Cigna's global real estate portfolio consists of approximately 8.1 million square feet of owned and leased properties. Our domestic portfolio has approximately 6.7 million square feet in 40 states, the District of Columbia, and Puerto Rico. Our International properties contain approximately 1.4 million square feet located throughout the following countries: Belgium, Canada, China, France, Germany, Hong Kong, India, Indonesia, Ireland, Italy, Malaysia, Netherlands, New Zealand, Singapore, South Korea, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, United Arab Emirates, and the United Kingdom.
See Note 2 to the Consolidated Financial Statements for further discussion of changes resulting from the retrospective adoption of amended accounting guidance for deferred policy acquisition costs in 2012.
Some factors that could cause results to differ are discussed throughout Management's Discussion and Analysis ("MD&A"), including in the Cautionary Statement. The forward-looking statements contained in this filing represent management's current estimate as of the date of this filing. Management does not assume any obligation to update these estimates.
The following discussion addresses the financial condition of the Company as of December 31, 2012, compared with December 31, 2011, and a comparison of results of operations for the years ended December 31, 2012, 2011 and 2010.
The primary segment reporting change is that the two businesses that comprised the former International segment (international health care
Prior year segment information has been conformed to the new segment structure.
For information on the Company's business strategy, see the "Description of Business" section of this Form 10-K beginning on page 1. The Company's ability to increase revenue, shareholders' net income and operating cash flows from ongoing operations is directly related to progress in executing its strategy as well as other key factors, including the Company's ability to:
profitably underwrite and price products and services at competitive levels that manage risk and reflect emerging experience;
interest rates, equity market returns, foreign currency fluctuations and credit market volatility, including the availability and cost of credit in the future;
In the first quarter of 2010, the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act ("Health Care Reform") were signed into law. Certain of the law's provisions are already effective while others will take effect from 2013 to 2018. The Company has implemented the provisions of Health Care Reform that are currently in effect (including the commercial minimum medical loss ratio requirements) and continues its implementation planning for those provisions that must be adopted in the future. Management is currently unable to estimate the full impact of Health Care Reform on the Company's future results of operations, and its financial condition and liquidity due to uncertainties related to interpretation, implementation and timing of its many provisions as well as the potential for the law to be amended. It is possible, however, that certain provisions of Health Care Reform could have a material impact on future results of operations.
to the favorable claim run-out of 2011 estimated claim reserves in 2012. The decrease in the 2012 estimated rebate accrual compared to 2011 reflects changes to the 2012 minimum loss ratio calculation in accordance with HHS regulations that can include combined 2011 and 2012 experience including rebates paid for the 2011 plan year, lower premiums resulting from a change in business practice regarding the billing for broker commissions, as well as modestly higher loss ratios due to slightly higher utilization.
Health Care Reform imposes new fees on health insurers that become payable in 2013 and 2014. Payment of these fees will result in charges to the Company's financial results in future periods. These fees will generally not be tax deductible with the exception of the reinsurance assessments on insurers and HMOs. Accordingly, the Company's effective tax rate is expected to be adversely impacted in future periods. The amount of the fees is expected to be material, although the Company is unable to estimate the impact of these fees on shareholders' net income and the effective tax rate because guidance for these calculations has not been finalized.
On June 28, 2012, the U.S. Supreme Court upheld the constitutionality of most parts of Health Care Reform, including the obligation to purchase health care coverage (the "individual mandate"). Management continues to closely monitor the implementation of Health Care Reform and is actively engaged with regulators and policymakers on the conversion of legislation to regulation. In addition, management is implementing the necessary capabilities to ensure that the Company is compliant with the law and assessing potential opportunities arising from Health Care Reform. These opportunities include the continued evolution and innovation of our broad health and wellness portfolio to improve the health and productivity of our clients and customers, as well as the expansion of our physician partnership capabilities to improve the quality of care and service experience for our customers while lowering costs and improving overall value.
In line with its growth strategy, the Company has strengthened its market position through various acquisition transactions. See Note 3 to the Consolidated Financial Statements for additional information.
The Company measures the financial results of its segments using "segment earnings (loss)", that is defined as shareholders' net income (loss) before after-tax realized investment results. Adjusted income (loss) from operations is defined as consolidated segment earnings (loss) excluding special items (described in the table below) and the results of the GMIB business. Adjusted income (loss) from operations is another measure of profitability used by the Company's management because it presents the underlying results of operations of the Company's businesses and permits analysis of trends in underlying revenue, expenses and shareholders' net income. This measure is not determined in accordance with accounting principles generally accepted in the United States ("GAAP") and should not be viewed as a substitute for the most directly comparable GAAP measure, that is shareholders' net income.
Summarized below is adjusted income from operations by segment and other key consolidated financial data:
Shareholders' net income decreased 1% in 2011 compared with 2010, due to significantly higher GMIB losses principally reflecting lower interest rates, substantially offset by higher adjusted income from operations.
Adjusted income from operations increased 12% in 2011 compared with 2010 primarily due to higher earnings contributions from the Company's Global Health Care and Global Supplemental Benefits segments. These results reflect solid business growth in strategically targeted markets and continued low medical services utilization trend.
Global medical customers increased 2%, reflecting growth in targeted markets, primarily the middle and select market segments domestically as well as growth in the international health care business. These increases were partially offset by exits from certain non-strategic markets, primarily Medicare IPFFS.
Cash flows from operating activities. For 2012, cash flows from operating activities were higher than 2011 primarily attributable to strong earnings and business growth in the Company's ongoing operating segments.
Acquisitions. During 2012, the Company acquired HealthSpring, Great American Supplemental Benefits and Finans Emeklilik for a combined purchase price of approximately $4.2 billion. See Note 3 to the Consolidated Financial Statement for additional information.
Pension Plan Contributions. During 2012, the Company contributed $250 million to the Company's domestic qualified pension plans; See Note 10 to the Consolidated Financial Statements for additional information; and
Premiums and fees increased by 4% in 2011, compared with 2010, primarily reflecting business growth in the Company's targeted market segments, partially offset by the Company's exit from the Medicare IPFFS business beginning in 2011. Excluding this business, premiums and fees increased by 9% in 2011 compared with 2010.
Net investment income increased by 4% in 2011, compared with 2010. The key factors causing the increase were higher investment assets and improved results from real estate investments, partially offset by lower reinvestment yields.
Mail order pharmacy revenues increased by 12% in 2012, compared with 2011, primarily reflecting higher prescription volume for injectible medications, partially offset by price decreases related to a shift to generic oral medications from brand names. In 2011, mail order pharmacy revenues increased by 2% compared with 2010 due in large part to price increases offset by a decline in volume.
Excluding the impact of these swaps and futures contracts, other revenues declined 3% in 2012, compared with 2011. The decline primarily reflects the absence of revenue in 2012 from Cigna Government Services, which was sold in the second quarter of 2011, partially offset by contributions from HealthSpring.
See Note 15 to the Consolidated Financial Statements for additional information.
changes in the estimate or different estimates that could have been selected could have a material effect on the Company's consolidated results of operations or financial condition.
Management has discussed the development and selection of its critical accounting estimates with the Audit Committee of the Company's Board of Directors and the Audit Committee has reviewed the disclosures presented below.
As explained further in Note 25 to the Consolidated Financial Statements, effective February 4, 2013, the Company entered into an agreement to reinsure 100% of the Company's GMDB and GMIB businesses, net of retrocessional arrangements in place prior to February 4, 2013, up to a specified limit. As a result, the Company will no longer consider liabilities associated with these contracts to be a critical accounting estimate because changes in these estimates are not expected to have a material effect on the Company's consolidated results of operations or financial condition.
The Company evaluates goodwill for impairment at least annually during the third quarter at the reporting unit level, based on discounted cash flow analyses and writes it down through results of operations if impaired.
See Note 10 to the Consolidated Financial Statements for assumptions and methods used to estimate pension liabilities.
the accrued pension benefit liability would increase by approximately $280 million as of December 31, 2012 resulting in an after-tax decrease to shareholders' equity of approximately $180 million as of December 31, 2012.
If the Company used the market value of assets to measure pension costs as opposed to the market-related value, annual pension cost for 2013 would decrease by approximately $9 million after-tax.
The impact of this favorable prior year development was an increase to shareholders' net income of $66 million after-tax ($101 million pre-tax) in 2012. 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.
See Note 11 to the Consolidated Financial Statements for a discussion of the Company's fair value measurements and the procedures performed by management to determine that the amounts represent appropriate estimates.
Assessment of "other-than-temporary" impairments of fixed maturities To determine whether a fixed maturity's decline in fair value below its amortized cost is other than temporary, the Company must evaluate the expected recovery in value and its intent to sell or the likelihood of a required sale of the fixed maturity prior to an expected recovery. To make this determination, the Company considers a number of general and specific factors including the regulatory, economic and market environment, length of time and severity of the decline, and the financial health and specific near term prospects of the issuer.
See Notes 2 (C) and 12 to the Consolidated Financial Statements for additional discussion of the Company's review of declines in fair value, including information regarding the Company's accounting policies for fixed maturities.
For all fixed maturities with cost in excess of their fair value, if this excess was determined to be other-than-temporary, shareholders' net income for the year ended December 31, 2012 would have decreased by approximately $20 million after-tax.
The Company measures the financial results of its segments using "segment earnings (loss)", which is defined as shareholders' income (loss) from continuing operations excluding after-tax realized investment gains and losses. "Adjusted income from operations" for each segment is defined as segment earnings excluding special items and the results of the Company's GMIB business. Adjusted income from operations is the primary measure of profitability used by the Company's management because it presents the underlying results of operations of the segment and permits analysis of trends. Each segment provides a reconciliation between segment earnings and adjusted income from operations.
As discussed in the Introduction section of this MD&A and Note 23 to the Consolidated Financial Statements, effective December 31, 2012, the Company changed its reporting segments. The Global Health Care segment now includes the Company's international health care business, previously reported in the former International segment and excludes certain disability and life business that is now reported in the Group Disability and Life segment. Prior year information has been conformed to the new segment presentation. The international health care business is included in the Commercial operating segment.
The Government operating segment offers Medicare Advantage plans to seniors in 13 states and the District of Columbia, Medicare Part D plans in all 50 states and the District of Columbia and Medicaid plans. Results for the Government operating segment include HealthSpring from the date of acquisition, January 31, 2012.
