-line method generally based on the estimated useful life of each asset as follows: buildings and improvements, 10 to 40 years; purchased software, one to five years; internally developed software, three to seven years; and furniture and equipment (including computer equipment), three to 10 years. Improvements to leased facilities are depreciated over the remaining lease term or the estimated life of the improvement. The Company considers events and circumstances that would indicate the carrying value of property, equipment or capitalized software might not be recoverable. If the Company determines the carrying value of any of these assets is not recoverable, an impairment charge is recorded. See Note 8 for additional information.
Goodwill represents the excess of the cost of businesses acquired over the fair value of their net assets. The resulting goodwill is assigned to those reporting units expected to realize cash flows from the acquisition, allocated to reporting units based on relative fair values and reported in the Global Health Care segment ($5.7 billion) and the Global Supplemental Benefits segment ($340 million). The Company evaluates goodwill for impairment at least annually during the third quarter at the reporting unit level and writes it down through results of operations if impaired. Fair value of a reporting unit is generally estimated based on a discounted cash flow analysis using assumptions that the Company believes a hypothetical market participant would use to determine a current transaction price. The significant assumptions and estimates used in determining fair value include the discount rate and future cash flows. A range of discount rates is used that corresponds with the reporting unit's weighted average cost of capital, consistent with that used for investment decisions considering the specific and detailed operating plans and strategies within the reporting units. In 2013, the resulting discounted cash flow analyses indicated that estimated fair values for the reporting units significantly exceeded their carrying values, including goodwill and other intangibles. Our Cigna-HealthSpring business contracts with CMS and various state governmental agencies to provide managed health care services, including Medicare Advantage plans and Medicare-approved prescription drug plans. Revenues from the Medicare programs are dependent, in whole or in part, upon annual funding from the federal government through CMS. Funding for these programs is dependent on many factors including general economic conditions, continuing government efforts to contain health care costs and budgetary constraints at the federal level and general political issues and priorities. Future changes in the funding for these programs by the federal government could substantially reduce our revenues and profitability and have a significant impact on the fair value of this reporting unit. See Note 8 for additional information.
Other assets primarily consist of guaranteed minimum income benefits ("GMIB") assets and various insurance-related assets. The Company's other intangible assets include purchased customer and producer relationships, provider networks, and trademarks. The Company amortizes other intangibles on an accelerated or straight-line basis over periods from 1 to 30 years. Management revises amortization periods if it believes there has been a change in the length of time that an intangible asset will continue to have value. Costs incurred to renew or extend the terms of these intangible assets are generally expensed as incurred. See Notes 8 and 10 for additional information.
Separate account assets and liabilities are contractholder funds maintained in accounts with specific investment objectives. The assets of these accounts are legally segregated and are not subject to claims that arise out of any of the Company's other businesses. These separate account assets are carried at fair value with equal amounts for related separate account liabilities. The investment income, gains and losses of these accounts generally accrue to the contractholders and, together with their deposits and withdrawals, are excluded from the Company's Consolidated Statements of Income and Cash Flows. Fees and charges earned for asset management or administrative services and mortality risks are reported in premiums and fees.
Future policy benefits represent the present value of estimated future obligations under long-term life and supplemental health insurance policies and annuity products currently in force. These obligations are estimated using actuarial methods and primarily consist of reserves for annuity contracts, life insurance benefits, guaranteed minimum death benefit ("GMDB") contracts (see Note 7 for additional information) and certain health, life, and accident insurance products in our Global Supplemental Benefits segment.
Obligations for annuities represent specified periodic benefits to be paid to an individual or groups of individuals over their remaining lives. Obligations for life insurance policies represent benefits to be paid to policyholders, net of future premiums to be received. Management estimates these obligations based on assumptions as to premiums, interest rates, mortality and surrenders, allowing for adverse deviation. Mortality, morbidity, and surrender assumptions are based on either the Company's own experience or actuarial tables. Interest rate assumptions are based on management's judgment considering the Company's experience and future expectations, and range from 1% to 9%. Obligations for the run-off settlement annuity business include adjustments for investment returns consistent with requirements of GAAP when a premium deficiency exists.
The Company's liability for disability claims reported but not yet paid is the present value of estimated future benefit payments over the expected disability period. The Company projects the expected disability period by using historical resolution rates combined with an analysis of current trends and operational factors to develop current estimates of resolution rates. Using the Company's experience, expected claim resolution rates may vary based upon the anticipated disability period, the covered benefit period, cause of disability, benefit design and the policyholder's age, gender and income level. The gross monthly benefit is reduced (offset) by disability income received under other benefit programs, such as Social Security Disability Income, workers' compensation, statutory disability or other group disability benefit plans. For offsets not yet finalized, the Company estimates the probability and amount of the offset based on the Company's experience over the past three to five years.
The Company discounts certain unpaid claim liabilities because benefit payments are made over extended periods. Substantially all of these liabilities are associated with the group long-term disability business. Discount rate assumptions for that business are based on projected investment returns for the asset portfolios that support these liabilities and range from 3.95% to 5.45%. Discounted liabilities were $3.5 billion at December 31, 2013 and $3.2 billion at December 31, 2012.
The liability is primarily calculated using "completion factors" developed by comparing the claim incurral date to the date claims were paid. Completion factors are impacted by several key items including changes in: 1) electronic (auto-adjudication) versus manual claim processing, 2) provider claims submission rates, 3) membership and 4) the mix of products. The Company uses historical completion factors combined with an analysis of current trends and operational factors to develop current estimates of completion factors. The Company estimates the liability for claims incurred in each month by applying the current estimates of completion factors to the current paid claims data. This approach implicitly assumes that historical completion rates will be a useful indicator for the current period.
Accounts payable, accrued expenses and other liabilities consist principally of liabilities for pension, other postretirement and postemployment benefits (see Note 9), GMIB contracts (see Note 10), self-insured exposures, management compensation, cash overdraft positions and various insurance-related liabilities, including experience rated refunds, the minimum medical loss ratio rebate accrual under Health Care Reform, and reinsurance contracts. Legal costs to defend the Company's litigation and arbitration matters are expensed when incurred in cases where the Company cannot reasonably estimate the ultimate cost to defend. In cases where the Company can reasonably estimate the cost to defend, a liability for these costs is accrued when the claim is reported.
