UNUM owns home office property consisting of six office buildings and four service buildings located throughout the Portland, Maine area. UNUM also owns office buildings in the United Kingdom, South Carolina and Argentina, which serve as the home offices of UNUM Limited, the Colonial Companies and Boston Seguros, respectively. In addition, UNUM leases office space, on periods principally from five to ten years, for use by its home office, affiliates and sales forces.
The following should be read in conjunction with UNUM's Consolidated Financial Statements and related notes reported in Item 8. On June 2, 1997, UNUM completed a two-for-one common stock split. Accordingly, all numbers of common shares and per common share data have been restated to reflect the stock split.
SELECTED CONSOLIDATED FINANCIAL DATA (Dollars in millions, except per common share data)
(b) Effective January 1, 1993, UNUM adopted Financial Accounting Standard No. 106, "Employers' Accounting for Postretirement Benefits Other than Pensions," which decreased net income by $32.1 million and Financial Accounting Standard No. 109, "Accounting for Income Taxes," which increased net income by $20.0 million.
The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. Certain information contained in this discussion, or in any other written or oral statements made by UNUM, are or may be considered as forward-looking. Forward-looking statements relate to future operations, strategies, financial results or other developments, and contain words or phrases such as "may," "expects," "should" or similar expressions. Forward- looking statements are based upon estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond UNUM's control or are subject to change.
Inherent in UNUM's business are certain risks and uncertainties. Therefore, UNUM cautions the reader that revenues and income could differ materially from those expected to occur depending on factors such as general economic conditions including changes in interest rates and the performance of financial markets, changes in domestic and foreign laws, regulations and taxes, competition, industry consolidation, competitor demutualization, credit risks and other factors. Insurance reserve liabilities can fluctuate as a result of changes in numerous factors, and such fluctuations can have material positive or negative effects on net income. The factors include, but are not limited to, interest rates, incidence rates and recovery rates. Incidence and recovery rates may be influenced by many factors, including but not limited to, the emergence of new diseases, new trends and developments in medical treatments, general economic and societal conditions of the markets where UNUM has operations, and the effectiveness of risk management programs. UNUM disclaims any obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future developments or otherwise.
This management's discussion and analysis focuses on results on a pretax operating income basis, which is defined as income (loss) before income taxes exclusive of realized investment gains (losses) and special items. Special items are excluded from this discussion as management considers them to be unusual and believes a discussion of the results on a pretax operating income basis provides a better understanding of the results of ongoing operations. The following table summarizes pretax operating income (loss) for the four business segments and Corporate for the years ended December 31, 1997, 1996 and 1995, and is followed by a discussion of the special items for those periods and a reconciliation of income (loss) before income taxes to pretax operating income (loss).
On October 1, 1996, UNUM Life Insurance Company of America ("UNUM America") and First UNUM Life Insurance Company ("First UNUM") closed the sale of their respective tax-sheltered annuity ("TSA") businesses to The Lincoln National Life Insurance Company and Lincoln Life & Annuity Company of New York, both subsidiaries of Lincoln National Corporation. The sale involved approximately 1,700 group contractholders, assets under management of approximately $3.3 billion and resulted in a deferred pretax gain which is recognized in income in proportion to contractholder and participant consents for assumption reinsurance. Refer to the caption "Retirement Products Segment" for further information. For the year ended December 31, 1997, consent for assumption reinsurance was provided by TSA contractholders and participants owning approximately 92% of assets under management. During 1997, these consents resulted in the recognition of $72.6 million of the total deferred pretax gain of $80.8 million. The recognized gains are reflected as fees and other income in the Retirement Products segment.
During fourth quarter 1997, certain reinsurance pools managed by UNUM's wholly-owned subsidiary, Duncanson & Holt Inc. ("D&H"), received new claim information from ceding insurance enterprises about certain older pool years and completed an analysis of recent claims experience deterioration. As a result of these factors, certain pools have strengthened claim reserves. The impact to UNUM in fourth quarter 1997 from these pool claim reserve increases was an $11.7 million reduction in fee income and a $6.7 million increase in benefits to policyholders in the Special Risk Insurance segment, reducing income before income taxes by $18.4 million. The $11.7 million reduction in fee income reflects lower profit commission levels in certain older pool years after the pool claim reserve strengthening. The $6.7 million increase in benefits to policyholders represents the amount of additional claim reserves UNUM recognized as a result of its participation in the pools that strengthened claim reserves.