The Global Health Care segment's adjusted income from operations increased 34% in 2012, as compared with 2011 reflecting:
strong earnings contributions from the government segment, primarily attributable to the acquired HealthSpring business reflecting effective medical cost and pharmacy management programs;
revenue growth in the U.S. commercial business, primarily due to a higher ASO customer base resulting in higher fees, as well as additional sales of stop loss and specialty products;
growth in premiums and fees of 9% in 2011 (excluding the impact of exiting the Medicare IPFFS business), primarily due to higher average membership in the guaranteed cost and ASO commercial businesses, particularly in the targeted market segments: Middle, Select and Individual;
Includes minimum premium business that has a risk profile similar to experience-rated funding arrangements. The risk portion of minimum premium revenue is reported in experience-rated medical premium whereas the self funding portion of minimum premium revenue is reported in fees. Also, includes certain non-participating cases for which special customer level reporting of experience is required.
Premiums and fees increased 45% in 2012, compared with 2011, primarily reflecting growth in the government segment due to the acquisition of HealthSpring. Revenue growth in the U.S. commercial business was driven by rate increases on most products consistent with underlying cost trends and a higher ASO customer base, resulting in higher fees, stop loss revenues and specialty product penetration. In addition, revenue in the international health care business increased primarily due to the conversion of the Vanbreda business from service to insurance contracts and, to a lesser extent, other business growth.
penetration of specialty products also contributed to the increase in revenues for the U.S. commercial business.
Net investment income decreased 2% in 2012 compared with 2011 reflecting lower yields, partially offset by the impact of the HealthSpring acquisition and higher income from partnership investments. Net investment income increased 14% in 2011 compared with 2010 benefiting from increased average asset levels driven by membership growth and higher income from partnership investments.
Medical claims expense decreased 1% in 2011 compared with 2010. Excluding the impact of Medicare IPFFS business, medical claims expenses increased 8% in 2011 compared with 2010, largely due to the acquisition of Vanbreda in the international health care business, as well as medical cost inflation, tempered by low medical services utilization trend in commercial risk businesses.
Operating expenses (including special items) increased by 22% in 2012 compared with 2011. Excluding special items, operating expenses increased by 20% in 2012 compared with 2011, primarily due to the acquisition of HealthSpring, investments in technology, business initiatives, and customer-driven volume growth, partially offset by the divestiture of Cigna Government Services in the second quarter of 2011 and expense management actions taken in 2012. Operating expenses increased 3% in 2011 compared with 2010. Excluding the impact of the Medicare IPFFS business, operating expenses increased 5% primarily due to business growth, strategic investments including brand strategy and Individual segment expansion, partially offset by the impact of exiting the Medicare IPFFS business and divestiture of Cigna Government Services.
The operating expense ratio increased from 2010 to 2011 primarily driven by a change in business mix resulting from the Company's decision to exit the non-strategic Medicare IPFFS business that was a fully-insured business. Excluding the impact of the Medicare IPFFS business, the operating expense ratio improved for 2011 compared with 2010 driven largely by continued focus on expense management.
Medical claims payable increased 42% in 2012 compared with 2011, primarily reflecting the acquisition of HealthSpring. Medical claims payable decreased by 7% in 2011 compared with 2010, primarily reflecting the run-out of the Medicare IPFFS business that the Company exited in 2011.
The Company's overall medical customer base as of December 31, 2012 increased 11% when compared with December 31, 2011, primarily reflecting ASO customer growth driven by strong retention and sales in targeted market segments, increases in the government segment, primarily reflecting the impact of the acquisition of HealthSpring as well as growth in the international health care business. The increase in the international health care risk customers in 2012 also reflects the conversion of the Vanbreda business from service to insurance contracts. The Global Health Care segment's overall medical customers as of December 31, 2011 increased 2% when compared with December 31, 2010, primarily reflecting new business sales and growth in ASO in the targeted Middle and Select market segments, growth in the Individual market segment that is sold under the guaranteed cost funding arrangement, as well as growth in the international health care business.
On February 15, 2013, CMS issued its Advance Notice of Methodological Changes for Calendar Year (CY) 2014 for Medicare Advantage (MA) Capitation Rates, Part C and Part D Payment Policies (the "Notice"). CMS is accepting comments on the Notice, and final terms are expected to be published on April 1, 2013. While management believes that a significant number of comments from interested parties (including Cigna) will be provided to CMS, there can be no assurance that CMS will amend its current position. Given the uncertainty regarding the final terms of the Notice, the Company cannot estimate the impact that it will have on its business, revenues or results of operations but recognizes that any impacts could be materially adverse. Accordingly, the Company is currently evaluating the potential implications of the Notice, including adjustments that the Company may make to the programs and services it offers to offset any adverse impacts.
Segment earnings for 2012 decreased 5% compared with 2011 reflecting lower adjusted income from operations, a special item for a realignment and efficiency plan charge in 2012 as well as the absence of the 2011 special item related to completing the 2007 and 2008 IRS examination. Segment adjusted income from operations decreased 3%, primarily attributable to a higher disability loss ratio and higher expense ratio, partially offset by a lower life loss ratio (see Benefits and Expenses below) and higher net investment income. Results in 2012 include the $43 million after-tax favorable impact of reserve studies. Results in 2011 include the $39 million after-tax favorable impact of reserve studies offset by a $7 million after-tax litigation accrual.
Segment earnings decreased 3% in 2011 compared with 2010 reflecting 5% lower adjusted income from operations offset by a $5 million favorable special item related to completing the 2007 and 2008 IRS examinations. Adjusted income from operations decreased as a result of:
the absence of the $11 million after-tax gain on the sale of the workers' compensation and case management business in 2010;
Premiums and fees increased 9% in 2012 compared with 2011 reflecting strong disability and life new sales, in-force growth and continued strong persistency.
Net investment income increased 3% in 2012 compared with 2011 due to higher assets and higher partnership investment income, partially offset by lower yields. Net investment income increased 1% in 2011 compared with 2010 due to higher average assets reflecting business growth and higher prepayment fees partially offset by lower yields.
Benefits and expenses increased 10% in 2012 compared with 2011 as a result of premium growth in the disability and life business, a higher loss ratio in the disability business and a higher operating expense ratio, partially offset by a lower loss ratio in the life business. The higher disability loss ratio reflects less favorable claim experience primarily as a result of higher new claims. The higher operating expense ratio is driven by higher commissions and strategic information technology and claim office investments. The lower life loss ratio primarily reflects lower new claims. Benefits and expenses include the favorable impact of reserve studies of $60 million in 2012 as compared with the $59 million favorable impact of reserve studies offset by a $10 million litigation accrual in 2011.
Benefits and expenses were essentially flat in 2011 as compared with 2010 reflecting disability and life business growth, less favorable disability claims experience and a higher operating expense ratio, largely offset by the absence of operating expenses associated with the workers' compensation and case management business that was sold in 2010 and favorable life and accident claims experience. The disability claims experience reflects higher incidence rates, mitigated in part by higher resolution rates reflecting the sustained strong performance of the Company's disability claims management process.
The higher operating expense ratio is driven by strategic investments. Benefits and expenses include the favorable before tax impact of reserve studies of $59 million in 2011 as compared with $55 million in 2010.
As explained in the Introduction section of this MD&A and Note 23 to the Consolidated Financial Statements, effective December 31, 2012, the Company changed its external reporting segments. Prior year information has been conformed to the new segment structure.
The Global Supplemental segment includes supplemental health, life and accident insurance products offered in the U.S. and foreign markets, primarily in Asia as well as Medicare supplemental coverage following the 2012 acquisition of Great American Supplemental Benefits.
Global Supplemental Benefits segment earnings increased 46% in 2012 compared to 2011. Segment earnings for 2012 include an after-tax charge of $6 million associated with the realignment and efficiency plan, and an $8 million favorable adjustment related to the first quarter 2012 expansion of a capital management strategy to permanently invest the earnings of its China and Indonesia operations overseas (see further discussion in the Liquidity and Capital Resources section of the MD&A). Excluding these adjustments and the unfavorable impact of foreign currency movements (presented in the table above) adjusted income from operations increased 42% for the 2012 compared with 2011. These increases were primarily driven by the strong revenue growth, primarily in South Korea and, to a lesser extent, margin improvement largely attributable to disciplined management of solicitation spending. Excluding the first quarter 2012 implementation effect of the capital management strategy, the Global Supplemental Benefits segment's effective tax rate for the full year 2012 was 24.6%, compared with 27.3% for 2011.
Global Supplemental Benefits segment earnings increased 15% in 2011 compared with 2010. Segment earnings for 2010 include a $10 million unfavorable tax adjustment related to the first quarter 2010 expansion of a capital management strategy to permanently invest the earnings of its Hong Kong operations overseas (see further discussion in the Liquidity and Capital Resources section of the MD&A). Excluding the impact of this tax adjustment and foreign currency movements (presented in the table above), the Global
Net investment income increased by 8% in 2012, compared with 2011, and 20% in 2011, compared with 2010. These increases were primarily due to asset growth in South Korea.
Excluding the special items (presented in the table above), expense ratios increased for 2012 compared to 2011. This increase was primarily driven by the impact of the higher expense ratios associated with FirstAssist. Excluding the special items (presented in the table above), expense ratios increased in 2011 compared with 2010, primarily due to strategic investments for future growth and costs to streamline operations, partially offset by higher revenues in South Korea.
For the Company's Global Supplemental Benefits segment, South Korea is the single largest geographic market, generating 54% of the segment's revenues and 90% of earnings in 2012. Due to the concentration of business in South Korea, the Global Supplemental Benefits segment is exposed to potential losses resulting from economic, regulatory and geopolitical developments in that country, as well as foreign currency movements affecting the South Korean currency, that could have a significant impact on the segment's results and the Company's consolidated financial results.
The Company's reinsurance operations were discontinued and are now an inactive business in run-off mode since the sale of the U.S. individual life, group life and accidental death reinsurance business in 2000. In 2010, the Company essentially exited from its workers' compensation and personal accident reinsurance business by purchasing retrocessional coverage from a Bermuda subsidiary of Enstar Group Limited. This segment is predominantly comprised of guaranteed minimum death benefit ("GMDB", also known as "VADBe") and guaranteed minimum income benefit ("GMIB") products.