Premiums and fees received for the Company's Medicare Advantage Plans and Medicare Part D products from customers and the Centers for Medicare and Medicaid Services ("CMS") are recognized as revenue ratably over the contract period. CMS provides risk-adjusted premium payments for the Medicare Advantage Plans and Medicare Part D products, based on the demographics and health severity of enrollees. The Company recognizes periodic changes to risk-adjusted premiums as revenue when the amounts are determinable and collection is reasonably assured. Additionally, Medicare Part D includes payments from CMS for risk sharing adjustments. The risk sharing adjustments that are estimated quarterly based on claim experience, compare actual incurred drug benefit costs to estimated costs submitted in original contracts and may result in more or less revenue from CMS. Final revenue adjustments are determined through an annual settlement with CMS that occurs after the contract year.
Benefits and expenses for universal life products consist of benefit claims in excess of policyholder account balances. Expenses are recognized when claims are submitted, and income is credited to policyholders in accordance with contract provisions.
The Company records compensation expense for stock awards and options over their vesting periods primarily based on the estimated fair value at the grant date. For stock options, fair value is estimated using an option-pricing model, whereas for restricted stock grants and units
The Company generally recognizes deferred income taxes for differences between the financial reporting and income tax reporting carrying values of assets and liabilities. Deferred income taxes are established based upon enacted tax rates and laws. A valuation allowance is recorded when the assessment of available evidence indicates there is a less than 50% likelihood that a deferred tax asset will be realized. Current income taxes generally represent amounts owed to or due from taxing authorities as related to filed income tax returns.
The Company records income taxes on the unremitted earnings of certain foreign subsidiaries at the foreign jurisdiction tax rate which can be significantly lower than the U.S. statutory tax rate.
On November 9, 2012, the Company acquired 51% of the total shares of Finans Emeklilik ve Hayat A.S. ("Finans Emeklilik"), a Turkish insurance company, from Finansbank A.S. ("Finansbank"), a Turkish retail bank, for a cash purchase price of approximately $116 million. Finansbank continues to hold 49% of the total shares. Finans Emeklilik operates in life insurance, accident insurance and pension product markets. The acquisition provides Cigna opportunities to reach and serve the growing middle class market in Turkey through Finansbank's network of retail banking branches.
In accordance with GAAP, the total purchase price, including the redeemable noncontrolling interest of $111 million, has been allocated to the tangible and intangible net assets acquired based on management's estimates of their fair value. Accordingly, approximately $113 million was allocated to identifiable intangible assets, primarily a distribution relationship and the value of business acquired ("VOBA") that represents the present value of the estimated net cash flows from the long duration contracts in force, with the remaining $116 million allocated to goodwill. The identifiable intangible assets will be amortized over an estimated useful life of approximately 10 years. Goodwill has been allocated to the Global Supplemental Benefits segment and is not deductible for federal income tax purposes.
The redeemable noncontrolling interest is classified as temporary equity in the Company's Consolidated Balance Sheet because Finansbank has the right to require the Company to purchase its 49% interest for the value of its net assets and the inforce business in 15 years.
On August 31, 2012, the Company acquired Great American Supplemental Benefits Group, one of the largest providers of supplemental health insurance products in the U.S. with cash from internal resources. The acquisition provides the Company with an increased presence in the Medicare supplemental benefits market. It also extends the Company's global direct-to-consumer retail channel as well as further enhances its distribution network of agents and brokers. Results of this business are reported in the Global Supplemental Benefits segment.
The results of this business have been included in the Company's Consolidated Financial Statements from the date of acquisition. The pro forma effects on total revenues and net income assuming the acquisition had occurred as of January 1, 2011 were not material to the Company for the years ended December 31, 2012 and 2011.
On January 31, 2012 the Company acquired the outstanding shares of HealthSpring, Inc. ("HealthSpring") for $55 per share in cash and Cigna stock awards, representing a cost of approximately $3.8 billion. HealthSpring provides Medicare Advantage coverage in 15 states and the District of Columbia, as well as a large, national stand-alone Medicare prescription drug business. The acquisition of HealthSpring strengthens the Company's ability to serve individuals across their life stages as well as deepens its presence in a number of geographic markets. The addition of HealthSpring brings industry leading physician partnership capabilities and creates the opportunity to deepen the Company's existing client and customer relationships, as well as facilitates a broader deployment of its range of health and wellness capabilities and product offerings. The Company funded the acquisition with internal cash resources.
Fair value of share-based compensation awards. On the date of the acquisition, HealthSpring employees' awards of options and restricted shares of HealthSpring stock were rolled over to Cigna stock options and restricted stock. Each holder of a HealthSpring stock option or restricted stock award received 1.24 Cigna stock options or restricted stock awards. The conversion ratio of 1.24 at the date of acquisition was determined by dividing the acquisition price of HealthSpring shares of $55 per share by the price of Cigna stock on January 31, 2012 of $44.43. The Cigna stock option exercise price was determined by using this same conversion ratio. Vesting periods and the remaining life of the options rolled over with the original HealthSpring awards.
Purchase price allocation. In accordance with GAAP, the total purchase price has been allocated to the tangible and intangible net assets acquired based on management's estimates of their fair values. Goodwill has been allocated to the Government operating segment and is not deductible for federal income tax purposes. The condensed balance sheet of HealthSpring at the acquisition date was as follows:
The results of HealthSpring have been included in the Company's Consolidated Financial Statements from the date of the acquisition. Revenues of HealthSpring included in the Company's results for the year ended December 31, 2012 were approximately $5.4 billion. During 2012, the Company recorded $53 million pre-tax ($40 million after-tax) of acquisition-related costs in other operating expenses.
Pro forma information. The following table presents selected unaudited pro forma information for the Company assuming the acquisition of HealthSpring had occurred as of January 1, 2011. This pro forma information does not purport to represent what the Company's actual results would have been if the acquisition had occurred as of the date indicated or what such results would be for any future periods.
The following outstanding employee stock options were not included in the computation of diluted earnings per share because their effect would have increased diluted earnings per share (antidilutive).
assumptions appropriately consider moderately adverse conditions. When a portion of the development related to the prior year incurred claims is offset by an increase determined appropriate to address moderately adverse conditions for the current year incurred claims, the Company does not consider that offset amount as having any impact on shareholders' net income.