In connection with the merger of Commercial Life Insurance Company ("Commercial Life") into UNUM America, the sale of UNUM America's TSA business, as well as UNUM's continued efforts to strengthen its focus on its core products, the company initiated a review of certain products, which resulted in the recognition of pretax charges totaling $39.4 million during third quarter 1996.
The Disability Insurance segment includes disability products offered through: UNUM America and First UNUM in North America; UNUM Limited in the United Kingdom; and UNUM Japan Accident Insurance Company Limited ("UNUM Japan"). The products included in this segment are group LTD, group short term disability ("group STD"), ID, disability reinsurance operations and long term care insurance.
UNUM completed a reinsurance agreement during the fourth quarter of 1996 for coverage related to its United States non-cancellable block of ID business (see the "Individual Disability" caption within this segment discussion). Starting January 1, 1997, the individual components of the operating results for the reinsured ID business are not reflected on separate lines in UNUM's statements of income; instead, components of the operating results are combined and reflected as a net amount in fees and other income. UNUM continues to focus on the underlying trends of the reinsured business, and in the following discussion reference to ID includes both the reinsured and non-reinsured portions of the business.
Pretax operating income increased in 1996, as compared with 1995, primarily as a result of increased investment income and lower benefit ratios in group LTD and at UNUM Limited. Partially offsetting these favorable factors were increased operating expenses for the segment and higher benefit ratios in disability reinsurance operations and ID. The increase in investment income for 1996 was primarily the result of reinvestment of the proceeds from the 1995 sale of UNUM's common stock portfolio into investment grade fixed income assets. During second quarter 1995, UNUM sold virtually all of the common stock portfolio of its United States subsidiaries, primarily due to consideration of statutory capital requirements associated with investment in common stocks and to increase future investment income.
Claim block acquisitions, which generate one-time premiums, are summarized in the table below. Management intends to pursue additional claim block acquisitions in the future.
Additionally, premium for ID includes the recapture of reinsurance premium totaling $10.6 million in 1996.
which reflects a lower level of price increases during the year and the success of product modifications and continuing customer service actions. Increased investment income and continued expense management also contributed to the improvement in 1997 earnings. Management continues to focus on steps to increase premiums and sales, including a strengthened emphasis on customer service to further improve persistency and additional investments in distribution channels. The significant sales growth experienced in 1997, combined with general pricing competition, may affect UNUM's ability to continue to increase sales by the same percentage growth seen in 1997, as compared with 1996.
The benefit ratio for 1997 was consistent with 1996. While the average incidence rate of claims declined in 1997, an increase in the average size of claims offset the favorable impact of incidence. Management continually monitors claim trends and responds to changes by periodically adjusting prices, altering underwriting guidelines, changing product features and strengthening risk management policies and procedures.
During 1997, UNUM Limited's pretax operating income was favorably affected by premium growth, driven by solid sales levels and improved persistency. Increased investment income, a lower benefit ratio and a lower operating expense ratio also contributed to improved results as compared with the corresponding period in 1996. The lower benefit ratio was primarily the result of UNUM Limited's continuing focus on risk management.
In general, UNUM Limited's earnings expressed in U.S. dollars are affected by fluctuations in the exchange rates used in the translation of earnings from British pounds sterling. The weighted average exchange rate was approximately $1.64, $1.56 and $1.58 for the years ended December 31, 1997, 1996 and 1995, respectively. At December 31, 1997, the spot rate was approximately $1.65.
On October 23, 1996, UNUM announced the execution of a definitive reinsurance agreement between UNUM America and Centre Life Reinsurance Limited ("Centre Re"), a Bermuda-based reinsurance specialist, for reinsurance coverage of the active life reserves of UNUM America's existing United States non-cancellable ID block of business. This agreement does not reinsure any claims incurred prior to January 1, 1996. The agreement follows UNUM's announcement in late 1994 that it would no longer market the non-cancellable form of ID coverage in the United States.