The Company excludes the results of the GMIB business from adjusted income from operations because the fair value of GMIB assets and liabilities must be recalculated each quarter using updated capital market assumptions. The resulting changes in fair value, that are reported in shareholders' net income, can be volatile and unpredictable.
Segment results in 2011 reflected higher losses for the GMIB and GMDB businesses compared to 2010 due to the significant declines in interest rates, periods of high volatility, and less favorable equity market conditions during 2011. In addition, segment results in 2010 reflect the favorable effect of resolving a federal tax matter.
Other revenues consisted of gains and losses from futures and swap contracts used in the GMDB and GMIB equity and interest rate hedge programs. See Note 13 to the Consolidated Financial Statements for additional information. The components were as follows:
GMIB fair value gains of $41 million for 2012, were primarily due to the effect of increases in underlying account values, updates in the claim exposure calculation, and a reduction in annuitization rates, partially offset by a reduction in lapse rates and general declines in interest rates.
Other, including operating expenses. The decrease in 2012 compared with 2011 was due to the favorable impact of reserve studies and lower operating expenses. The increase in 2011 compared with 2010 was due to the reduced favorable impacts of reserve studies.
deferred gains recognized from the sale of the retirement benefits and individual life insurance and annuity businesses; and
Net investment income decreased 3% in 2012 compared with 2011, primarily reflecting lower average yields and decreased 1% in 2011 compared with 2010 due to lower portfolio yields partially offset by higher average invested assets.
Other revenues were flat in 2012 compared with 2011 and decreased 8% in 2011 compared with 2010 primarily due to lower deferred gain amortization related to the sold retirement benefits and individual life insurance and annuity businesses. 2012 results were partially offset by higher investment management fees.
Benefits and expenses decreased 7% 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, intersegment eliminations, compensation cost for stock options and certain corporate overhead expenses such as directors' expenses and pension expense related to the Company's frozen pension plans.
charges associated with litigation matters due primarily to recent developments. See Note 24 to the Consolidated Financial Statements for additional information;
Corporate's adjusted loss from operations was lower in 2011 compared with 2010 primarily reflecting decreased pension expense and lower tax adjustments related to postretirement benefits and compensation resulting from Health Care Reform. These factors were partially offset by increased net interest expense due to higher average borrowings outstanding in 2011.
Management, guided by regulatory requirements and rating agency capital guidelines, determines the amount of capital resources that the Company maintains. Management allocates resources to new long-term business commitments when returns, considering the risks, look promising and when the resources available to support existing business are adequate.
The availability of capital resources will be impacted by equity and credit market conditions. Extreme volatility in credit or equity market conditions may reduce the Company's ability to issue debt or equity securities.
Cash flows from operating activities consist of cash receipts and disbursements for premiums and fees, mail order pharmacy and other revenues, gains (losses) recognized in connection with the Company's GMDB and GMIB equity hedge programs, investment income, taxes, and benefits and expenses. Because certain income and expense transactions do not generate cash, and because cash transactions related to revenues and expenses may occur in periods different from when those revenues and expenses are recognized in shareholders' net income, cash flows from operating activities can be significantly different from shareholders' net income.
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 or from investment contract liabilities (that include universal life insurance liabilities) because such liabilities are considered financing activities with policyholders.
Cash flows from operating activities increased by $859 million in 2012 compared with 2011, primarily the result of strong earnings growth in the ongoing business segments in 2012. In addition, 2011 operating cash flows were adversely affected by significant claim run-out from the Medicare IPFFS business that the Company exited in 2011.
Cash used in investing activities was $3.9 billion in 2012, $3.6 billion of which was for the acquisitions (net of cash acquired) of HealthSpring, Great American Supplemental Benefits, and the joint venture in Turkey. Cash used in investing activities also included net purchases of investments of $132 million and net purchases of property and equipment (primarily internal-use software) of $408 million.
Cash used in financing activities in 2012 primarily reflects the repayment of debt assumed in the HealthSpring acquisition of $326 million and the repurchase of common stock for $208 million. These effects were partially offset by the change in short-term debt of $98 million primarily from the issuance of commercial paper, proceeds from the issuance of common stock from employee benefit plans of $121 million and net deposits to contractholder deposit funds of $73 million.
repurchased 5.3 million shares for $225 million and 6.2 million shares for $201 million during 2010.
Cash used in investing activities was $1.3 billion. This use of cash primarily consisted of net purchases of investments of $746 million, cash used to fund acquisitions (net of cash acquired) of $114 million, and net purchases of property and equipment of $422 million.
repayment of $200 million of commercial paper outstanding as of December 31, 2012. The Company expects to have at least $200 million outstanding as of March 31, 2013.
In addition, the parent company will be required to fund a portion of the $2.2 billion reinsurance premium due to Berkshire. The premium will ultimately be paid to Berkshire in cash, that will be funded by the sale or internal transfer of investment assets supporting this business, tax benefits related to the transaction, and parent cash of $100 million.
The Company expects, based on its current cash position and current projections for subsidiary dividends, to have sufficient liquidity to meet the obligations discussed above.
However, the Company's cash projections may not be realized and the demand for funds could exceed available cash if:
a substantial increase in funding over current projections is required for the Company's pension plan.
Solvency regulation. Many states have adopted some form of the National Association of Insurance Commissioners ("NAIC") model solvency-related laws and risk-based capital rules ("RBC rules") for life and health insurance companies. The RBC rules recommend a minimum level of capital depending on the types and quality of investments held, the types of business written and the types of liabilities incurred. If the ratio of the insurer's adjusted surplus to its risk-based capital falls below statutory required minimums, the insurer could be subject to regulatory actions ranging from increased scrutiny to conservatorship.
In addition, various non-U.S. jurisdictions prescribe minimum surplus requirements that are based upon solvency, liquidity and reserve coverage measures. During 2012, the Company's HMOs and life and health insurance subsidiaries, as well as non-U.S. insurance subsidiaries, were compliant with applicable RBC and non-U.S. surplus rules.
The Company is contingently liable for various contractual obligations entered into in the ordinary course of business. The maturities of the Company's primary contractual cash obligations, as of December 31, 2012, are estimated to be as follows:
As discussed further in Note 25 to the Consolidated Financial Statements, effective February 4, 2013, the Company entered into a reinsurance agreement for its GMDB and GMIB businesses. The reinsurance premium due to Berkshire of $2.2 billion is not included in the contractual obligations table presented above. In addition, the expected future cash flows for GMDB and GMIB contracts included in the table above do not consider this reinsurance arrangement.
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 $18 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. The Company manages its 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 the Company. The total amount of these reinsured reserves excluded is approximately $6 billion.
Other long-term liabilities. These items are presented in accounts payable, accrued expenses and other liabilities in the Company's Consolidated Balance Sheets. This table includes estimated payments for GMIB contracts, pension and other postretirement and postemployment benefit obligations, supplemental and deferred compensation plans, interest rate and foreign currency swap contracts, and certain tax and reinsurance liabilities.
Estimated payments of $75 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. The Company's best estimate is that contributions to the qualified domestic pension plans during 2013 will be approximately $250 million. The Company expects to make payments subsequent to 2013 for these obligations, however subsequent payments have been excluded from the table as their timing is based on plan assumptions which may materially differ from actual activities (see Note 10 to the Consolidated Financial Statements for further information on pension and other postretirement benefit obligations).
The above table also does not contain $51 million of liabilities for uncertain tax positions because the Company cannot reasonably estimate the timing of their resolution with the respective taxing authorities. See Note 20 to the Consolidated Financial Statements for the year ended December 31, 2012 for further information.
As of December 31, 2012, $15.9 billion, or 90%, of the fixed maturities in the Company's investment portfolio were investment grade (Baa and above, or equivalent), and the remaining $1.8 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 includes private placement investments of $5.4 billion, which are generally less marketable than publicly-traded bonds, but yields on these investments tend to be higher than yields on publicly-traded bonds with comparable credit risk. The Company performs a credit analysis of each issuer, diversifies investments by industry and issuer and requires financial and other covenants that allow the Company to monitor issuers for deteriorating financial strength and pursue remedial actions, if warranted. Also included in corporate fixed maturities are investments in companies that are domiciled or have significant business interests in European countries with the most significant political or economic concerns (Portugal, Italy, Ireland, Greece and Spain). Fixed maturity investments in these companies represent approximately $400 million at December 31, 2012, have an average quality rating of BAA and are diversified by industry sector. Financial institutions comprised less than 2% of investments in these companies.
and Hong Kong. Foreign government obligations also include $167 million of investments in European sovereign debt, including $1 million in countries with the most significant political or economic concerns.
The Company's investment in state and local government securities is diversified by issuer and geography with no single exposure greater than $34 million. The Company assesses each issuer's credit quality based on a fundamental analysis of underlying financial information and does not rely solely on statistical rating organizations or monoline insurer guarantees. As of December 31, 2012, 97% of the Company's investments in these securities were rated A3 or better excluding guarantees by monoline bond insurers, consistent with December 31, 2011. As of December 31, 2012, approximately 63% or $1,538 million of the Company's total investments in state and local government securities were guaranteed by monoline bond insurers, providing additional credit quality support. The quality ratings of these investments with and without this guaranteed support as of December 31, 2012 were as follows:
As of December 31, 2012, the Company had no direct investments in monoline bond insurers. Guarantees provided by various monoline bond insurers for certain of the Company's investments in state and local governments and other asset-backed securities as of December 31, 2012 were:
The Company's commercial mortgage loans are fixed rate loans, diversified by property type, location and borrower to reduce exposure to potential losses. Loans are secured by high quality commercial properties and are generally made at less than 75% of the property's value at origination of the loan. In addition to property value, debt service coverage, building tenancy and stability of cash flows are all important financial underwriting considerations. Property type, location, quality, and borrower are all important underwriting considerations as well. The Company holds no direct residential mortgage loans and generally does not securitize or service mortgage loans.
Commercial real estate capital markets remain most active for well leased, quality commercial real estate located in strong institutional investment markets. The vast majority of properties securing the mortgages in the Company's mortgage portfolio possess these characteristics. While commercial real estate fundamentals continued to improve, the improvement has varied across geographies and property types. A broad recovery is dependent on continued improvement in the national economy.
The commercial mortgage portfolio contains approximately 140 loans. Four impaired loans with a carrying value of $125 million are classified as problem or potential problem loans, including two loans totaling $60 million that are current based on restructured terms and two loans totaling $65 million, net of reserves, that are current but full collection of principal is not expected. All of the remaining loans continue to perform under their contractual terms. The Company has $419 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 nearly 30%, the Company remains confident that the vast majority of borrowers will continue to perform as expected under the contract terms.