2012 Plan. During the third quarter of 2012, the Company, in connection with the execution of its strategy, committed to a series of actions to further improve its organizational alignment, operational effectiveness, and efficiency. As a result, the Company recognized charges in other operating expenses of $77 million pre-tax ($50 million after-tax) in the third quarter of 2012 consisting primarily of severance costs. The Global Health Care segment reported $65 million pre-tax ($42 million after-tax) of the charge. The remainder was reported as follows: $9 million pre-tax ($6 million after-tax) in Global Supplemental Benefits and $3 million pre-tax ($2 million after-tax) in Group Disability and Life. We expect substantially all payments to be complete by first quarter 2014.
Summarized below is activity for 2012 and 2013 for the plans described above.
The Company's insurance subsidiaries enter into agreements with other insurance companies to assume and cede reinsurance. Reinsurance is ceded primarily to limit losses from large exposures and to permit recovery of a portion of direct or assumed losses. Reinsurance is also used in acquisition and disposition transactions when the underwriting company is not being acquired. Reinsurance does not relieve the originating insurer of liability. The Company regularly evaluates the financial condition of its reinsurers and monitors its concentrations of credit risk.
This transaction resulted in an after-tax charge to shareholders' net income in the first quarter of 2013 of $507 million ($781 million pre-tax reported as follows: $727 million in other benefits expense; $45 million in GMIB fair value loss; and $9 million in other operating expenses). The payment to Berkshire under the agreement was $2.2 billion and was funded from the sale of investment assets, tax benefits related to the transaction and available parent cash.
The following disclosures for the reinsured GMDB and GMIB business provide further context to prior year results, as well as activity in the assets and liabilities for these businesses, including the impact of the reinsurance transaction with Berkshire.
The payment attributable to GMDB from the Berkshire reinsurance transaction was approximately $1.6 billion. Because this payment exceeded the recorded reserve on February 4, 2013, the Company recorded a reserve strengthening of $0.7 billion ($0.5 billion after-tax) in the first quarter of 2013.
As discussed further in Note 10, because GMIB contracts are without significant life insurance risk, they are not accounted for as insurance products. Instead, the Company reports GMIB liabilities and assets as derivatives at fair value. The GMIB asset is classified in Other assets, including other intangibles, and the GMIB liability is classified in Accounts payable, accrued expenses and other liabilities in the Consolidated Balance Sheet. Disclosures related to fair value are included in Note 10 and derivatives are further described in Note 12.
The Berkshire reinsurance transaction resulted in an increase in GMIB assets, representing the increased receivable from that transaction. As of December 31, 2013, GMIB assets included $352 million from Berkshire.
In addition, the GMIB business had GMIB assets of $399 million (classified in Other assets, including other intangibles in the Consolidated Balance Sheet) from two other retrocessionaires as of December 31, 2013.
The Company's Run-off Reinsurance operations also assumed risks related to workers' compensation and personal accident business, and purchased reinsurance coverage to reduce the risk of loss on these contracts. The reinsurance recoverables were $107 million as of December 31, 2013 and 89% were secured by assets in trust or letters of credit.
Retirement benefits business. The Company had reinsurance recoverables of $1.2 billion as of December 31, 2013 and $1.3 billion as of December 31, 2012 from Prudential Retirement Insurance and Annuity Company resulting from the sale of the retirement benefits business, primarily in the form of a reinsurance arrangement. The reinsurance recoverable is reduced as the Company's reinsured liabilities are paid or directly assumed by the reinsurer and is secured primarily by fixed maturities whose book value is equal to or greater than 100% of the reinsured liabilities. These fixed maturities are held in a trust established for the benefit of the Company. As of December 31, 2013, the book value of the trust assets exceeded the recoverable.
Other property and equipment includes assets recorded under capital leases with a cost of $306 million, accumulated amortization of $16 million, and a net carrying value of $290 million as of December 31, 2013. Assets under capital leases were not material in 2012.
The Company also announced a change in the cost sharing arrangement with retirees for pharmacy subsidy payments received from the U.S. Government effective January 1, 2014. This plan amendment resulted in a reduction to the other post retirement benefit obligation of $57 million ($37 million after-tax, recorded in accumulated other comprehensive income).
accumulated benefit obligations of $4.7 billion as of December 31, 2013 and $5.3 billion as of December 31, 2012.
The Company funds its qualified pension plans at least at the minimum amount required by the Employee Retirement Income Security Act of 1974 and the Pension Protection Act of 2006. For 2014, the Company expects to make minimum required contributions totaling approximately $100 million. Future years' contributions will ultimately be based on a wide range of factors including but not limited to asset returns, discount rates, and funding targets.
Other postretirement benefits. Unfunded retiree health benefit plans had accumulated benefit obligations of $190 million at December 31, 2013 and $294 million at December 31, 2012. Retiree life insurance plans had accumulated benefit obligations of $133 million as of December 31, 2013 and $148 million as of December 31, 2012.
Plan assets. The Company's current target investment allocation percentages (50% fixed income, 25% equity securities, 11% securities partnerships, 7% hedge funds and 7% real estate) are developed by management as guidelines, although the fair values of each asset category are expected to vary as a result of changes in market conditions. As funding levels improved during 2013, the Company gradually reduced its allocation to equity securities and moved into fixed income to mitigate some of the volatility in returns. As the funding level continues to improve, the Company would expect to further reduce the allocation to equity securities and move further into fixed income investments. Although it has decreased its allocation to equity securities in 2013, the pension plan asset portfolio continues to include a 29% allocation of equity securities, consisting of domestic and international investments, in an effort to achieve a higher rate of return on pension plan investments over the long-term payout period of the pension benefit obligations.
As of December 31, 2013, pension plan assets included $3.8 billion invested in the separate accounts of Connecticut General Life Insurance Company ("CGLIC") and Life Insurance Company of North America, that are subsidiaries of the Company, as well as an additional $245 million invested directly in funds offered by the buyer of the retirement benefits business.
Plan assets classified in Level 3 include investments primarily in securities partnerships, equity real estate and hedge funds generally valued based on the pension plan's ownership share of the equity of the investee including changes in the fair values of its underlying investments.
The following table summarizes the changes in pension plan assets classified in Level 3 for the years ended December 31, 2013 and December 31, 2012. Actual return on plan assets in this table may include changes in fair value that are attributable to both observable and unobservable inputs.