The agreement is a finite reinsurance arrangement that transfers liabilities to Centre Re based on the level of statutory reserves. Centre Re has an obligation to absorb losses within a defined risk layer, while UNUM must fund an experience layer representing the difference between reserves related to the reinsured block, based on generally accepted accounting principles ("GAAP"), and the bottom of Centre Re's defined risk layer. Within this experience layer, UNUM retains the earnings risk related to potential adverse experience from the reinsured block. Under the agreement, UNUM funds a trust account, initially established in late 1996, with assets equal to the related amount of GAAP reserves plus the amount of its experience layer. The value of UNUM's experience layer increases or decreases in conjunction with the underlying operating results of the reinsured block. Additionally, realized gains or losses on assets sold, and unrealized gains or losses on marketable securities held in the trust and the related claim reserves, affect the valuation of the experience layer. UNUM reflects the carrying value of the experience layer in its Consolidated Balance Sheet as a deposit asset, which at December 31, 1997, totaled approximately $347 million. Changes in the experience layer derived from the underlying operating results of the reinsured block are reflected in fees and other income and realized gains or losses from sales of trust assets are reflected as realized investment gains (losses) in UNUM's Consolidated Statement of Income. Changes in the experience layer resulting from unrealized gains or losses on marketable securities held in the trust and the related claim reserves are reflected as unrealized gains or losses in the equity section of UNUM's Consolidated Balance Sheet.
For the year ended December 31, 1997, pretax operating income for individual disability was negatively affected by unfavorable claims experience, primarily resulting from increased incidence, partially offset by lower expense levels, as compared with the same period in 1996. Premium growth continued to decline as a result of UNUM's exit from the traditional, fixed price, non-cancellable product in the United States. Sales of the guaranteed renewable Lifelong Disability Protection product, which replaced the non-cancellable product, have grown 94% in 1997 over 1996.
The Long Term Care ("LTC") block of business, while still relatively small, should provide one of the company's most significant growth opportunities in the future. LTC's pretax operating results improved for the year ended December 31, 1997, compared with the same period in 1996, driven by significant premium growth of 32%. LTC's contribution to the segment's pretax operating income continues to increase when compared with 1996.
The Special Risk Insurance segment includes group life, special risk accident insurance, non-disability reinsurance operations, reinsurance underwriting management operations and other special risk insurance products.
The segment's operating expense ratio improved in 1997 to 21.4% from 25.2% in 1996, primarily driven by favorable expense growth across most lines of business combined with the strong premium growth in group life. In 1997, the segment's benefit ratio increased to 70.6% as compared with 69.7% in 1996. The increase was primarily the result of unfavorable claims experience in the special risk accident insurance product line and certain reinsurance pools.
The Colonial Products segment includes Colonial Life & Accident Insurance Company ("Colonial") and affiliates. Colonial offers payroll-deducted, voluntary employee benefit products, including accident and sickness, disability, cancer and life insurance. These products are offered to employees at their worksites and are marketed by Colonial primarily through independent sales representatives.
Pretax operating income for the Colonial Products segment increased for the year ended December 31, 1997, as compared with 1996. The increase was primarily attributable to additional investment income, premium growth and reduced operating expense ratios across most lines of business, partially offset by a higher benefit ratio in the cancer product line and an increase in interest credited. During 1997, management continued its efforts to increase sales and premium at Colonial by enhancing collaborative sales across UNUM and implementing organizational changes to focus on specific distribution channels to market Colonial products. Colonial's pretax operating income increased in 1996 as compared with 1995, primarily due to favorable benefit ratios in certain product lines and increased investment income.
The increase in investment income in 1997 and 1996 was primarily due to the growth in the asset base resulting from increased cash flows largely from a product mix shift, along with a change in asset composition to higher yielding securities. Additionally, the alliance formed with Lincoln Life positively affected investment income growth. The additional investment income generated from the alliance was partially offset by the increase in interest credited.
(a) For the definition of pretax operating income see the Consolidated Overview.
To effect the sale of the TSA business, UNUM transferred into a trust account held for the benefit of Lincoln approximately $2,690 million of assets. The transfer of these assets and subsequent novations reduced investment income and interest credited significantly in 1997, as compared with 1996.
UNUM continues to report the amount of interest credited to TSA contracts for which the consent to transfer from indemnity reinsurance to assumption reinsurance has not been received, with an equivalent amount being reported in fees and other income for the reimbursement from Lincoln. The TSA businesses accounted for $0.4 million, $13.5 million and $16.4 million of the Retirement Products segment's pretax operating income in 1997, 1996 and 1995, respectively.