The Company recognizes 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 2012 or 2011.
The following table shows problem and potential problem investments at amortized cost, net of valuation reserves and write-downs:
Net problem investments represent less than 1% of total investments excluding policy loans at December 31, 2012. Net problem investments decreased by $131 million during 2012, primarily due to a substantial paydown on a prior period problem mortgage loan and the subsequent reclassification of the remaining balance of that loan to good standing based on the results of the annual loan review completed during the second quarter of 2012.
Commercial mortgage loans are considered impaired when it is probable that the Company will not collect all amounts due according to the terms of the original loan agreement. In the above table, problem and potential problem commercial mortgage loans totaling $125 million (net of valuation reserves) at December 31, 2012, are considered impaired. During 2012, the Company recorded a $10 million pre-tax ($7 million after-tax) increase to valuation reserves on impaired commercial mortgage loans. See Note 12 to the Consolidated Financial Statements of this Form 10-K for additional information regarding impaired commercial mortgage loans.
Included in after-tax realized investment gains (losses) were changes in valuation reserves related to commercial mortgage loans and other-than-temporary impairments on fixed maturity securities as follows:
The financial markets continue to be impacted by economic uncertainty in the United States and Europe, however, asset values increased during 2012, reflecting a decrease in market yields. Future realized and unrealized investment results will be impacted largely by market conditions that exist when a transaction occurs or at the reporting date. These future conditions are not reasonably predictable. Management believes that the vast majority of the Company's fixed maturity investments will continue to perform under their contractual terms, and that declines in their fair values below carrying value are temporary. Based on the strategy to match the duration of invested assets to the duration of insurance and contractholder liabilities, the Company expects to hold a significant portion of these assets for the long term. Future credit-related losses are not expected to have a material adverse effect on the Company's financial condition or liquidity.
While management believes the commercial mortgage loan portfolio is positioned to perform well due to its solid aggregate loan-to-value ratio, strong debt service coverage and minimal underwater positions, broad commercial real estate market fundamentals continue to be under stress reflecting a slow economic recovery. Should these conditions remain for an extended period or worsen substantially, it could result in an increase in problem and potential problem loans. Given the current economic environment, future impairments are possible; however, management does not expect those losses to have a material adverse effect on the Company's financial condition or liquidity.
Use of local currencies for foreign operations. The Company generally conducts its international business through foreign operating entities that maintain assets and liabilities in local currencies. While this technique does not reduce the Company's foreign currency exposure of its net assets, it substantially limits exchange rate risk to those net assets.
a hypothetical strengthening of the U.S. dollar to foreign currencies, primarily for the net assets of foreign subsidiaries denominated in a foreign currency; and
changes in the fair values of all insurance-related assets and liabilities have been excluded because their primary risks are insurance rather than market risk;
The effects of hypothetical changes in market rates or prices on the fair values of certain of the Company's financial instruments, subject to the exclusions noted above (particularly insurance liabilities), would have been as follows as of December 31(the effects of the GMIB business are presented as though the Company's 2013 reinsurance agreement was effective as of December 31, 2012):
at December 31, 2011 reflecting the reinsurance of the remaining net GMIB liability in 2013.
The effect of a hypothetical strengthening of the U.S. dollar relative to the foreign currencies held by the Company was estimated to be 10% of the U.S. dollar equivalent fair value. The Company's foreign operations hold investment assets, such as fixed maturities, cash, and cash equivalents, that are generally invested in the currency of the related liabilities. Due to the increase in the fair value of these investments in 2012, that are primarily denominated in the South Korean won, the effect of a hypothetical 10% strengthening in U.S. dollar to foreign currencies at December 31, 2012 was greater than that effect at December 31, 2011.
In 2012, the primary effect of a hypothetical decrease in the market prices of equity exposures was a 10% decrease in the value of equity securities reported as investment assets because the equity exposures of the Company's GMIB contracts were significantly reduced by the 2013 reinsurance agreement.
In 2011, the effect of a hypothetical decrease in the market prices of equity exposures was estimated based on a 10% decrease in mutual fund values underlying GMIB contracts and the equity futures contracts used to partially hedge these GMIB equity exposures, as well as the value of equity securities held by the Company.
Cautionary Statement for Purposes of the "Safe Harbor" Provisions of the Private Securities Litigation Reform Act of 1995
3.risks associated with pending and potential state and federal class action lawsuits, disputes regarding reinsurance arrangements, other litigation and regulatory actions challenging the Company's businesses, including disputes related to payments to health care professionals, government investigations and proceedings, tax audits and related litigation, and regulatory market conduct and other reviews, audits and investigations, including the possibility that the acquired HealthSpring business may be adversely affected by potential changes in risk adjustment data validation audit and payment adjustment methodology;
4.challenges and risks associated with implementing improvement initiatives and strategic actions in the ongoing operations of the businesses, including those related to: (i) growth in targeted geographies, product lines, buying segments and distribution channels, (ii) offering products that meet emerging market needs, (iii) strengthening underwriting and pricing effectiveness, (iv) strengthening medical cost results and a growing medical customer base, (v) delivering quality service to members and health care professionals using effective technology solutions, and (vi) lowering administrative costs;
7.the ability of the Company to execute its growth plans by successfully leveraging capabilities and integrating acquired businesses, including the HealthSpring businesses by, among other things, operating Medicare Advantage plans and HealthSpring's prescription drug plan, retaining and growing the customer base, realizing revenue, expense and other synergies, renewing contracts on competitive terms or maintaining performance under Medicare contracts, successfully leveraging the information technology platform of the acquired businesses, and retaining key personnel;
8.risks associated with security or interruption of information systems, that could, among other things, cause operational disruption; CIGNA CORPORATION - 2012 Form 10-K 61
10.the failure to maintain effective prevention, detection and control systems for regulatory compliance and detection of fraud and abuse;
12.liability associated with the Company's operations of onsite clinics and medical facilities, including the health care centers operated by the HealthSpring business;
19.risks associated with the Company's reinsurance arrangements for the run-off retirement benefits business, individual life insurance and annuity business, variable annuity death benefits and guaranteed minimum income benefits businesses, including but not limited to, failure by reinsurers to meet their reinsurance obligations or that the reinsurance arrangements do not otherwise provide adequate protection; or
(iii)provide reasonable assurance regarding prevention or timely detection of unauthorized acquisitions, use or disposition of the Company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.
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. In particular, as a result of the changes in segment reporting discussed further in Note 23, benefits expense amounts previously reported in Other Benefits Expense for the international health care business have been reclassified to Global Health Care Medical Claims Expense in the Consolidated Statements of Income. Similarly, insurance liabilities previously classified as Unpaid Claims for the international health care business have been reclassified to Global Health Care Medical Claims Payable in the Consolidated Balance Sheets.
Fees Paid to the Federal Government by Health Insurers (Accounting Standards Update ("ASU") 2011-06). In 2011, the Financial Accounting Standards Board ("FASB") issued accounting guidance for a health insurance industry assessment (the "fee") mandated by the Patient Protection and Affordable Care Act of 2010 ("Health Care Reform"). This 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 be adversely impacted in future periods. 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 amount of these fees is expected to be material, although the Company is unable to estimate the impact of these fees on shareholders' net income and the effective tax rate because guidance from the federal department of Health and Human Services for these calculations has not been finalized.
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 through retrospective adjustment of comparative prior periods. Summarized below are the effects of this amended guidance on previously reported amounts as of December 31, 2011 and for the years ended December 31, 2011 and 2010. Previously reported amounts presented below include certain immaterial reclassifications.
The Company first assesses its intent to sell or whether it is more likely than not to be required to sell such fixed maturities before their fair values recover.
If either of those conditions is met, an impairment loss is recognized in net income for the excess of the amortized cost over fair value.
Even when there is no intent or requirement to sell the fixed maturity, if the Company determines that it does not expect to recover the amortized cost basis of fixed maturities the credit portion of the impairment loss is recognized in net income and the non-credit portion, if any, is recognized in accumulated other comprehensive income.
Fixed maturities and equity securities also include trading and certain hybrid securities that are carried at fair value with changes in fair value reported in realized investment gains and losses. The Company has irrevocably elected the fair value option for these securities to simplify accounting and mitigate volatility in results of operations and financial condition. Hybrid securities include certain preferred stock and debt securities with call or conversion options.
Commercial mortgage loans. Mortgage loans held by the Company 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, 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 their remaining carrying value primarily because it is less than the fair value of the underlying real estate.
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 real estate entities, that are carried at unpaid principal balances (mezzanine loans). These 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.
Short-term investments. Investments with maturities of greater than 90 days but less than one year from time of purchase are classified as short-term, available for sale and carried at fair value, which approximates cost.
Derivatives are reported on the balance sheet at fair value with changes in fair values reported in shareholders' net income or accumulated other comprehensive income.
Net investment income. When interest and principal payments on investments are current, the Company recognizes interest income when it is earned. The Company stops recognizing interest income when interest payments are delinquent based on contractual terms or when certain terms (interest rate or maturity date) of the investment have been restructured. Net investment income on these investments is only recognized when interest payments are actually received. Interest and dividends on trading and hybrid securities and prepayment penalties on mortgage loans are included in net investment income when they are earned.
Investment gains and losses. Realized investment gains and losses are based on specifically identified assets and result from sales, investment asset write-downs, changes in the fair values of trading and hybrid securities and certain derivatives, changes in valuation reserves and prepayment penalties on fixed maturities.
Universal life products are deferred and amortized in proportion to the present value of total estimated gross profits over the expected lives of the contracts.
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 $218 million in 2012, $259 million in 2011 and $251 million in 2010 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 a long-lived asset is not recoverable, an impairment charge is recorded. See Note 9 for additional information.
Liabilities for contractholder deposit funds primarily include deposits received from customers for investment-related and universal life products and investment earnings on their fund balances. These liabilities are adjusted to reflect administrative charges and, for universal life fund balances, mortality charges. In addition, this caption includes premium stabilization reserves that are insurance experience refunds for group contracts that are left with the Company to pay future premiums, deposit administration funds that are used to fund nonpension retiree insurance programs, retained asset accounts and annuities or supplementary contracts without significant life contingencies. Interest credited on these funds is accrued ratably over the contract period.