The assets related to other postretirement benefit plans are invested in deposit funds with interest credited based on fixed income investments in the general account of CGLIC. As there are significant unobservable inputs used in determining the fair value of these assets, they are classified as Level 3. During 2013, these assets had a loss of $1 million, as well as a net withdrawal from the fund of $3 million, while during 2012, they earned a return of $1 million, offset by a net withdrawal of $3 million.
Fixed maturities included $458 million of net appreciation required to adjust future policy benefits for the run-off settlement annuity business including $60 million of appreciation for securities classified in Level 3.
Other derivative assets reflected interest rate and foreign currency swaps qualifying as cash flow hedges. Other derivative liabilities included $15 million of interest rate and foreign currency swaps qualifying as cash flow hedges and $1 million of interest rate and foreign currency swaps not designated as accounting hedges. See Note 12 for additional information.
The GMIB assets represented retrocessional contracts in place from two external reinsurers that cover 55% of the exposures on these contracts. See Note 7 for additional information.
Short-term investments are carried at fair value which approximates cost. On a regular basis the Company compares market prices for these securities to recorded amounts to validate that current carrying amounts approximate exit prices. The short-term nature of the investments and corroboration of the reported amounts over the holding period support their classification in Level 2.
Other derivatives classified in Level 2 represent over-the-counter instruments such as interest rate and foreign currency swap contracts. Fair values for these instruments are determined using market observable inputs including forward currency and interest rate curves and widely published market observable indices. Credit risk related to the counterparty and the Company is considered when estimating the fair values of these derivatives. However, the Company is largely protected by collateral arrangements with counterparties, and determined that no adjustment for credit risk was required as of December 31, 2013 or December 31, 2012. The nature and use of these other derivatives are described in Note 12.
The Company classifies certain newly issued, privately-placed, complex or illiquid securities, as well as assets and liabilities relating to GMIB, in Level 3.
Fixed maturities and equity securities. Approximately 7% of fixed maturities and equity securities are priced using significant unobservable inputs and classified in this category, including:
Fair values of other asset and mortgage-backed securities and corporate and government fixed maturities are primarily determined using pricing models that incorporate the specific characteristics of each asset and related assumptions including the investment type and structure, credit quality, industry and maturity date in comparison to current market indices, spreads and liquidity of assets with similar characteristics. For other asset and mortgage-backed securities, inputs and assumptions for pricing may also include collateral attributes and prepayment speeds. Recent trades in the subject security or similar securities are assessed when available, and the Company may also review published research in its evaluation, as well as the issuer's financial statements. Approximately 10% of fixed maturities classified
in Level 3 represent single, unadjusted, non-binding broker quotes that are not considered market observable. Certain private equity investments and subordinated corporate fixed maturities, representing approximately 15% of securities included in Level 3, are valued at transaction price in the absence of market data indicating a change in the estimated fair values.
Significant increases in any of these inputs would result in a lower fair value measurement while decreases in these inputs would result in a higher fair value measurement. Generally, the unobservable inputs are not interrelated and a change in the assumption used for one unobservable input is not accompanied by a change in the other unobservable input. The tables do not include Level 3 securities when fair value and significant unobservable inputs were not developed directly by the Company, including securities using a single, unadjusted non-binding broker quote and securities valued at transaction price. See the preceding discussion regarding the Company's valuation processes and controls.
Guaranteed minimum income benefit contracts. As discussed in Note 7, the Company effectively exited the GMIB business as a result of the February 4, 2013 agreement with Berkshire. Although these GMIB assets and liabilities must continue to be reported as derivatives at fair value, the only assumption that is expected to impact future shareholders' net income is the risk of non-performance. This assumption reflects a market participant's view of (a) the risk of the Company not fulfilling its GMIB obligations (GMIB liability) and (b) the credit risk that the reinsurers do not pay their obligations (GMIB asset).
The Company reports GMIB liabilities and assets as derivatives at fair value because cash flows of these liabilities and assets are affected by equity markets and interest rates, but are without significant life insurance risk and are settled in lump sum payments. Under the terms of these written and purchased contracts, the Company periodically receives and pays fees based on either contractholders' account values or deposits increased at a contractual rate. The Company will also pay and receive cash depending on changes in account values and interest rates when contractholders first elect to receive minimum income payments. The Company estimates the fair value of the assets and liabilities for GMIB contracts by calculating the results for many scenarios run through a model utilizing various assumptions that include non-performance risk, among other things.
Other assumptions that affect the GMIB asset and liability include capital market assumptions (including market returns, interest rates and market volatilities of the underlying equity and bond mutual fund investments) and future annuitant behavior (including mortality, lapse, and annuity election rates). As certain assumptions used to estimate fair values for these contracts are largely unobservable (primarily related to future annuitant behavior), the Company classifies GMIB assets and liabilities in Level 3.
The Company regularly evaluates each of the assumptions used in establishing these assets and liabilities. Significant decreases in assumed lapse rates or spreads used to calculate non-performance risk, or increases in assumed annuity election rates would result in higher fair value measurements. A change in one of these assumptions is not necessarily accompanied by a change in another assumption.
GMIB liabilities are reported in the Company's Consolidated Balance Sheets in Accounts payable, accrued expenses and other liabilities. GMIB assets associated with these contracts represent net receivables in connection with reinsurance that the Company has purchased from three external reinsurers and are reported in the Company's Consolidated Balance Sheets in Other assets, including other intangibles.
The following tables summarize the changes in financial assets and financial liabilities classified in Level 3 for the years ended December 31, 2013 and 2012. Separate account asset changes are reported separately under the heading "Separate account assets" as the changes in fair values of these assets accrue directly to policyholders. Gains and losses reported in these tables may include net changes in fair value that are attributable to both observable and unobservable inputs.
Realized investment gains (losses) and net investment income for amounts related to fixed maturities and equity securities and realized investment gains (losses) for the impact of changes in non-performance risk related to GMIB assets and liabilities beginning February 4, 2013, similar to hedge ineffectiveness; and
Because GMIB reinsurance arrangements remain in effect at the reporting date, the Company has reflected the total gain or loss for the period as the total gain or loss included in income attributable to instruments still held at the reporting date. However, the Company reduces the GMIB assets and liabilities resulting from these reinsurance arrangements when annuitants lapse, die, elect their benefit, or reach the age after which the right to elect their benefit expires.
Separate account assets classified in Level 3 include investments primarily in securities partnerships, real estate and hedge funds generally valued based on the separate account's ownership share of the equity of the investee including changes in the fair values of its underlying investments.