For the year ended December 31, 1996, the Retirement Products segment reported decreased pretax operating income as compared with the same period in 1995. The decrease was primarily due to reduced earnings from the runoff of GICs, DAs and 401(k) plans during the year and lower interest spread margins on tax-sheltered annuities through October 1, 1996, the effective date of the TSA sale. Also, investment income declined reflecting the transfer of $2,690 million of assets to Lincoln on October 1, 1996, to effect the sale of the TSA business, and the shifting of assets to lower yielding, highly liquid instruments during the year in anticipation of the transfer.
- -------- (a) For the definition of pretax operating loss see the Consolidated Overview.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of UNUM Corporation and subsidiaries as of December 31, 1997 and 1996, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly, in all material respects, the information required to be included therein.
Portland, Maine February 4, 1998, except for Note 10 for which the date is February 13, 1998
In conjunction with the sale of UNUM's tax-sheltered annuity business during 1996, fixed maturities available for sale of $588.6 million and short-term investments of $1,825.9 million were transferred to the buyer on October 1, 1996. Upon transfer, there was a corresponding increase in UNUM's deposit assets.
The accompanying consolidated financial statements of UNUM Corporation and subsidiaries ("UNUM") have been prepared on the basis of generally accepted accounting principles. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
[bullet] Fixed maturities available for sale (certain bonds and redeemable preferred stocks)--at fair value.
Certain assets from tax-sheltered annuity ("TSA") contracts are in separate accounts that are pooled investment funds of securities. Prior to January 1, 1997, the assets of UNUM's defined benefit plan were held in the separate accounts (see Note 9 "Employee Benefit and Incentive Plans"). Investment income and realized gains and losses on these accounts accrue directly to the contractholders. Assets, carried at market value, and liabilities of the separate accounts are shown separately in the Consolidated Balance Sheets. The assets of the separate accounts are legally segregated and are not subject to claims that arise out of any other business of UNUM.
Liabilities for restructuring activities are recorded when management, prior to the balance sheet date, commits to execute an exit plan that will result in the incurral of costs that have no future economic benefit or approves a plan of termination and communicates sufficient detail of the plan to employees. Liabilities for restructuring activities are included in other liabilities in the Consolidated Balance Sheets.
Group insurance premiums are recognized as income over the period to which the premiums relate. Individual disability premiums are recognized as income when due. Benefits and expenses are matched with earned premiums to result in recognition of profits over the life of the contracts. This association is accomplished by recording a provision for future policy benefits and unpaid claims and claim expenses and by amortizing deferred policy acquisition costs.
During 1995, UNUM sold virtually all of the common stock portfolio of its United States subsidiaries. The sale of the common stock portfolio, which partially supported certain disability reserves, and the reinvestment of the proceeds primarily in investment grade fixed income assets at yields below the average portfolio yield, resulted in lower reserve discount rates for certain disability products reported in the Disability Insurance segment. This change in accounting estimate to lower certain discount rates resulted in an increase of $128.6 million to benefits to policyholders in the Consolidated Statement of Income, and a decrease to net income of $83.6 million.
During 1995, UNUM increased group long term disability reserves for incurred but not reported ("IBNR") claims, as reported in the Disability Insurance segment. The increased IBNR reserves were based on management's judgment that claims incurred but not yet reported would reflect increased levels of claims incidence and severity. This change in accounting estimate resulted in an increase to benefits to policyholders in the Consolidated Statement of Income of $38.4 million, and a decrease to net income of $25.0 million.
During 1995, UNUM increased reserves for unpaid claims related to the association group disability business by $15.0 million to reflect management's expectations of slower than expected claim recoveries. This change in accounting estimate, which was reported in the Disability Insurance segment, decreased net income by $9.8 million.
Effective December 31, 1997, UNUM adopted FAS No. 129, "Disclosures of Information About Capital Structure," which consolidates disclosure requirements related to the type and nature of securities contained in an entity's capital structure. FAS 129 does not add to or change any of UNUM's disclosures.
Effective January 1, 1996, UNUM adopted FAS No. 123, "Accounting for Stock-Based Compensation." FAS 123 established financial accounting and reporting standards for stock-based employee compensation plans. The statement defines a new method of accounting for employee stock compensation plans using a fair value based method, under which compensation cost is measured and recognized in results of operations. Alternatively, FAS 123 allows an entity to retain the accounting for employee stock compensation plans defined under APB 25, "Accounting for Stock Issued to Employees." UNUM retained the accounting defined under APB 25, and as required, discloses in a footnote the pro forma effects of stock-based compensation using the fair value based method defined under FAS 123. Refer to Note 10 "Stockholders' Equity" for the related disclosures.