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 10%. 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 discounts certain claim liabilities related to group long-term disability and workers' compensation because benefit payments may be made over extended periods. Discount rate assumptions are based on projected investment returns for the asset portfolios that support these liabilities and range from 1.83% to 6.25%. When estimates change, the Company records the adjustment in benefits and expenses in the period in which the change in estimate is identified. Discounted liabilities associated with the long-term disability and certain workers' compensation businesses were $3.2 billion at December 31, 2012 and 2011.
Despite reflecting both historical and emerging trends in setting reserves, it is possible that the actual medical trend for the current period will develop differently from expectations, which could have a material impact on the Company's medical claims payable and shareholders' net income.
The redeemable noncontrolling interest comprises the preferred and common stock interests not purchased by the Company in its acquisition of Finans Emeklilik in 2012 (see Note 3A for further information.) This redeemable noncontrolling interest relates to the right of the holder to require the Company to purchase the holder's 49% interest at a redemption value equal to its net assets in Finans Emklilik and the value of its inforce business in 15 years. Cigna also has the right to require the holder to sell its 49% interest to Cigna for the same value in 15 years. The redeemable noncontrolling interest was recorded at fair value on the date of purchase. Subsequently, if the estimated redemption value exceeds the recorded value for the redeemable noncontrolling interest, an adjustment to increase the redeemable noncontrolling interest will be recorded and impact income available to common shareholders.
Premiums for group life, accident and health insurance and managed care coverages are recognized as revenue on a pro rata basis over the contract period. Benefits and expenses are recognized when incurred. Premiums and fees include revenue from experience-rated contracts that is based on the estimated ultimate claim, and in some cases, administrative cost experience of the contract. For these contracts, premium revenue includes an adjustment for experience-rated refunds which is calculated according to contract terms and using the customer's experience (including estimates of incurred but not reported claims). Beginning in 2011, premium revenue also includes an adjustment to reflect the estimated effect of rebates due to customers under the minimum medical loss ratio provisions of Health Care Reform.
Contract fees, that are based upon related administrative expenses, are recognized in premiums and fees as they are earned ratably over the contract period.
Fees for mortality and surrender charges are recognized as assessed, that is as earned.
Contract fees and expenses for administrative services only programs and pharmacy programs and services are recognized as services are provided net of estimated refunds under performance guarantees. In some cases, the Company provides performance guarantees associated with meeting certain service standards, clinical outcomes or financial metrics. If these service standards, clinical outcomes or financial metrics are not met, the Company may be financially at risk up to a stated percentage of the contracted fee or a stated dollar amount. The Company establishes deferred revenues for estimated payouts associated with these performance guarantees. Approximately 16% of ASO fees reported for the year ended December 31, 2012 were at risk, with reimbursements estimated to be approximately 1%.
The Company and its domestic subsidiaries file a consolidated United States federal income tax return. The Company's foreign subsidiaries file tax returns in accordance with foreign law. U.S. taxation of these foreign subsidiaries may differ in timing and amount from taxation under foreign laws. Reportable U.S. taxable income for these subsidiaries is reflected in the U.S. tax return of the affiliates' domestic parent.
The Company recognizes deferred income taxes when the financial statement and tax-based carrying values of assets and liabilities are different. In addition, deferred income tax liabilities are recognized on the unremitted earnings of foreign subsidiaries that are not permanently invested overseas. For subsidiaries whose earnings are considered permanently invested overseas, income taxes are accrued at the local foreign tax rate. The Company establishes valuation allowances against deferred tax assets if it is determined more likely than not that the deferred tax asset will not be realized. The need for a valuation allowance is determined based on the evaluation of various factors, including expectations of future earnings and management's judgment. Note 20 contains detailed information about the Company's income taxes.
The Company recognizes interim period income taxes by determining an estimated annual effective tax rate and applying that rate to year-to-date pretax results. The estimated annual effective tax rate is updated periodically based on revised projections of full year income. Although the effective tax rate approach is generally used for interim periods, taxes on significant, unusual and infrequent items are recognized at the statutory tax rate entirely in the period the amounts are realized.
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 in the value of its net assets and the inforce business in 15 years.
The results of Finans Emeklilik are 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 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 Company finalized the purchase price in the first quarter of 2013 that resulted in an increase of $19 million to $326 million. 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. Subsequent to the segment reporting changes in 2012, results of this business are reported in the Global Supplemental Benefits segment.
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 13 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.
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. Subsequent to the segment reporting changes in 2012, goodwill has been allocated to the Government operating segment as of December 31, 2012 and is not deductible for federal income tax purposes. The condensed balance sheet of HealthSpring at the acquisition date was as follows:
The fair value of the customer relationship and the amortization method were determined using an income approach that relies on projected future net cash flows including key assumptions for the customer attrition rate and discount rate. The estimated weighted average useful life reflects the time period and pattern of use that Cigna expects for over 90% of the projected benefits. Accordingly, amortization was recorded on an accelerated basis in 2012 and will decline in subsequent years.
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. During 2012, the Company updated its allocation of the purchase price based on additional information. Accordingly, the allocation to identifiable intangible assets was decreased by $18 million to $40 million. The allocation to goodwill was increased by $8 million to $64 million. Subsequent to the segment reporting changes in 2012, goodwill has been reported in the Global Supplemental Benefits segment.
On December 31, 2010, the Company essentially exited from its workers' compensation and personal accident reinsurance business by purchasing retrocessional coverage from a Bermuda subsidiary of Enstar Group Limited and transferring administration of this business to the reinsurer. Under the reinsurance agreement, Cigna is indemnified for liabilities with respect to its workers' compensation and personal accident reinsurance business to the extent that these liabilities do not exceed 190% of the December 31, 2010 net reserves. The Company believes that the risk of loss beyond this maximum aggregate is remote. The reinsurance arrangement is secured by assets held in trust. Cash consideration paid to the reinsurer was $190 million. The net effect of this transaction was an after-tax loss of $20 million ($31 million pre-tax), primarily reported in other operating expenses in the Run-off Reinsurance segment.
For the year ended December 31, 2011, actual experience differed from the Company's key assumptions, resulting in favorable incurred claims related to prior years' medical claims payable of $140 million, or 1.5% of the current year incurred claims as reported for the year ended December 31, 2010. Actual completion factors resulted in $96 million, or 1.0% of the favorability, while actual medical cost trend resulted in the remaining $44 million, or 0.5%.
Third, changes in reserves for the Company's retrospectively experience-rated business do not always impact shareholders' net income. For the Company's retrospectively experience-rated business only adjustments to medical claims payable on accounts in deficit affect shareholders' net income. An increase or decrease to medical claims payable on accounts in deficit, in effect, accrues to the Company and directly impacts shareholders' net income. An account is in deficit when the accumulated medical costs and administrative charges, including profit charges, exceed the accumulated premium received. Adjustments to medical claims payable on accounts in surplus accrue directly to the policyholder with no impact on the Company's shareholders' net income. An account is in surplus when the accumulated premium received exceeds the accumulated medical costs and administrative charges, including profit charges.
In 2000, the Company determined that the GMDB reinsurance business was premium deficient because the recorded future policy benefit reserve was less than the expected present value of future claims and expenses less the expected present value of future premiums and investment income using revised assumptions based on actual and expected experience. The Company tests for premium deficiency by reviewing its reserve each quarter using current market conditions and its long-term assumptions. Under premium deficiency accounting, if the recorded reserve is determined to be insufficient, an increase to the reserve is reflected as a charge to current period income. Consistent with GAAP, the Company does not recognize gains on premium deficient long duration products.
The reserves represent estimates of the present value of net amounts expected to be paid, less the present value of net future premiums. Included in net amounts expected to be paid is the excess of the guaranteed death benefits over the values of the contractholders' accounts (based on underlying equity and bond mutual fund investments).
The assumed mean investment performance ("growth interest rate") for the underlying equity mutual funds for the portion of the liability that is covered by the Company's growth interest rate hedge program is based on the market-observable LIBOR swap curve. The assumed mean investment performance for the remainder of the underlying equity mutual funds considers the Company's GMDB equity hedge program using futures contracts, and is based on the Company's view that short-term interest rates will average 4% over future periods, but considers that current short-term rates are less than 4%. The mean investment performance assumption for the underlying fixed income mutual funds (bonds and money market) is 5% based on a review of historical returns. The investment performance for underlying equity and fixed income mutual funds is reduced by fund fees ranging from 1% to 3% across all funds.
Market volatility refers to market fluctuation. The volatility assumption is based on a review of historical monthly returns for each key index (e.g. S&P 500) over a period of at least ten years. Volatility represents the dispersion of historical returns compared to the average historical return (standard deviation) for each index. The assumption is 18% to 24%, varying by equity fund type; 5% to 7%, varying by bond fund type; and 0% to 1% for money market funds. These volatility assumptions are used along with the mean investment performance assumption to project future return scenarios.
The discount rate is 5.75%, which is determined based on the underlying and projected yield of the portfolio of assets supporting the GMDB liability.
The lapse rate assumption (full surrender of an annuity prior to a contractholder's death) is 0% to 11%, depending on contract type, policy duration and the ratio of the net amount at risk to account value.
Reserve Strengthening: In each of the three years presented, the Company completed its normal review of reserves (including assumptions), and recorded additional other benefits expense to strengthen GMDB reserves. The amounts and primary drivers of the reserve strengthening in each year were:
2011: Reserve strengthening of $70 million ($45 million after-tax) was driven primarily by volatility-related impacts due to turbulent equity market conditions, adverse interest rate impacts, and adverse impacts of overall market declines in the third quarter that include an increase in the provision for expected future partial surrenders and declines in the value of contractholders' non-equity investments.
2010: Reserve strengthening of $52 million pre-tax ($34 million after-tax) was primarily due to adverse interest rate impacts, and to a lesser extent, an update to the lapse assumption for policies that have already taken or may take a significant partial withdrawal.
The majority of the Company's exposure arises under annuities that guarantee that the benefit received at death will be no less than the highest historical account value of the related mutual fund investments on a contractholder's anniversary date. Under this type of death benefit, the Company is liable to the extent the highest historical anniversary account value exceeds the fair value of the related mutual fund investments at the time of a contractholder's death. Other annuity designs that the Company reinsured guarantee that the benefit received at death will be:
the contractholder's account value as of the last anniversary date (anniversary reset); or
of the underlying mutual fund investments. This data does not reflect the impacts of reinsurance in place as of December 31, 2012 nor the reinsurance placed on February 4, 2013.