(1)Included in this amount were gains of $76 million attributable to instruments still held at December 31, 2013 and gains of $49 million attributable to instruments still held at December 31, 2012.
Some financial assets and liabilities are not carried at fair value each reporting period, but may be measured using fair value only under certain conditions, such as investments in partnerships and commercial mortgage loans when they become impaired. Impaired commercial mortgage loans and partnerships representing less than 1% of total investments were written down to their fair values, resulting in realized investment losses of $12 million, after-tax in 2013 and $7 million, after-tax in 2012.
The following table includes the Company's financial instruments not recorded at fair value that are subject to fair value disclosure requirements at December 31, 2013 and December 31, 2012. Financial instruments that are carried in the Company's Consolidated Financial Statements at amounts that approximate fair value are excluded from the following table.
interest rates are derived by calculating the appropriate spread over comparable U.S. Treasury rates, based on the property type, quality rating and average life of the loan. The quality ratings reflect the relative risk of the loan, considering debt service coverage, the loan-to-value ratio and other factors. Fair values of impaired mortgage loans are based on the estimated fair value of the underlying collateral generally determined using an internal discounted cash flow model. The fair value measurements were classified in Level 3 because the cash flow models incorporate significant unobservable inputs.
The above table includes investments with a fair value of $2.6 billion supporting the Company's run-off settlement annuity business, with gross unrealized appreciation of $478 million and gross unrealized depreciation of $20 million at December 31, 2013. Such unrealized amounts are required to support future policy benefit liabilities of this business and, as such, are not included in accumulated other comprehensive income. At December 31, 2012, investments supporting this business had a fair value of $3.1 billion, gross unrealized appreciation of $883 million and gross unrealized depreciation of $8 million.
As of December 31, 2013, fixed maturities (excluding trading and hybrid securities) with a decline in fair value from amortized cost (primarily corporate securities) were by length of time of decline, as follows:
As of December 31, 2013, the unrealized depreciation of investment grade fixed maturities is primarily due to increases in market yields since purchase. Excluding trading and hybrid securities, equity securities with a fair value lower than cost were not material at December 31, 2013.
At December 31, commercial mortgage loans were distributed among the following property types and geographic regions:
Credit quality. The Company regularly evaluates and monitors credit risk, beginning with the initial underwriting of a mortgage loan and continuing throughout the investment holding period. Mortgage origination professionals employ an internal credit quality rating system designed to evaluate the relative risk of the transaction at each loan's origination that is then updated each year as part of the annual portfolio loan review. The Company evaluates and monitors credit quality on an ongoing basis, classifying each loan as a loan in good standing, potential problem loan or problem loan.
Quality ratings are based on our evaluation of a number of key inputs related to the loan, including real estate market-related factors such as rental rates and vacancies, and property-specific inputs such as growth rate assumptions and lease rollover statistics. However, the two most significant contributors to the credit quality rating are the debt service coverage and loan-to-value ratios. The debt service coverage ratio measures the amount of property cash flow available to meet annual interest and principal payments on debt with a ratio below 1.0 indicating that there is not enough cash flow to cover the required loan payments. The loan-to-value ratio, commonly expressed as a percentage, compares the amount of the loan to the fair value of the underlying property collateralizing the loan.
During 2013, the Company restructured its subordinate interest in two cross-collateralized pools of industrial loans totaling $31 million by extending the maturity dates and reducing the interest rates. This modification was considered a troubled debt restructuring and the loans were classified as problem mortgage loans because the borrower was experiencing financial difficulties and an interest rate concession was granted. No valuation reserves were required because the fair values of the underlying properties exceeded the carrying values of the outstanding loans.
Problem and potential problem mortgage loans, net of valuation reserves, totaled $158 million at December 31, 2013 and $215 million at December 31, 2012. At December 31, 2013 and December 31, 2012, mortgage loans located in the South Atlantic region represented the most significant component of problem and potential problem mortgage loans. Loans collateralized by industrial properties represented the most significant concentration by property type at December 31, 2013, with no significant concentration by property type at December 31, 2012.
As of December 31, 2013, the Company had commitments to contribute:
$305 million to limited liability entities that hold either real estate or loans to real estate entities that are diversified by property type and geographic region; and
As of December 31, 2013 and 2012, the Company did not have a concentration of investments in a single issuer or borrower exceeding 10% of shareholders' equity.
The Company uses derivative financial instruments to manage the characteristics of investment assets to meet the varying demands of the related insurance and contractholder liabilities. The Company has written and purchased reinsurance contracts under its Run-off Reinsurance segment that are accounted for as freestanding derivatives. The Company also used derivative financial instruments to manage the equity, foreign currency, and certain interest rate risk exposures of its Run-off Reinsurance segment until February 4, 2013
(for further information, see Note 7). For information on the Company's accounting policy for derivative financial instruments, see Note 2. Derivatives in the Company's separate accounts are excluded from the following discussion because associated gains and losses generally accrue directly to separate account policyholders.
The Company uses derivative financial instruments as a part of its investment strategy to manage the characteristics of investment assets (such as duration, yield, currency and liquidity) to meet the varying demands of the related insurance and contractholder liabilities (such as paying claims, investment returns, and withdrawals). Derivatives are typically used in this strategy to reduce interest rate and foreign currency risks.
Volume of activity. The following table provides the notional values of these derivative instruments as of December 31:
these contracts in 2013. The fair value effects on the financial statements are included in Note 10 and the volume of activity is included in Note 23.
As a result of the reinsurance agreement with Berkshire to effectively exit the GMDB and GMIB business, the GMDB and GMIB hedge programs were terminated beginning February 4, 2013. See Note 7 for further details regarding this business.
the risks and rewards created by and shared through the entity; and
In the normal course of its investing activities, the Company makes passive investments in securities that are issued by variable interest entities for which the Company is not the sponsor or manager. These investments are predominantly asset-backed securities primarily collateralized by foreign bank obligations or mortgage-backed securities. The asset-backed securities largely represent fixed-rate debt securities issued by trusts that hold perpetual floating-rate subordinated notes issued by foreign banks. The mortgage-backed securities represent senior interests in pools of commercial or residential mortgages created and held by special-purpose entities to provide investors with diversified exposure to these assets. The Company owns senior securities issued by several entities and receives fixed-rate cash flows from the underlying assets in the pools.