In June 1997, the FASB issued FAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which establishes standards for reporting information about operating segments. Generally, FAS 131 requires that financial information be reported on the basis that is used internally for evaluating performance. UNUM is required to adopt FAS 131 effective January 1, 1998, and comparative information for earlier years must be restated. This statement does not need to be applied to interim financial statements in the initial year of application. UNUM is currently considering what impact, if any, FAS 131 will have on its current segment reporting structure.
UNUM's fixed maturities are reported at fair value as a result of being classified as available for sale. Accordingly, the related liability for unpaid claims and claims expenses is adjusted to reflect the changes that would have been necessary if the related fixed maturities were sold at their fair value and the proceeds were reinvested at current yields. At December 31, 1997, and 1996, the unrealized gain on available for sale fixed maturities was $417.9 million and $286.0 million, respectively, and the related unpaid claims adjustment was $237.1 million and $168.7 million, respectively.
The fair values, which also represent carrying amounts, and the cost of equity securities available for sale were as follows at December 31, 1997:
Gross unrealized investment gains on equity securities available for sale totaled $9.6 million and $7.5 million, at December 31, 1997, and 1996, respectively. Gross unrealized investment losses were immaterial at December 31, 1997, and 1996.
At December 31, 1997, and 1996, impaired loans totaled $43.4 million and $50.4 million, respectively. Included in the $43.4 million were $20.8 million of loans which had a related allowance for probable losses of $3.5 million, and loans of $22.6 million which had no related allowance for probable losses. Included in the $50.4 million of impaired loans at December 31, 1996, were $38.9 million of loans which had a related allowance for probable losses of $5.7 million, and a loan of $11.5 million which had no related allowance for probable losses.
UNUM was committed at December 31, 1997, to purchase fixed maturities and other invested assets in the amount of $52.8 million.
Additions represent charges to net realized investment gains (losses) less recoveries and deductions represent reserves released upon disposal or restructuring of the related asset.
The interest rates used in the calculation of disability claims reserves at December 31, 1997, and 1996, were principally as follows:
The effects of changes in reserve estimates and assumptions were more significant in 1995, primarily as a result of increased reserves from lower discount rates for certain disability products following the sale of the common stock portfolio, and adjustments to strengthen certain disability reserves in 1995.
Beginning in 1995, as explained in Note 2 "Investments," unpaid claims are adjusted to reflect changes that would have been necessary if the unrealized gains and losses had been realized. Where applicable, UNUM has reflected those adjustments in the liability balances with corresponding credits or charges, net of related deferred taxes, reported as a component of unrealized gains in stockholders' equity.
To effect the sale of the TSA business, UNUM transferred into a trust account held for the benefit of Lincoln approximately $2,690 million of assets. UNUM has recorded a deposit asset in its Consolidated Balance Sheet representing the assets which support the TSA contracts of those contractholders and participants that have not given consent for assumption reinsurance. At December 31, 1997, the deposit asset related to the TSA transaction was approximately $264 million.
The results shown above for the year ended December 31, 1997, include $72.6 million of revenues, reported as fees and other income, $47.0 million of net income and basic and diluted net income per common share of $0.34 and $0.33, respectively, related to the recognition of the deferred pretax gain for those contractholders and participants that have given consent for assumption reinsurance.
On October 23, 1996, UNUM announced the execution of a definitive reinsurance agreement between UNUM America and Centre Life Reinsurance Limited ("Centre Re"), a Bermuda-based reinsurance specialist, for reinsurance coverage of the active life reserves of UNUM America's existing United States non-cancellable individual disability ("ID") block of business. This agreement does not reinsure any claims incurred prior to January 1, 1996. The agreement follows UNUM's announcement in late 1994 that it would no longer market the non-cancellable form of ID coverage in the United States.
The effect of all reinsurance on premiums earned and written for the years ended December 31, 1997, 1996 and 1995 was as follows:
At December 31, 1997, UNUM Corporation had a $500 million committed revolving credit facility that expires on October 1, 2001. UNUM's commercial paper program is supported by the revolving credit facility and is available for general liquidity needs, capital expansion, acquisitions and stock repurchase. The committed revolving credit facility contains certain covenants which, among other provisions, require maintenance of certain levels of stockholders' equity and limits on debt levels.