Ceded Reinsurance: Ongoing operations. The Company's insurance subsidiaries have reinsurance recoverables from various reinsurance arrangements in the ordinary course of business for its Global Health Care, Group Disability and Life, and Global Supplemental Benefits segments as well as the corporate-owned life insurance business. Reinsurance recoverables are $345 million as of December 31, 2012, with 16% of the recoverable balance protected by collateral.
The Company reviews its reinsurance arrangements and establishes reserves against the recoverables in the event that recovery is not considered probable. As of December 31, 2012, the Company's recoverables related to these segments were net of a reserve of $4 million.
Liabilities related to GMDB, workers' compensation and personal accident are included in future policy benefits and unpaid claims. Because the GMIB contracts are treated as derivatives under GAAP, the asset related to GMIB is recorded in the Other assets, including other intangibles caption and the liability related to GMIB is recorded in Accounts payable, accrued expenses, and other liabilities on the Company's Consolidated Balance Sheets (see Notes 11 and 24 for additional discussion of the GMIB assets and liabilities).
The reinsurance recoverables for GMDB, workers' compensation, and personal accident total $170 million as of December 31, 2012. Of this amount, approximately 97% are secured by assets in trust or letters of credit.
Summary. The Company's reserves for underlying reinsurance exposures assumed by the Company, as well as for amounts recoverable from reinsurers/retrocessionaires for both ongoing operations and the run-off reinsurance operation, are considered appropriate as of December 31, 2012, based on current information. The Company bears the risk of loss if its retrocessionaires do not meet or are unable to meet their reinsurance obligations to the Company.
The increase in direct premiums in 2012 as compared to 2011 primarily reflects the Company's acquisitions of HealthSpring and Great American Supplemental Benefits as well as the conversion of Vanbreda business from service to insurance contracts in 2012. The increase in assumed premiums in 2012 largely results from the acquisition of FirstAssist. The decrease in assumed premiums in 2011 as compared to 2010 primarily reflects the effect of the Company's exit from a large, low-margin assumed government life insurance program. The effects of reinsurance on written premiums and fees for short-duration contracts were not materially different from the recognized premium and fee amounts shown in the table above.
The Company estimates annual pre-tax amortization for intangible assets, including internal-use software, over the next five calendar years to be as follows: $415 million in 2013, $368 million in 2014, $312 million in 2015, $262 million in 2016, and $213 million in 2017.
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 2013, the Company expects to make minimum required and voluntary contributions totaling approximately $250 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.
The Company expects to recognize pre-tax losses of $75 million in 2013 from amortization of past experience. This estimate is based on a weighted average amortization period for the frozen and inactive plans of approximately 28 years, that is based on the average expected remaining life of plan participants.
Other postretirement benefits. Unfunded retiree health benefit plans had accumulated benefit obligations of $294 million at December 31, 2012, and $302 million at December 31, 2011. Retiree life insurance plans had accumulated benefit obligations of $148 million as of December 31, 2012 and $150 million as of December 31, 2011.
The Company expects to recognize in 2013 pre-tax gains of $9 million related to amortization of prior service cost and no pre-tax losses from amortization of past experience. The original amortization period is based on an average remaining service period of active employees associated with the other postretirement benefit plans of approximately 11 years. The weighted average remaining amortization period for prior service cost is approximately 2.5 years.
The estimated rate of future increases in the per capita cost of health care benefits is 7.5% in 2013, decreasing by 0.5% per year to 5% in 2018 and beyond. This estimate reflects the Company's current claim experience and management's estimate that rates of growth will decline in the future. A 1% increase or decrease in the estimated rate would have changed 2012 reported amounts as follows:
Plan assets. The Company's current target investment allocation percentages (37% equity securities, 30% fixed income, 15% securities partnerships, 10% hedge funds and 8% 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. The pension plan asset portfolio has continued to include a significant allocation of equity securities, consisting of domestic and international investments, in an effort to earn a higher rate of return on pension plan investments over the long-term payout period of the pension benefit obligations. As funding levels improve, the Company would expect to gradually reduce the allocation to equity securities and move into fixed income to mitigate the volatility in returns, while also providing adequate liquidity to fund benefit distributions. The timing of any updates in allocation is not certain.
The fair values of plan assets by category and by the fair value hierarchy as defined by GAAP are as follows. See Note 11 for a description of how fair value is determined, including the level within the fair value hierarchy and the procedures the Company uses to validate fair value measurements.
A pooled separate account has several participating benefit plans and each owns a share of the total pool of investments.
Because many fixed maturities do not trade daily, fair values are often derived using recent trades of securities with similar features and characteristics. When recent trades are not available, pricing models are used to determine these prices. These models calculate fair values by discounting future cash flows at estimated market interest rates. Such market rates are derived by calculating the appropriate spreads
median return at each duration. As with the broader curve, Citigroup monitors the bond portfolio to ensure that only high quality issues are included. In setting its discount rate for 2012, the Company reviewed alternative indices and determined that they were not materially different than the result produced by the Citigroup Above-Median curve.
To measure pension costs, the Company uses a market-related asset valuation for domestic pension plan assets invested in non-fixed income investments. The market-related value of these pension assets recognizes the difference between actual and expected long-term returns in the portfolio over 5 years, a method that reduces the short-term impact of market fluctuations on pension cost. At December 31, 2012, the market-related asset value was approximately $3.5 billion compared with a market value of approximately $3.6 billion.
The GMIB assets represent retrocessional contracts in place from two external reinsurers which cover 55% of the exposures on these contracts.
Other derivative assets included $10 million of interest rate and foreign currency swaps qualifying as cash flow hedges and $35 million of interest rate swaps not designated as accounting hedges. Other derivative liabilities reflected foreign currency and interest rate swaps qualifying as cash flow hedges. See Note 13 for additional information.
Inputs for instruments classified in Level 1 include unadjusted quoted prices for identical assets in active markets accessible at the measurement date. Active markets provide pricing data for trades occurring at least weekly and include exchanges and dealer markets.
The Company classifies certain newly-issued, privately-placed, complex or illiquid securities, as well as assets and liabilities relating to GMIB, in Level 3.
The following table summarizes the fair value and significant unobservable inputs used in pricing Level 3 securities that were developed directly by the Company as of December 31, 2012. The range and weighted average basis point amounts reflect the Company's best estimates of the unobservable adjustments a market participant would make to the market observable spreads (adjustment to discount rates) used to calculate the fair values in a discounted cash flow analysis.
that because this block of contracts is in run-off mode, an insurer looking to acquire these contracts would have similar existing contracts with related administrative and risk management capabilities
The annual lapse rate assumption reflects experience that differs by the company issuing the underlying variable annuity contracts, ranges from 0% to 12% at December 31, 2012, and depends on the time since contract issue and the relative value of the guarantee. The weighted average annual lapse rate is 1.8%.
The nonperformance risk adjustment is incorporated by adding spread to the discount rate in the calculation of both (1) the GMIB liability to reflect a hypothetical market participant's view of the risk of the Company not fulfilling its GMIB obligations, and (2) the GMIB asset to reflect a hypothetical market participant's view of the reinsurers' credit risk, after considering collateral. The estimated market-implied spread is company-specific for each party involved to the extent that company-specific market data is available and is based on industry averages for similarly-rated companies when company-specific data is not available. The spread is impacted by the credit default swap spreads of the specific parent companies, adjusted to reflect subsidiaries' credit ratings relative to their parent company and any available collateral. The additional spread over LIBOR incorporated into the discount rate ranged from 5 to 140 basis points for the GMIB liability with a weighted average of 55 basis points and ranged from 15 to 100 basis points for the GMIB reinsurance asset with a weighted average of 65 basis points for that portion of the interest rate curve most relevant to these policies.
In the tables above, gains and losses included in other comprehensive income are reflected in Net unrealized appreciation (depreciation) on securities in the Consolidated Statements of Other Comprehensive Income.
Under FASB's guidance for fair value measurements, the Company's GMIB assets and liabilities are expected to be volatile in future periods because the underlying capital markets assumptions will be based largely on market observable inputs at the close of each reporting period including interest rates and market implied volatilities.
GMIB fair value gains of $41 million for 2012 were primarily due to the effect of increases in underlying account values due to favorable equity markets, updates in the claim exposure calculation based on a review of actual claim amounts compared to projected values in the fair value model and a reduction in the annuitization rates. These favorable effects were partially offset by a reduction in lapse rates and general declines in interest rates.
(1)As of December 31, 2011, non-guaranteed separate accounts included $3.0 billion in assets supporting the Company's pension plans, including $702 million classified in Level 3.
actively-traded institutional and retail mutual fund investments and separate accounts priced using the daily net asset value that is the exit price.
During 2011, impaired commercial mortgage loans and real estate entities representing less than 1% of total investments were written down to their fair values, resulting in realized investment losses of $15 million after-tax.
Securities in the following table are included in fixed maturities and equity securities on the Company's Consolidated Balance Sheets. The Company's hybrid investments include certain preferred stock or debt securities with call or conversion features.
The above table includes investments with a fair value of $3.1 billion supporting the Company's run-off settlement annuity business, with gross unrealized appreciation of $883 million and gross unrealized depreciation of $8 million at December 31, 2012. 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, 2011, investments supporting this business had a fair value of $3 billion, gross unrealized appreciation of $851 million and gross unrealized depreciation of $25 million.
Credit quality. The Company applies a consistent and disciplined approach to evaluating and monitoring credit risk, beginning with the initial underwriting of a mortgage loan and continuing throughout the investment holding period. Mortgage origination professionals employ an internal rating system developed from the Company's experience in real estate investing and mortgage lending. A quality rating, designed to evaluate the relative risk of the transaction, is assigned at each loan's origination and is updated each year as part of the annual portfolio loan review. The Company monitors credit quality on an ongoing basis, classifying each loan as a loan in good standing, potential problem loan or problem loan.
The following tables summarize the credit risk profile of the Company's commercial mortgage loan portfolio using carrying values classified based on loan-to-value and debt service coverage ratios, as of December 31, 2012 and 2011:
During 2012, the Company restructured a $119 million problem mortgage loan, net of a valuation reserve, into two notes carried at $100 million and $19 million. The $100 million note was reclassified to impaired commercial mortgage loans with no valuation reserves and the $19 million note was classified as another long-term investment. This modification was considered a troubled debt restructuring because the borrower was experiencing financial difficulties and an interest rate concession was granted. No valuation reserve was required because the fair value of the underlying property equaled the carrying value of the outstanding loan. Following the restructuring, the $100 million note was paid down by $46 million with the remaining $54 million note reclassified to good standing due to an improved quality rating based on significant improvements in its loan-to-value and debt service coverage ratios resulting from the annual loan review.
Other loans were modified during 2012 and 2011, but were not considered troubled debt restructures. The impact of modifications to these loans was not material to the Company's results of operations, financial condition or liquidity.
Problem and potential problem mortgage loans, net of valuation reserves, totaled $215 million at December 31, 2012 and $336 million at December 31, 2011. At December 31, 2012, mortgage loans located in the South Atlantic region represented the most significant component of problem and potential problem mortgage loans, with no significant concentration by property type. At December 31, 2011, mortgage loans collateralized by industrial properties represent the most significant component of problem and potential problem mortgage loans, with no significant concentration by geographic region.
During 2012, the Company recorded a $10 million pre-tax ($7 million after-tax) increase in valuation reserves on three impaired commercial mortgage loans collateralized by industrial properties and one impaired commercial mortgage loan collateralized by a retail property. The average recorded investment in impaired loans was $167 million during 2012 and $176 million during 2011. The Company recognizes interest income on problem mortgage loans only when payment is actually received because of the risk profile of the underlying investment. Additional interest income that would have been reflected in net income if interest on non-accrual commercial mortgage loans had been received in accordance with the original terms was not significant for 2012 or 2011. Interest income on impaired commercial mortgage loans was not significant for 2012 or 2011. See Note 2 for further information on impaired commercial mortgage loans.
As of December 31, 2012 and 2011, real estate investments consisted primarily of office and industrial buildings in California. Investments with a carrying value of $49 million as of December 31, 2012 and 2011 were non-income producing during the preceding twelve months. As of December 31, 2012, the Company had commitments to contribute additional equity of $7 million to real estate investments.
Investments in real estate entities and securities partnerships with a carrying value of $199 million at December 31, 2012 and $171 million at December 31, 2011 were non-income producing during the preceding twelve months.
As of December 31, 2012, the Company had commitments to contribute:
$312 million to entities that hold securities diversified by issuer and maturity date.
The Company expects to disburse approximately 50% of the committed amounts in 2013.
Short-term investments and cash equivalents included corporate securities of $1.1 billion, federal government securities of $167 million and money market funds of $217 million as of December 31, 2012. The Company's short-term investments and cash equivalents as of December 31, 2011 included corporate securities of $4.1 billion, federal government securities of $164 million and money market funds of $40 million. The decrease during 2012 is primarily due to funds used to acquire HealthSpring. See Note 3 for further information.
Purpose. The Company has written reinsurance contracts with issuers of variable annuity contracts that provide annuitants with certain guarantees of minimum income benefits resulting from the level of variable annuity account values compared with a contractually guaranteed amount ("GMIB liabilities"). According to the contractual terms of the written reinsurance contracts, payment by the Company depends on the actual account value in the underlying mutual funds and the level of interest rates when the contractholders elect to receive minimum income payments. The Company has purchased retrocessional coverage for 55% of these contracts to reduce a portion of the risks assumed ("GMIB assets"). Effective February 4, 2013, the Company reinsured the remainder of the exposures on these contracts. See Note 25 for additional information.
Accounting policy. The Company accounts for these GMIB liabilities and assets as written and purchased options at fair value because cash flows are affected by equity markets and interest rates, but are without significant life insurance risk and are settled in lump sum payments. These derivatives are not designated as hedges and their fair values are reported in other liabilities (GMIB liability) and other assets (GMIB asset), with changes in fair value reported in GMIB fair value (gain) loss.
Volume of activity. The potential undiscounted future payments for the written options (GMIB liability, as defined in Note 24) was $1,065 million as of December 31, 2012 and $1,244 million as of December 31, 2011. The potential undiscounted future receipts for the purchased options (GMIB asset) was $586 million as of December 31, 2012 and $684 million as of December 31, 2011.
The following table provides the effect of these derivative instruments on the financial statements for the indicated periods:
Purpose. The Company uses derivative financial instruments under a dynamic hedge program designed to substantially reduce domestic and international equity market exposures resulting from changes in variable annuity account values based on underlying mutual funds for certain reinsurance contracts that guarantee minimum death benefits ("GMDB"). During the second quarter of 2012, the Company expanded this hedge program to cover approximately one-half of the equity market exposures associated with its GMIB business, increasing the covered exposure from approximately one-quarter. The Company also operates a dynamic hedge program to reduce the exposure to changes in interest rate levels on the growth rate for approximately one-third of its GMDB and one-quarter of its GMIB businesses ("GMDB and GMIB growth interest rate hedge program"). These hedge programs are dynamic because the Company will regularly rebalance the hedging instruments within established parameters as equity and interest rate exposures of these businesses change. These hedge programs were terminated after February 4, 2013 as a result of the Company's agreement to reinsure the remainder of GMDB and GMIB businesses. See Notes 7 and 11 for further details regarding these businesses.
The Company manages these hedge programs using exchange-traded equity, foreign currency, and interest rate futures contracts, as well as interest rate swap contracts. These contracts are generally expected to rise in value as equity markets and interest rates decline, and decline in value as equity markets and interest rates rise.
Volume of activity. The notional values of futures and swap contracts used in the GMDB and GMIB equity and growth interest rate hedge programs are included in the following table. Equity futures consist primarily of S&P 500, S&P 400, Russell 2000, NASDAQ, TOPIX (Japanese), EUROSTOXX and FTSE (British) equity indices. Currency futures consist of Euros, Japanese yen and British pounds.
Balance sheet presentation of amounts receivable or payable relating to futures daily variation margin are excluded from this table.
Derivative financial instruments are also used by the Company 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.
Purpose. The Company uses interest rate, foreign currency, and combination (interest rate and foreign currency) swap contracts to hedge the interest and foreign currency cash flows of its fixed maturity bonds to match associated insurance liabilities.
Accounting policy. Using cash flow hedge accounting, fair values are reported in other long-term investments or other liabilities and accumulated other comprehensive income and amortized into net investment income or reported in other realized investment gains and losses as interest or principal payments are received.
Volume of activity. The following table provides the notional values of these derivative instruments for the indicated periods:
In order to provide certain services to its Medicare Advantage customers, the Company contracts with independent physician associations (IPAs) that are variable interest entities. Physicians provide health care services to the Medicare Advantage customers and the Company provides medical management and administrative services to the IPAs.
Net investment income for separate accounts (that is not reflected in the Company's revenues) was $181 million for 2012, $207 million for 2011, and $163 million for 2010.
Credit-related losses include other-than-temporary declines in fair value of fixed maturities and equity securities and changes in valuation reserves and asset write-downs related to commercial mortgage loans and investments in real estate entities. There were no credit losses on fixed maturities for which a portion of the impairment was recognized in other comprehensive income.
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 on May 15 and November 15 of each year beginning May 15, 2012 for the 5-Year Notes and February 15 and August 15 of each year beginning February 15, 2012 for the 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).
the present value of the remaining principal and interest payments on the Notes being redeemed discounted at the applicable Treasury rate plus 20 basis points (10-Year 4.5% Notes due 2021) or 25 basis points (30-Year 5.875% Notes due 2041).
In the fourth quarter of 2010, the Company entered into the following transactions related to its long-term debt:
The Company may redeem the Notes issued in 2010 at any time, in whole or in part, at a redemption price equal to the greater of:
The Company was in compliance with its debt covenants as of December 31, 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, 2012 or 2011.
The Company provides for income taxes on the undistributed earnings of certain foreign operations using the foreign jurisdictions' tax rate, as compared to the higher U.S. statutory tax rate. Commencing in the first quarter of 2012, the Company began using this approach to compute income taxes attributable to its China and Indonesia operations, based upon a determination that the related earnings would be permanently invested overseas. The Company
Shareholders' net income for the year ended December 31, 2012 increased by $37 million related to this method of providing for income taxes including $13 million attributable to the first quarter implementation of this method for the Company's China and Indonesia operations. Permanent investment of foreign operation earnings has resulted in cumulative unrecognized deferred tax liabilities of $116 million through December 31, 2012. The year-to-date change in the cumulative unrecognized deferred tax liability includes an increase of $10 million associated with unrecorded deferred tax liabilities reported through other comprehensive income.
The significant decline in the 2010 valuation allowance primarily reflects the resolution of a disputed federal income tax matter specific to the run-off reinsurance operations.
The Company's deferred tax asset is net of federal, state, and foreign valuation allowances. The foreign valuation allowance was initially recorded in connection with the Company's 2011 acquisition of FirstAssist, for which there was a year over year decline of $7 million. This reduction did not impact shareholder's net income. The valuation allowance reflects management's assessment that certain deferred tax assets may not be realizable.
The December 31, 2012 unrecognized tax benefit balance included $29 million that would increase shareholders' net income if recognized. The Company has determined it is at least reasonably possible that within the next twelve months there could be a significant change in the level of unrecognized tax benefits specific to development in ongoing IRS examinations. These changes are not expected to have a material impact on shareholders' net income.
The Company classifies net interest expense on uncertain tax positions and any applicable penalties as a component of income tax expense, but excludes these amounts from the liability for uncertain tax positions. The Company's liability for net interest and penalties was $3 million at December 31, 2012, $2 million at December 31, 2011 and $14 million at December 31, 2010. The 2011 decline included $11 million associated with the completion of the 2007 and 2008 IRS examinations.
During the first quarter of 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 ($33 million reported in income tax expense, partially offset by a $9 million pre-tax charge). The increase in shareholders' net income included a reduction in net unrecognized tax benefits of $11 million and a reduction of interest expense of $11 million (reported in income tax expense).
The Company has had a continuing dispute with the IRS for tax years 2004 through 2006 regarding the appropriate reserve methodology for certain reinsurance contracts. Trial was held before the United States Tax Court for the 2004 tax year in September 2011. Prior to trial, the IRS conceded the underlying adjustments but continued to challenge the Company's reserve methodology as a matter of law. The United States Tax Court issued its opinion for the 2004 year on September 13, 2012. While declining to rule on the broader legal issue, the opinion confirmed the Company's tax reserve calculation and referenced an IRS representation that it would not challenge the Company's reserving methodology in future tax years, thereby providing certainty that the Company may continue to use its current reserve methodology prospectively. Tax computations for the 2004 tax year have been reviewed by the staff of the Joint Committee of Taxation and the parties are currently awaiting entry of the Tax Court's decision, that is expected shortly. On January 9, 2013 the Tax Court entered its decision on this issue for the 2005 and 2006 tax years, ordering and deciding that the Company has no tax deficiency.
The People Resources Committee ("the Committee") of the Board of Directors awards stock options, restricted stock, deferred stock and, beginning in 2010, strategic performance shares to certain employees. To a very limited extent, the Committee has issued common stock instead of cash compensation and dividend equivalent rights as part of restricted and deferred stock units. The Company issues shares from Treasury stock for option exercises, awards of restricted stock and payment of deferred and restricted stock units.
The Company had the following number of shares of common stock available for award at December 31: 8.4 million in 2012, 11.7 million in 2011 and 7.5 million in 2010.
The table below shows the status of, and changes in, common stock options during the last three years:
The following table summarizes information for outstanding common stock options at December 31, 2012:
The fair value of vested restricted stock was: $66 million in 2012, $24 million in 2011 and $18 million in 2010.
At the end of 2012, approximately 955 employees held 1.6 million strategic performance shares and $26 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 2013 and 2014.
the supplemental health, life and accident business becomes a separate reporting segment named Global Supplemental Benefits.
The Commercial operating segment includes both the U.S. commercial and international health care businesses that offer insured and self-insured medical, dental, behavioral health, vision, and prescription drug benefit plans, health advocacy programs and other products and services that may be integrated to provide comprehensive global health care benefit programs to employers and their employees, including globally mobile individuals. Cigna, either directly or through its partners, offers some or all of these products and services in all 50 states, the District of Columbia, the U.S. Virgin Islands, Canada, Europe, the Middle East, and Asia. Cigna services its globally mobile customers virtually everywhere in the world. These products and services are offered through a variety of funding arrangements such as administrative services only (ASO), guaranteed cost and retrospectively experience rated.
The Government operating segment offers Medicare Advantage plans to seniors in 13 states and the District of Columbia, Medicare Part D plans in all 50 states and the District of Columbia and Medicaid plans.
Group Disability and Life represents group disability, life and accident insurance products, including certain disability and life insurance business previously reported in the former Health Care segment.
The Company measures the financial results of its segments using "segment earnings (loss)", which is 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 since this is not a metric used to allocate resources or evaluate segment performance.
Includes minimum premium business that has a risk profile similar to experience-rated funding arrangements. The risk portion of minimum premium revenue is reported in experience-rated medical premium whereas the self funding portion of minimum premium revenue is reported in fees. Also includes certain non-participating cases for which special customer level reporting of experience is required.
Premiums and fees, mail order pharmacy revenues and other revenues by geographic location were as follows for the years ended December 31:
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 has the right to redirect the management of the related assets to provide for benefit payments. As of December 31, 2012, employers maintained assets that exceeded the benefit obligations. Benefit obligations under these arrangements were $559 million as of December 31, 2012. As of December 31, 2012, approximately 21% 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, 2012. Separate account assets supporting these guarantees are classified in Levels 1 and 2 of the GAAP fair value hierarchy. See Note 11 for further information on the fair value hierarchy.
See Notes 11 (fair value) and 13 (derivatives) for further information on GMIB contracts. Under these guarantees, the future payment amounts are dependent on equity and bond fund market and interest rate levels prior to and at the date of annuitization election, that must occur within 30 days of a policy anniversary, after the appropriate waiting period. Therefore, the future payments are not fixed and determinable under the terms of the contract. Accordingly, the Company's maximum potential undiscounted future payment of $1.1 billion was determined using the following hypothetical assumptions:
all annuitants elected to receive their benefit on the next available date (2013 through 2018); and
The Company had indemnification obligations as of December 31, 2012 in connection with acquisition and disposition transactions. These indemnification obligations are triggered by the breach of representations or covenants provided by the Company, such as representations for the presentation of financial statements, the filing of tax returns, compliance with law or the identification of outstanding litigation. These obligations are typically subject to various time limitations, defined by the contract or by operation of law, such as statutes of limitation. In some cases, the maximum potential amount due is subject to contractual limitations based on a percentage of the transaction purchase price, while in other cases limitations are not specified or applicable. The Company does not believe that it is possible to determine the maximum potential amount due under these obligations, since not all amounts due under these indemnification obligations are subject to limitation. There were no liabilities for these indemnification obligations as of December 31, 2012.
Employee benefits regulation. The business of administering and insuring employee benefit programs, particularly health care programs, is heavily regulated by federal and state laws and administrative agencies, such as state departments of insurance and the Federal Departments of Labor and Justice, as well as the courts. Regulation, legislation and judicial decisions have resulted in changes to industry and the Company's business practices and will continue to do so in the future. In addition, the Company's subsidiaries are routinely involved with various claims, lawsuits and regulatory and IRS audits and investigations that could result in financial liability, changes in business practices, or both.
Other possible regulatory and legislative changes or judicial decisions that could have an adverse effect on the Company's employee benefits businesses include:
changes in public policy and in the political environment, that could affect state and federal law, including legislative and regulatory proposals related to health care issues, that could increase cost and affect the market for the Company's health care products and services;
additional restrictions on the use of prescription drug formularies and rulings from pending purported class action litigation, that could result in adjustments to or the elimination of the average wholesale price of pharmaceutical products as a benchmark in establishing certain rates, charges, discounts, guarantees and fees for various prescription drugs;
The Company is aware of an insurer that is in rehabilitation, an intermediate action before insolvency. On May 3, 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. On May 14, 2012 the regulator filed a post-trial motion requesting the court to reconsider its decision. On September 28, 2012, an Order of Judgment was entered finalizing the court's opinion that the insurer is not insolvent and remains in rehabilitation. The regulator has appealed the court's decision. If the state court's decision is reversed and the insurer is declared insolvent and placed in liquidation, the Company and other insurers may be required to pay a portion of policyholder claims through guaranty fund assessments from various states in which the Company's insurance subsidiaries write premiums. Based on current information available, in the event of a reversal of the state court decision and liquidation of the insurer, the Company has estimated that potential future assessments could result in future charges totaling approximately $60 million after-tax. The Company will continue to monitor the outcome of the court's deliberations.
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. Such legal matters include benefit claims, breach of contract claims, tort claims, disputes regarding reinsurance arrangements, employment related suits, employee benefit claims, wage and hour claims, and intellectual property and real estate related disputes. Litigation of income tax matters is accounted for under FASB's accounting guidance for uncertainty in income taxes. Further information can be found in Note 20. The outcome of litigation and other legal matters is always uncertain, and unfavorable outcomes that are not justified by the evidence can occur. The Company believes that it has valid defenses to the legal matters pending against it and is defending itself vigorously.
When the Company (in the course of its regular review of pending litigation and legal matters) has determined that a material loss is reasonably possible, the matter is disclosed including an estimate or range of loss or a statement that such an estimate cannot be made. In many proceedings, however, it is inherently difficult to determine whether any loss is probable or even possible or to estimate the amount or range of any loss. In accordance with applicable accounting guidance, when litigation and regulatory matters present loss contingencies that are both probable and estimable, the Company accrues the estimated loss by a charge to income. The amount accrued represents the Company's best estimate of the probable loss. If only a range of estimated losses can be determined, the Company accrues an amount within the range that, in the Company's judgment, reflects the most likely outcome; if none of the estimates within that range is a better estimate than any other amount, the Company accrues at the low end of the range. In cases that the Company has accrued an estimated loss, the accrued amount may differ materially from the ultimate amount of the relevant costs.
formula. The plaintiffs allege various ERISA violations including, among other things, that the Plan's cash balance formula discriminates against older employees; the conversion resulted in a wear away period (when the pre-conversion accrued benefit exceeded the post-conversion benefit); and these conditions are not adequately disclosed in the Plan.
On December 20, 2012, the new trial judge 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 by the first trial judge in 2008. Both parties appealed the order and the judge stayed implementation of the order pending resolution of the appeals. In light of the re-affirmed remedy ordered by the District Court, the Company was required to re-evaluate its reserve for this case. Due to the current economic environment of low interest rates that have a significant impact on the valuation of potential future pension benefits, the Company was required to increase its reserve for this matter in the fourth quarter of 2012. 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, which was denied on January 16, 2013. Plaintiffs petitioned for an immediate appeal of the order denying class certification, that the Company opposed.
Effective February 4, 2013, the Company entered into an agreement with Berkshire Hathaway Life Insurance Company of Nebraska (Berkshire) to reinsure the GMDB and GMIB businesses. Berkshire will reinsure 100% of the Company's future claim payments, net of retrocessional arrangements in place prior to February 4, 2013, for a reinsurance premium of $2.2 billion. The reinsurance agreement is subject to an overall limit of approximately $3.8 billion plus future premiums collected under the contracts being reinsured that will be paid to Berkshire. The Company estimates that these future premium amounts will be from $0.1 to $0.3 billion and, accordingly, expects future claims of approximately $4 billion to be covered by the agreement.
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 ("the Company") at December 31, 2012 and December 31, 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (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. 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.
As described in Management's Annual Report on Internal Control over Financial Reporting, management has excluded Great American Supplemental Benefits Group from its assessment of internal control over financial reporting as of December 31, 2012 because it was acquired by the Company in a purchase business combination during the year ended December 31, 2012. We have also excluded Great American Supplemental Benefits Group from our audit of internal control over financial reporting. Great American Supplemental Benefits Group's total assets acquired represent approximately 2% of consolidated total assets as of December 31, 2012; total revenues acquired represent less than 1% of consolidated total revenues for the year ended December 31, 2012.
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 a litigation matter in Global Health Care.
The first quarter of 2011 includes an after-tax gain of $13 million for the GMIB business and a net tax benefit of $24 million related to the resolution of a Federal tax matter.
The fourth quarter of 2011 includes an after-tax gain of $7 million for the GMIB business and, an after-tax charge of $31 million for costs associated with acquisitions.
Assumes that the value of the investment in Cigna common stock and each index was $100 on December 31, 2007 and that all dividends were reinvested.