The Company has not provided, and does not intend to provide, financial support to these entities that it is not contractually required to provide. The Company performs ongoing qualitative analyses of its involvement with these variable interest entities to determine if consolidation is required. The Company's maximum potential exposure to loss related to the investment entities is limited to the carrying amount of its investment reported in fixed maturities and equity securities, and its aggregate ownership interest is insignificant relative to the total principal amount issued by these entities. The Company's maximum exposure to loss related to the IPA arrangements is limited to the liability for incurred but not reported claims for the Company's Medicare Advantage customers. These liabilities are not material and are generally secured by deposits maintained by the IPAs.
Included in pre-tax realized investment gains (losses) were increases in valuation reserves related to commercial mortgage loans and other-than-temporary impairments on fixed maturities and partnership investments as follows:
The Company recognized pre-tax gains of $3 million in 2013, compared with pre-tax gains of $5 million in 2012 and pre-tax losses of $7 million in 2011 on hybrid securities.
As described in Note 3, the Company acquired HealthSpring on January 31, 2012. At the acquisition date, HealthSpring had $326 million of debt outstanding. In accordance with debt covenants, HealthSpring's debt obligation was paid immediately following the acquisition. This repayment is reported as a financing activity in the statement of cash flows for the year ended December 31, 2012.
In December 2012, the Company extended the life of its June 2011 five-year revolving credit and letter of credit agreement for $1.5 billion, that permits up to $500 million to be used for letters of credit. This agreement is diversified among 16 banks, with 3 banks having approximately 35% of the commitment and the remainder spread among 13 banks. The credit agreement includes options that are subject to consent by the administrative agent and the committing banks, to increase the commitment amount to $2 billion and to extend the term past December 2017. The credit agreement is available for general corporate purposes, including as a commercial paper backstop and for the issuance of letters of credit. This agreement has certain covenants, including a financial covenant requiring the Company to maintain a total debt-to-adjusted capital ratio at or below 0.50 to 1.00. As of December 31, 2013, the Company had $6.0 billion of borrowing capacity within the maximum debt coverage covenant in the agreement in addition to the $5.2 billion of debt outstanding. There were letters of credit of $39 million issued as of December 31, 2013.
On November 10, 2011, the Company issued $2.1 billion of long-term debt as follows: $600 million of 5-Year Notes due November 15, 2016 at a stated interest rate of 2.75% ($600 million, net of discount, with an effective interest rate of 2.936% per year), $750 million of 10-Year Notes due February 15, 2022 at a stated interest rate of 4% ($743 million, net of discount, with an effective interest rate of 4.346% per year) and $750 million of 30-Year Notes due February 15, 2042 at a stated interest rate of 5.375% ($750 million, net of discount, with an effective interest rate of 5.542% per year). Interest is payable semi-annually for the 5-Year, 10-Year and 30-Year Notes. The proceeds of this debt were used to fund the HealthSpring acquisition in January 2012.
the present value of the remaining principal and interest payments on the Notes being redeemed, discounted at the applicable Treasury rate plus 30 basis points (5-Year 2.75% Notes due 2016), 35 basis points (10-Year 4% Notes due 2022), or 40 basis points (30-Year 5.375% Notes due 2042).
Maturities of debt and capital leases are as follows (in millions): $133 in 2014, $28 in 2015, $618 in 2016, $253 in 2017, $131 in 2018 and the remainder in years after 2018. Interest expense on long-term debt, short-term debt and capital leases was $270 million in 2013, $268 million in 2012, and $202 million in 2011.
On November 16, 2011, the Company issued 15.2 million shares of its common stock at $42.75 per share. Proceeds of $650 million ($629 million net of underwriting discount and fees) were used to partially fund the HealthSpring acquisition in January 2012.
The Company maintains a share repurchase program that was authorized by its Board of Directors. The decision to repurchase shares depends on market conditions and alternative uses of capital. The Company has, and may continue from time to time, to repurchase shares on the open market through a Rule 10b5-1 plan that permits a company to repurchase its shares at times when it otherwise might be precluded from doing so under insider trading laws or because of self-imposed trading blackout periods.
In 2013 we repurchased 13.6 million shares for $1.0 billion. From January 1, 2014 through February 26, 2014 we repurchased 5.0 million shares for $411 million. On February 26, 2014, the Company's Board of Directors increased share repurchase authority by $500 million. Accordingly, the total remaining share repurchase authorization as of February 26, 2014 was $901 million. The Company repurchased 4.4 million shares for $208 million during 2012.
The Company has authorized a total of 25 million shares of $1 par value preferred stock. No shares of preferred stock were outstanding at December 31, 2013 or 2012.
Accumulated other comprehensive loss excludes amounts required to adjust future policy benefits for the run-off settlement annuity business and a portion of deferred acquisition costs associated with the corporate owned life insurance business. As required by GAAP, the Company parenthetically identifies the income statement line item affected by reclassification adjustments in the table below. Changes in the components of accumulated other comprehensive loss were as follows:
State insurance departments and foreign jurisdictions that regulate certain of the Company's subsidiaries prescribe accounting practices (differing in some respects from GAAP) to determine statutory net income and surplus. The Company's life insurance and HMO company subsidiaries are regulated by such statutory requirements. The statutory net income for the years ended, and statutory surplus as of, December 31 of the Company's life insurance and HMO subsidiaries were as follows:
The minimum statutory surplus required by regulators for the Company's life insurance and HMO company subsidiaries was approximately $2 billion as of December 31, 2013. As of December 31, 2013, statutory surplus for each of the Company's life insurance and HMO subsidiaries is sufficient to meet the minimum required by regulators. As of December 31, 2013, the Company's life insurance and HMO subsidiaries had investments on deposit with state departments of insurance with statutory carrying values of $335 million. The Company's life insurance and HMO subsidiaries are also subject to regulatory restrictions that limit the amount of annual dividends or other distributions (such as loans or cash advances) insurance companies may extend to the parent company without prior approval of regulatory authorities. The maximum dividend distribution that the Company's life insurance and HMO subsidiaries may make during 2014 without prior approval is approximately $772 million. Restricted net assets of the Company as of December 31, 2013, were approximately $8.4 billion. Certain life insurance subsidiaries of the Company are permitted to loan up to $600 million to the parent company without prior approval.
Consolidated pre-tax income from the Company's foreign operations was approximately 12% in 2013, 8% in 2012 and 10% in 2011.