On December 4, 1997, UNUM borrowed 100 million pounds sterling ($168.3 million) through a private placement with an investor in the United Kingdom. The borrowing has an expected term of 10 years. The borrowing is callable by either party over the life of the agreement, under certain circumstances. UNUM used the net proceeds to repay commercial paper and for general corporate purposes.
Upon issuance of the 100 million pounds sterling borrowing, UNUM entered into currency and interest rate swap agreements that converted the principal amount to U.S. dollars and the interest obligation on the debt from a pound sterling based fixed rate to a U.S. dollar fixed rate.
In the normal course of business, UNUM enters into letters of credit, primarily to satisfy capital requirements related to certain subsidiary transactions. UNUM had outstanding letters of credit of $84.6 million and $56.7 million at December 31, 1997, and 1996, respectively, which are not reflected in the Consolidated Balance Sheets.
Prior to January 1, 1997, UNUM had a noncontributory defined benefit pension plan covering substantially all domestic UNUM employees, excluding employees of D&H and Colonial Companies, who were covered under separate plans. These plans were replaced by the Lifecycle Plan.
On March 14, 1997, UNUM's Board of Directors authorized a two-for-one common stock split, subject to shareholder approval of a proposal to increase the number of authorized shares of common stock. On May 9, 1997, UNUM's shareholders approved an increase in the number of authorized shares of common stock to 240 million from 120 million. The stock split was completed on June 2, 1997, through the distribution of one additional share for each share of stock already issued, to holders of record on May 19, 1997. Accordingly, all numbers of common shares and per common share data have been restated to reflect the stock split. Par value of $10.0 million was transferred to common stock from additional paid-in capital in second quarter 1997.
Effective February 13, 1998, UNUM's Board of Directors approved an expansion of the Company's stock repurchase program by authorizing an additional 4.6 million shares. At February 13, 1998, following the increased authorization, approximately 6.0 million shares of common stock remained authorized for repurchase.
The fair value of each option granted is estimated on the date of grant using a modified Black-Scholes option-pricing model with the following assumptions:
The 1998 Goals Stock Option Plan ("1998 Option Plan") provides for granting to all eligible employees up to 300 options to purchase UNUM Corporation common stock. The options will vest to the employee nine years from the date of grant. Vesting may be accelerated to an earlier date at the discretion of the plan administrator. Grants of 166,200 shares, 205,000 shares and 2,210,700 shares were made in 1997, 1996 and 1995, respectively. No further grants will be made under this plan.
A summary of the status of UNUM's four stock-based compensation plans as of December 31, 1997, 1996 and 1995, and changes during the years then ended is presented below:
Between 1991 and 1994, certain officers were granted limited stock appreciation rights ("LSARs") in conjunction with their options for those years. If a change in control of UNUM Corporation, as defined in the plans, should occur, the option holder can exercise the LSAR. An LSAR is meant to compensate an officer if the associated options lose value due to a change in control by allowing the officer to receive payment for the difference between the option exercise price and the highest price paid per share in connection with the change in control. As an underlying stock option is exercised, the LSARs are automatically canceled. At December 31, 1997, 1996 and 1995, there were 557,800 LSARs, 796,600 LSARs and 961,650 LSARs outstanding, respectively.
UNUM adopted a Shareholder Rights Plan on March 13, 1992. Under the Plan, each Right, under specific circumstances, entitles the holder to purchase one one-hundredth of a share of Series A Junior Participating Preferred Stock at a purchase price of $150. The Rights become exercisable at a specified time after (1) a person or group acquires 10% or more of UNUM Corporation common stock or (2) a tender or exchange offer for 10% or more of UNUM Corporation common stock. The Rights expire at the close of business on March 13, 2002, unless earlier redeemed by the Company under certain circumstances at a price of $0.01 per Right.
UNUM is subject to various state insurance regulatory restrictions that limit the maximum amount of dividends available from its United States domiciled insurance subsidiaries without prior approval. The amount available under current law for payment of dividends during 1998 to UNUM Corporation from all U.S. domiciled insurance subsidiaries without state insurance regulatory approval is approximately $210 million. Dividends in excess of this amount may only be paid with state insurance regulatory approval. The aggregate statutory capital and surplus of the United States domiciled insurance subsidiaries of UNUM Corporation was approximately $1,186 million and $1,205 million, at December 31, 1997, and 1996, respectively. The aggregate statutory net operating income, which excludes realized investment gains and losses net of tax, of UNUM Corporation's United States domiciled insurance subsidiaries was approximately $227 million, $167 million and $143 million for 1997, 1996 and 1995, respectively. State insurance regulatory authorities prescribe statutory accounting practices that differ in certain respects from generally accepted accounting principles. The significant differences relate to deferred acquisition costs, deferred income taxes, non-admitted asset balances, required investment risk reserves and reserve calculation assumptions. UNUM Corporation also has the ability to draw a dividend from its United Kingdom based affiliate, UNUM Limited.