The indefinite reinvestment of earnings of foreign operations resulted in an increase to shareholders' net income of $42 million in 2013 and $37 million in 2012. The Company has accumulated indefinitely reinvested foreign earnings of $1.1 billion with cumulative unrecognized deferred tax liabilities of $160 million through December 31, 2013.
In 2011, the IRS completed its examination of the Company's 2007 and 2008 consolidated federal income tax returns, resulting in an increase to shareholders' net income of $24 million.
Management believes that consolidated taxable income expected to be generated in the future will be sufficient to realize the Company's net deferred tax asset. Substantially all of the Company's deferred tax benefits may be carried forward indefinitely. The Company establishes a valuation allowance when it determines it is more likely than not that a deferred tax asset will not be realized. Valuation allowances have been established for certain deferred tax assets that are evaluated for realization on a separate entity basis, rather than considering consolidated results.
Unrecognized tax benefits decreased $34 million in 2013 of which $16 million increased shareholders' net income. The decrease was primarily attributable to completion of the IRS examination of the Company's 2009 and 2010 consolidated federal income tax returns.
The Company's long-standing dispute with the IRS for tax years 2004 through 2006, regarding the appropriate reserve methodology for certain reinsurance contracts, has been resolved. On February 28, 2013, the United States Tax Court entered its decision on this matter for the 2004 tax year, finding the Company had an overpayment of federal income tax for the period. The refund was received on June 24, 2013. On January 9, 2013, the United States Tax Court entered its decision on this matter for the 2005 and 2006 tax years, finding that the Company had no additional tax liability for these years. There are no outstanding IRS related matters with regard to the 2007 and 2008 tax years.
The following table summarizes information for outstanding common stock options at December 31, 2013:
The expected volatility reflects the Company's past daily stock price volatility. The Company does not consider volatility implied in the market prices of traded options to be a good indicator of future volatility because remaining maturities of traded options are less than one year. The risk-free interest rate is derived using the four-year U.S. Treasury bond yield rate as of the award date for the primary grant. Expected option life reflects the Company's historical experience.
The fair value of vested restricted stock was: $94 million in 2013, $66 million in 2012 and $24 million in 2011.
At the end of 2013, approximately 1,100 employees held 1.6 million strategic performance shares and $33 million of related compensation expense was expected to be recognized over the next two years. For strategic performance shares subject to a performance condition, the amount of expense may vary based on actual performance in 2014 and 2015.
The Company's operating leases are primarily for office space. Some of these leases include renewal options and other incentives that are amortized over the life of the lease. Rental expenses for operating leases amounted to $120 million in 2013, $130 million in 2012 and $115 million in 2011. As of December 31, 2013, future net minimum rental payments under non-cancelable operating leases were approximately $641 million, payable as follows (in millions): $131 in 2014, $127 in 2015, $105 in 2016, $75 in 2017, $59 in 2018 and $144 thereafter.
The Company also has capital lease arrangements. See Note 8 and Note 15 for further information on assets recorded under capital leases and the related obligations.
The Government operating segment offers Medicare Advantage and Medicare Part D plans to seniors and Medicaid plans.
Run-off Reinsurance is predominantly comprised of GMDB and GMIB business that was ceded to Berkshire on February 4, 2013.
The Company measures the financial results of its segments using "segment earnings (loss)", defined as shareholders' income (loss) from continuing operations before after-tax realized investment results. The Company determines segment earnings (loss) consistent with accounting policies used in preparing the consolidated financial statements, except that amounts included in Corporate are not allocated to segments. The Company allocates certain other operating expenses, such as systems and other key corporate overhead expenses, on systematic bases. Income taxes are generally computed as if each segment were filing a separate income tax return. The Company does not report total assets by segment as this is not a metric used to allocate resources or evaluate segment performance.
As a percentage of consolidated revenues, premiums and fees from CMS were 22.0% in 2013, 21.9% in 2012 and 4.6% in 2011. These amounts were reported in the Government operating segment included in the Global Health Care reporting segment.
The Company guarantees that separate account assets will be sufficient to pay certain retiree or life benefits. The sponsoring employers are primarily responsible for ensuring that assets are sufficient to pay these benefits and are required to maintain assets that exceed a certain percentage of benefit obligations. This percentage varies depending on the asset class within a sponsoring employer's portfolio (for example, a bond fund would require a lower percentage than a riskier equity fund) and thus will vary as the composition of the portfolio changes. If employers do not maintain the required levels of separate account assets, the Company or an affiliate of the buyer of the retirement benefits business (see Note 7 for additional information) has the right to redirect the management of the related assets to provide for benefit payments. As of December 31, 2013, employers maintained assets that exceeded the benefit obligations. Benefit
obligations under these arrangements were $514 million as of December 31, 2013. As of December 31, 2013, approximately 14% of these guarantees are reinsured by an affiliate of the buyer of the retirement benefits business. The remaining guarantees are provided by the Company with minimal reinsurance from third parties. There were no additional liabilities required for these guarantees as of December 31, 2013. Separate account assets supporting these guarantees are classified in Levels 1 and 2 of the GAAP fair value hierarchy. See Note 10 for further information on the fair value hierarchy.
The Company operates in a regulatory environment that may require the Company to participate in assessments under state insurance guaranty association laws. The Company's exposure to assessments for certain obligations of insolvent insurance companies to policyholders and claimants is based on its share of business written in the relevant jurisdictions. For the year ended December 31, 2013 and 2012, charges related to guaranty fund assessments were immaterial to the Company's results of operations.
The Company is aware of an insurer that is in rehabilitation, an intermediate action before insolvency. In 2012, the state court denied the regulator's amended petitions for liquidation and set forth specific requirements and a deadline for the regulator to develop a plan of rehabilitation without liquidating the insurer. The regulator has appealed the court's decision. During the second quarter of 2013, the regulator submitted a rehabilitation plan to the court that calls for significant benefit reductions to current policyholders. If the rehabilitation plan is approved by the court, guaranty fund payments may be required to restore to policyholders some of the benefit reductions mandated by the rehabilitation plan. In addition, if the actions taken in the rehabilitation plan fail to improve this insurer's financial condition, or if the state court's ruling is overturned on appeal, this insurer may be forced to liquidate. In that event, the Company would be required to pay additional future assessments.
The Company is routinely involved in numerous claims, lawsuits, regulatory and IRS audits, investigations and other legal matters arising, for the most part, in the ordinary course of managing a health services business, including payments to providers and benefit level disputes. These legal actions may include benefit claims, breach of contract claims, tort claims, provider disputes, disputes regarding reinsurance arrangements, employment and employment discrimination-related suits, employee benefit claims, wage and hour claims, tax matters, privacy, intellectual property claims and real estate related disputes. Litigation of income tax matters is accounted for under FASB's accounting guidance for uncertain income tax positions. Further information on income tax matters can be found in Note 19. Also, there are currently, and may be in the future, attempts to bring class action lawsuits against the industry.
The business of administering and insuring health services programs, particularly health care and group insurance programs, is heavily regulated by federal and state laws and administrative agencies, such as state departments of insurance and the U.S. Departments of Labor and Justice, as well as the courts. Health care regulation and legislation in its various forms, including the implementation of the Patient Protection and Affordable Care Act, other regulatory reform initiatives, such as those relating to Medicare programs, or additional changes in existing laws or regulations or their interpretations, could have a material adverse effect on the Company's business, results of operations and financial condition.
In addition, there is heightened review by federal and state regulators of the health care, disability and life insurance industry business and related reporting practices. Cigna is frequently the subject of regulatory market conduct reviews and other examinations of its business and reporting practices, audits and investigations by state insurance and health and welfare departments, state attorneys general, the Centers for Medicare and Medicaid Services ("CMS") and the Office of Inspector General ("OIG"). With respect to Cigna's Medicare Advantage business, CMS and OIG perform audits to determine a health plan's compliance with federal regulations and contractual obligations, including compliance with proper coding practices (sometimes referred to as Risk Adjustment Data Validation Audits or RADV audits), that may result in retrospective adjustments to payments made to health plans. Regulatory actions can result in assessments, civil or criminal fines or penalties or other sanctions, including loss of licensing or exclusion from participation in government programs.
The outcome of litigation and other legal or regulatory matters is always uncertain, and unfavorable outcomes that are not justified by the evidence or existing law can occur. The Company believes that it has valid defenses to the matters pending against it and is defending itself vigorously. Except as otherwise noted, the Company believes that the legal actions, regulatory matters, proceedings and investigations currently pending against it should not have a material adverse effect on the Company's results of operation, financial condition or liquidity based upon current knowledge and taking into consideration current accruals. The Company had pre-tax reserves as of December 31, 2013 of $189 million ($123 million after-tax) for the matters discussed below. Due to numerous uncertain factors presented in these cases, it is not possible to estimate an aggregate range of loss (if any) for these matters at this time. In light of the uncertainties involved in these matters, there is no assurance that their ultimate resolution will not exceed the amounts currently accrued by the Company. An adverse outcome in one or more of these matters could be material to the Company's results of operations, financial condition or liquidity for any particular period.
In 2008, the court issued a decision finding in favor of Cigna Corporation and the Cigna Pension Plan on the age discrimination and wear-away claims. However, the court found in favor of the plaintiffs on many aspects of the disclosure claims and ordered an
enhanced level of benefits from the existing cash balance formula for the majority of the class, requiring class members to receive their frozen benefits under the pre-conversion Cigna Pension Plan and their post-1997 accrued benefits under the post-conversion Cigna Pension Plan. The court also ordered, among other things, pre-judgment and post-judgment interest.
On December 20, 2012, the court issued a decision awarding equitable relief to the class. The court's order requires the Company to reform the pension plan to provide a substantially identical remedy to that ordered in 2008. Both parties appealed the order and the judge stayed implementation of the order pending resolution of the appeals. The Company will continue to vigorously defend its position in this case.
Plaintiffs filed a motion to certify a nationwide class of subscriber plaintiffs on December 19, 2011 that was denied on January 16, 2013. Plaintiffs petitioned for an immediate appeal of the order denying class certification, but their petition was denied by the United States Court of Appeals for the Third Circuit on March 14, 2013, meaning that plaintiffs cannot appeal the denial of class certification until there is a final judgment in the case. As a result, the case is proceeding in the District Court on behalf of the named plaintiffs only.
Adventist Health System. The Company defended itself in an arbitration filed in February 2011 under the rules of the American Arbitration Association titled Adventist Health System v. Cigna HealthCare of Florida, et. al. Adventist alleged that it was under-reimbursed by Cigna under an Orlando-based contract between the parties that expired in 2009. The Company has denied the claims in the arbitration. In October 2013, the parties settled this matter.
Disability claims regulatory matter. Over the past few years, there has been heightened review by state regulators of the claims handling practices within the disability and life insurance industry. This has resulted in an increase in coordinated multi-state examinations that target specific market practices in addition to regularly recurring single state examinations of an insurer's overall operations. The Company has been subject to such an examination and, during the second quarter of 2013, finalized an agreement with the Departments of Insurance for Maine, Massachusetts, Pennsylvania, Connecticut and California (together, the "monitoring states") related to the Company's long-term disability claims handling practices.
In connection with the terms of the agreement, the Company recorded a charge of $77 million before-tax ($51 million after-tax) in the first quarter of 2013. The charge is comprised of two elements: (1) $48 million of benefit costs and reserves from reassessed claims expected to be reopened, including $925,000 in fines, $750,000 in regulatory surcharges and $9.5 million in claims handling expenses; and (2) $29 million in additional costs for open claims as a result of the claims handling changes being implemented. This charge is reported in the Group Disability and Life segment. The Company will be subject to re-examination 24 months after the execution date of the agreement. If the monitoring states find material non-compliance with the terms of the agreement upon re-examination, the Company may be subject to additional fines or penalties. In addition to the monitoring states, most of the other jurisdictions have joined the agreement as participating, non-monitoring states.
The first quarter of 2013 includes an after-tax gain of $25 for the GMIB business, an after-tax charge of $507 million for the transaction with Berkshire to effectively exit the Run-off Reinsurance business, and an after-tax charge of $51 million related to the disability claims regulatory matter in the Group Disability and Life segment.
The second quarter of 2013 includes an after-tax charge of $24 million for the Pharmacy Benefits Manager ("PBM") partnering agreement with Catamaran.
The first quarter of 2012 includes an after-tax gain of $41 million for the GMIB business, an after-tax charge of $28 million for costs associated with acquisitions, and an after-tax charge of $13 million for costs associated with a litigation matter in Global Health Care.
The second quarter of 2012 includes an after-tax loss of $51 million for the GMIB business.