UNUM has not provided for a deferred tax liability of approximately $11 million that arose prior to 1984, which related to the policyholders' surplus accounts of UNUM's life insurance subsidiaries, as management believes the conditions under which such taxes would be paid to be remote.
UNUM subsidiaries had operating loss carryforwards totaling $5.3 million as of December 31, 1997. The operating loss carryforwards will expire, if not utilized, in 1999 through 2003.
Fair values are based on quoted market prices, when available. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. These valuation techniques require management to develop a significant number of assumptions, including discount rates and estimates of future cash flow. Derived fair value estimates cannot be substantiated by comparison to independent markets or to disclosures by other companies with similar financial instruments. These fair value disclosures do not purport to be the amount that could be realized in immediate settlement of the financial instrument.
The following table summarizes the carrying amounts and fair values of UNUM's financial instruments at December 31, 1997, and 1996:
Policy Loans, Short-term Investments, Cash, Accrued Investment Income and Deposit Assets: Fair values for these instruments approximate the carrying amounts reported in the Consolidated Balance Sheets.
Investment-type Insurance Contracts: Fair values for liabilities under investment-type insurance contracts with defined maturities are estimated using discounted cash flow calculations based on interest rates that would be offered currently for similar contracts with maturities consistent with those remaining for the contracts being valued. Fair values for liabilities under investment-type insurance contracts with no defined maturities are the amounts payable on demand after surrender charges at the balance sheet date.
Any resulting gains or losses from early termination of a derivative designated as a hedge are deferred and recognized in income or as an adjustment of the carrying amount of the underlying asset or liability when the hedged transaction occurs. Any gains or losses that result when the designated item is extinguished, such as maturity, sale, or termination, or when the hedged transaction is no longer likely to occur, are included in income in the period in which the extinguishment takes place or it is known that the hedged anticipated transaction will not occur.
On December 4, 1997, UNUM borrowed 100 million pounds sterling ($168.3 million) through a private placement with an investor in the United Kingdom (see Note 8 "Notes Payable"). Upon issuance of the 100 million pounds sterling borrowing, UNUM entered into currency and interest rate swap agreements that converted the principal amount to U.S. dollars and the interest obligation on the debt from a pound sterling based fixed rate to a U.S. dollar fixed rate. No gains or losses on the swap agreements, which qualify for hedge accounting, are recorded while the related debt is outstanding. These swap agreements expire in December 2007 and have notional amounts that equal the principal amount of the loan.
Other than the swap agreements discussed previously, UNUM had no other open derivative financial instruments at December 31, 1997. UNUM had open interest rate futures contracts at December 31, 1996, with notional amounts of $178.2 million to hedge anticipated sales of investments in 1997. These futures contracts had a related net unrealized gain of $1.6 million.
In the normal course of its business operations, UNUM is involved in litigation from time to time with claimants, beneficiaries and others, and a number of lawsuits were pending at December 31, 1997. In some instances, these proceedings include claims for punitive damages and similar types of relief in unspecified or substantial amounts, in addition to amounts for alleged contractual liability or other compensatory damages. In the opinion
of management, the ultimate liability, if any, arising from this litigation is not expected to have a material adverse effect on the consolidated financial position, operating results or liquidity of UNUM.
On December 29, 1993, UNUM filed a suit in the United States District Court for the District of Maine, seeking a federal income tax refund. The suit was based on a claim for a deduction in certain prior tax years for $652 million in cash and stock distributed to policyholders in connection with the 1986 conversion of Union Mutual Life Insurance Company to a stock company. UNUM has fully paid, and provided for in prior years' financial statements, the tax at issue in this litigation. On May 23, 1996, the District Court issued its decision that the distribution in question was not a deductible expenditure. On December 2, 1997, the United States Court of Appeals affirmed the decision of the District Court denying UNUM's claim for refund. UNUM is currently considering whether to request that the United States Supreme Court review the decision of the United States Court of Appeals.
The following is a summary of unaudited quarterly results of operations for 1997 and 1996: