The Company values its available-for-sale fixed maturity and equity securities at fair value, with unrealized holding gains and losses reported as a component of comprehensive income. Companies are required to also adjust deferred acquisition costs and/or certain policyholder liabilities to reflect the changes that would have been necessary if the unrealized investment gains and losses related to the available-for-sale securities had been realized. Prior to the merger, Unum adjusted policyholder liabilities and Provident adjusted deferred policy acquisition costs (DPAC) and value of business acquired (VOBA) for those products where these assets existed. To present financial information in a common reporting format, management has determined that the combined entity will adjust policyholder liabilities rather than DPAC and VOBA. Prior period financial statements have been restated to reflect this reclassification. The reclassification did not change other comprehensive income, accumulated other comprehensive income, or fixed maturity and equity securities. The reclassification reflected in the December 31, 1998, consolidated statement of financial condition resulted in an increase of $329.7 million in DPAC, $1.5 million in VOBA, and $331.2 million in reserves for future policy and contract benefits.
Subsequent to the merger date, the Company began to integrate the valuation procedures of the two organizations to provide for a more effective linking of pricing and reserving assumptions and to facilitate a more efficient process for adjusting liabilities to emerging trends. Included in this integration activity were a review and an update of assumptions that underlie policy and contract benefit liabilities. The purpose of the
The review resulted in an increase in the benefits and reserves for future benefits for the Company's domestic group long-term disability unpaid claim liabilities. As a result of the review, the Company increased its policy and contract benefit liabilities $359.2 million in the third quarter of 1999, which reduced 1999 results $359.2 million before tax and $233.5 million after tax. See Note 2 of the "Notes to Consolidated Financial Statements" for further discussion of these charges and "Liquidity and Capital Resources" for a discussion of capital and financing needs.
During 1999, the Company recorded before-tax expenses related to the merger of approximately $184.7 million ($139.6 million after tax) for severance and related costs, exit costs for duplicate facilities and asset abandonments, and investment banking, legal, and accounting fees. The Company also recorded in 1999 a before-tax expense of approximately $125.9 million ($81.8 million after tax) related to the early retirement offer to the Company's employees. These expenses are reported in the Corporate segment as other operating expenses and are further discussed in the section "Corporate Segment Operating Results." Additionally, in 1999 the Company expensed $24.7 million ($16.1 million after tax) of incremental costs associated with the merger. These incremental costs consist primarily of compensation, training, integration, and licensing costs.
The Company acquired The Paul Revere Corporation (Paul Revere) on March 27, 1997. The financial information contained herein includes the accounts and operating results of Paul Revere from the date of acquisition.
In addition to the increases in benefit liabilities of $599.9 million and the merger-related and early retirement offer expenses of $310.6 million discussed in the previous section, during 1999 the Company recognized $327.8 million of before-tax charges related to its reinsurance operations. These charges are as follows (in millions):
A portion of the losses recognized in 1999 relating to the Company's reinsurance operations does not receive a tax benefit, which unfavorably impacted the effective tax rate. Additionally, a portion of the 1999 expenses related to the merger was non-deductible for federal income tax purposes, resulting in a tax rate that was less than the U.S. federal statutory tax rate of 35 percent.
In 1999, the Company recorded refunds from the Internal Revenue Service relating to the final settlement of remaining issues for the 1986 through 1992 tax years. The refund of taxes was $30.4 million, and interest on the refunds was $35.4 million. Overall, including interest and the tax provision thereon, 1999 results increased $36.8 million due to settlements of prior year tax issues.
In the following discussion of operating results by segment, "revenue" includes premium income, net investment income, and other income. "Income" or "loss" excludes net realized investment gains and losses and federal income taxes.
The increases in premium income result from strong sales trends over the past several quarters as well as an emphasis on renewal of existing business. However, the rate of growth for group disability and group life sales decreased during 1999. Several factors contributed to the decrease in sales, including rate increases, turnover in the field sales force, and merger-related activities (training, office relocation, and new processes and systems). The Company has a number of initiatives underway to help restore sales momentum, including targeted incentive plans, organizational changes to create a greater focus on the customer, and enhanced communication with producers. The Company expects that these actions will favorably impact future sales growth, but management intends to maintain pricing discipline to balance sales growth and profitability which will likely lead to lower long-term sales growth than historically experienced by the Company. Employee Benefits new annualized sales decreased 2.9 percent to $952.5 million in 1999 from $981.1 million 1998. New annualized sales were $804.2 million in 1997.
Premium persistency for group long-term and short-term disability in the fourth quarter of 1999 was lower than historical levels due to several large case terminations, the aggressive renewal program, and the disruption in the field sales force. For both products, the terminated block was less profitable than the total block. It is expected that persistency in 2000 will continue to be lower than historical levels for group disability as well as group life.
Revenue from the managed disability line of business, which includes GENEX Services, Inc. and Options and Choices, Inc., totaled $107.8 million in 1999 compared to $96.2 million in 1998 and $72.8 million in 1997. Both of these companies were acquired during 1997.
Group disability revenue increased to $3,029.0 million in 1999 compared to $2,632.1 million in 1998. Premium income growth was driven primarily by prior period sales. As previously discussed, the rate of growth in new sales declined during 1999. New annualized sales for group long-term disability were $385.2 million in 1999 compared to $441.7 million in 1998. New annualized sales for group short-term disability were $172.0 million in 1999 as compared to $176.2 million in 1998. A critical part of the Company's strategy for group disability during 2000 involves executing an aggressive renewal program and managing persistency, both of which management expects will have a positive impact on future premium growth and profitability. However, the lower than historical premium persistency experienced during the fourth quarter of 1999 will have a negative impact on future premium income. The Company is implementing pricing changes in the group disability line. Prices will increase or decrease by market segment, as appropriate, to respond to current claim experience and various other factors and assumptions.
Net investment income is expected to continue to increase due to the increase in the level of invested assets allocated to this line of business and also due to the portfolio restructuring, as discussed in "Investments."
The Individual segment includes results from the individual disability, individual life, and individual long-term care lines of business.
Income in the individual disability line of business decreased to $190.0 million in 1998 from $207.5 million in 1997. As noted in the "Employee Benefits Segment Operating Results," claim resolution rates were revised downward in the fourth quarter of 1998 for claim operations integration activities related to the merger. The Company recorded a $100.3 million charge in the fourth quarter of 1998 in the Individual segment related to the revised claim resolution rates for individual disability. At December 31, 1998, management assumed the revised individual disability claim resolution rates for the first, second, third, and fourth quarters of 1999 to be 90, 90, 85, and 90 percent of assumptions, before adjusting for the impact of the claim operations integration activities. The actual experience for the Company was 89 percent in the first quarter, 90 percent in the second quarter, 93 percent in the third quarter, and 95 percent in the fourth quarter of 1999. If the impact of merger-related claim operations integration activities on claim durations had not been anticipated at December 31, 1998, income for the individual disability line of business would have been negatively impacted by $100.3 million in 1999. In addition, the excess of the actual 1999 experience over that assumed resulted in a positive effect on income of $25.6 million. The $100.3 million reserve increase in the Individual segment was not considered material from a capital adequacy position. See Note 7 of the "Notes to Consolidated Financial Statements" for further discussion.
The individual long-term care line of business reported increased premium income for both 1999 and 1998 as compared to the previous year, primarily due to new sales growth. New annualized sales were $40.0 million for 1999, an increase of 70.2 percent over the $23.5 million reported in 1998. New annualized sales were $14.8 million in 1997. The Company expects the strong sales momentum in individual long-term care to continue.
Income in the individual life and long-term care lines of business increased slightly to $33.2 million in 1999 from $32.6 million in 1998. The benefit ratio and operating expense ratio for individual life improved in 1999 as compared to 1998. The 1999 operating expense ratio for long-term care also compares favorably with 1998. Income in the individual life and long-term care lines of business was $32.6 million in 1997. The increase in premium income for 1998 was offset by a less favorable benefit ratio.
Revenue in the Voluntary Benefits segment increased to $804.5 million in 1999 from $770.4 million 1998. Sales growth and favorable persistency were the primary factors contributing to the increase in premium income. New annualized sales in this segment were $245.3 million in 1999, $233.8 million in 1998, and $253.5 million in 1997. Management continues its efforts to increase sales through the realignment of the sales organization and the enhancement of collaborative sales. However, these sales are not necessarily indicative of the levels that may be attained in the future.
During the first quarter of 1999, the Company began a comprehensive strategic review of its reinsurance operations to determine the appropriateness of their fit within the context of the merged entity. These operations include the reinsurance management operations of Duncanson & Holt, Inc. (D&H) and the risk assumption, which includes reinsurance pool participation; direct reinsurance which includes accident and health (A&H), long-term care (LTC), and long-term disability coverages; and Lloyd's of London (Lloyd's) syndicate participations. In April 1999, the strategic review was completed, and the Company concluded that these operations were not solidly aligned with the Company's strength in the disability insurance market. The Company decided to exit these operations through a combination of a sale, reinsurance, and/or placing certain components in run-off and recorded a first quarter charge of $74.1 million in the Other segment. During the first and second quarters of 1999, the Company recorded $27.0 million and $2.0 million, respectively, in the Corporate segment related to the write-off of goodwill.
During the third quarter of 1999, the Company continued its efforts to sell its reinsurance management operations. No potential buyers expressed interest in acquiring the entire domestic and international reinsurance management operations. However, in October 1999, the Company entered into an agreement to sell the reinsurance management operations of its A&H and LTC reinsurance facilities and to reinsure the Company's risk participation in these facilities.
Because of the limited interest expressed by potential buyers in the reinsurance management operations, the Company reevaluated its strategy to exit the reinsurance operations. The Company decided to continue to operate its North America long-term disability reinsurance operation and to refocus it with the objective of improving profitability. With respect to Lloyd's, the Company decided to implement a strategy which limits participation in year 2000 underwriting risks, ceases participation in Lloyd's underwriting risks after year 2000, and manages the run-off of its risk participation in open years of account of Lloyd's reinsurance syndicates. The Company also decided to discontinue its accident reinsurance business in London beginning in year 2000. During the third quarter of 1999, the Company recognized a charge of $193.3 million in the Other segment and $28.7 million in the Corporate segment related to the write-off of goodwill. An additional loss of $2.7 million was realized in the fourth quarter of 1999 upon completion of the transaction to reinsure the A&H and LTC risk participations. See Note 13 of the "Notes to Consolidated Financial Statements" for further discussion of the 1999 charges related to the reinsurance businesses.
As discussed in the preceding "Accounting Policy Changes, Financial Statement Reclassifications, and Merger Expenses," the Company lowered the discount rate used to calculate certain of Unum's disability claim reserves to conform with Provident's process and assumptions, which decreased group long- term disability reinsurance income by $10.1 million in 1999.
integration activities on claim duration had not been anticipated at December 31, 1998, 1999 income for the reinsurance pools and management line of business would have been negatively impacted by $2.4 million. See Note 7 of the "Notes to Consolidated Financial Statements" for further discussion.
During the fourth quarter of 1997, certain reinsurance pools managed by the Company's reinsurance management operations 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 strengthened claim reserves. The impact to the Company from these pool claim reserve increases was an $11.7 million reduction in other income and a $6.7 million increase in benefits to policyholders, reducing 1997 before-tax income by $18.4 million. The $11.7 million reduction in other income reflected lower profit commission levels in certain older pool years after the pool claim reserve strengthening. The $6.7 million increase in benefits to policyholders represented the amount of additional claim reserves the Company recognized as a result of its participation in the pools that strengthened claim reserves.
Income from this line of business was $29.8 million in 1999, $27.9 million in 1998, and $19.4 million in 1997. The 1999 results reflect slightly higher premium income and wider spreads between interest earned and credited rates. The increase in 1998 was due to wider spreads between interest earned and credited rates and a decrease in commissions and operating expenses.
Income in the group pension line of business was $26.6 million in 1999, $23.2 million in 1998, and $111.6 million in 1997. In the fourth quarter of 1996, the Company closed the sale of certain of Unum's group tax-sheltered annuity businesses to affiliates of Lincoln National Corporation. The sale resulted in a deferred before-tax gain of which $72.6 million was recognized in income during 1997. Also contributing to the decrease in 1998 income was an $8.0 million reserve strengthening for group single premium annuities and a $1.9 million charge for guaranty fund assessments. The run-off of the group pension line results in a decline in assets under management and, in turn, a continued decline in the net investment income produced by the assets.
Effective January 1, 1998, the Company entered into an agreement with Connecticut General Life Insurance Company (Connecticut General) for Connecticut General to reinsure, on a 100 percent coinsurance basis, its in- force medical stop-loss insurance coverages sold to clients of CIGNA Healthcare and its affiliates (CIGNA). This reinsured block constitutes substantially all of the Company's medical stop-loss insurance business. The small portion remaining consists of medical stop-loss coverages sold to clients other than those of CIGNA. The medical stop-loss business produced revenue of $14.1 million in 1998.
Employee related expense consists of employee severance costs, change in control costs, restricted stock costs which fully vested upon stockholder adoption of the merger agreement or upon completion of the merger, and outplacement costs to assist employees who are involuntarily terminated. Severance benefits and change in control costs are $60.2 million, and costs associated with the vesting of restricted stock are $17.5 million. The Company estimates that in total approximately 1,615 positions will be eliminated over a twelve month period beginning June 30, 1999, 215 positions higher than the original estimate of 1,400. Approximately 1,000 of these positions will be eliminated through the early retirement offer. As of December 31, 1999, approximately 800 and 580 positions had been eliminated as a result of the early retirement offer and involuntary terminations, respectively, and $26.5 million of the estimated $60.2 million had been paid for severance benefits and change in control costs.
Exit activities related to duplicate facilities/asset abandonments consist of closing of duplicate offices and write-off of redundant computer hardware and software. The Company currently expects to close approximately 90 duplicate field offices over a period of one year after June 30, 1999. The cost associated with these office closures is approximately $25.6 million, which represents the cost of future minimum lease payments less any estimated amounts recovered under subleases. As of December 31, 1999, $3.7 million of this estimated liability had been paid. Also, certain physical assets, primarily computer equipment, redundant systems, and systems incapable of supporting the combined entity, have been abandoned as a result of the merger. This abandonment resulted in a write-down of the assets' book values by approximately $41.8 million during 1999.
Of the $39.6 million of investment banking, legal, and accounting fees, $39.1 million was paid in 1999.
These expenses are $77.6 million higher on a before-tax basis than the estimated expenses disclosed in the Joint Proxy Statement/Prospectus of Unum and Provident dated June 2, 1999. This increase results from approximately 350 more employees than estimated accepting the early retirement offer, approximately 215 additional positions which will be eliminated during the twelve month post-merger period, additional change in control costs of $27.4 million, and the identification of additional software redundancies.
In addition to the expenses described above, in 1999, the Company expensed $24.7 million of other incremental costs associated with the merger, $21.8 million of which are included in the Corporate segment. These expenses consist primarily of compensation, training, integration, and licensing costs.
During 1999, the Company actively pursued its strategy of extending the duration of its investments and shifting the mix of assets for approximately $2.1 billion of its investments. This program was approximately 81 percent complete as of December 31, 1999, with total completion expected in the first half of 2000. Management believes this strategy will reduce its vulnerability to interest rate risk in the future and anticipates that, as a result, investment income may increase on an annualized basis approximately $40 million.
The Company's investment in mortgage-backed securities was approximately $3.1 billion and $2.1 billion on an amortized cost basis at December 31, 1999 and 1998, respectively. At December 31, 1999, the mortgage-backed securities had an average life of 11.1 years and effective duration of 10.1 years. The mortgage-backed securities are valued on a monthly basis using valuations supplied by the brokerage firms that are dealers in these securities. The primary risk involved in investing in mortgage-backed securities is the uncertainty of the timing of cash flows from the underlying loans due to prepayment of principal. The Company uses models which incorporate economic variables and possible future interest rate scenarios to predict future prepayment rates. The Company has not invested in mortgage-backed derivatives, such as interest-only, principal-only or residuals, where market values can be highly volatile relative to changes in interest rates.
Below-investment-grade bonds are inherently more risky than investment-grade bonds since the risk of default by the issuer, by definition and as exhibited by bond rating, is higher. Also, the secondary market for certain below- investment-grade issues can be highly illiquid. Management does not anticipate any liquidity problem caused by the investments in below-investment-grade securities, nor does it expect these investments to adversely affect its ability to hold its other investments to maturity.
The Company's exposure to below-investment-grade fixed maturity securities at December 31, 1999, was $2,147.4 million, representing 8.1 percent of invested assets, below the Company's internal limit of 10.0 percent of invested assets for this type of investment. The Company's exposure to below-investment- grade fixed maturities totaled $1,452.6 million at December 31, 1998, representing 5.3 percent of invested assets.
Allowances for probable losses on mortgage loans and real estate held for sale are established based on a review of specific assets as well as on an overall portfolio basis, considering the value of the underlying assets and collateral. If a decline in value is considered to be other than temporary or if the asset is deemed permanently impaired, the investment is reduced to estimated net realizable value, and the reduction is recorded as a realized investment loss. The allowance for probable losses on mortgage loans and real estate was $32.9 million and $37.8 million, respectively, at December 31, 1999. Management monitors the risk associated with the invested asset portfolio and regularly reviews and adjusts the allowance for probable losses.
The Company's exposure to non-current investments totaled $20.6 million at December 31, 1999, or 0.1 percent of invested assets. These non-current investments are foreclosed real estate held for sale and fixed income securities and mortgage loans that became more than thirty days past due in principal and interest payments.
The Company believes the cash flows from its operations will be sufficient to meet its operating and financial cash flow requirements, excluding the strain placed on capital as a result of the charges recorded in connection with the merger. As a result of the effect on capital during 1999 of the merger related charges, the Company raised approximately $500 million through the debt markets during the fourth quarter of 1999 by securing $200 million of one-year bank debt and by issuing commercial paper. The Company is exploring alternative financing sources to further increase its financial flexibility. The Company intends to file a shelf registration during the first half of 2000 in order to provide funding flexibility through the issuance of debt and equity securities. Any funding will be used to refinance short-term debt on a long-term basis and to fund internal expansion, acquisitions, investment opportunities, and the retirement of the Company's debt and equity. For all of 1999, the Company raised approximately $700 million of capital in the debt markets.
. in 1999, $303.3 million was available for the payment of dividends to the Company from its domestic insurance subsidiaries, and approximately $20.0 million was available for the payment of dividends from Unum Limited, and
. in 2000, $267.6 million will be available for the payment of dividends to the Company from its domestic insurance subsidiaries, and approximately $24.9 million will be available for the payment of dividends from Unum Limited.
In April 1998, the Company entered into a $150.0 million five-year revolving credit facility and a $150.0 million 364-day revolving credit facility with various domestic and international banks. The purpose of these two facilities was for general corporate uses. These two facilities terminated in June 1999 with the close of the merger.
In the fourth quarter of 1998, the Company rescinded its stock repurchase program as a result of the pending merger. During 1998 and 1997, the Company acquired approximately 1.4 million and 7.1 million shares, respectively, of its common stock in the open market at an aggregate cost of $72.7 million and $286.7 million, respectively.
implications, and AM Best placed a negative rating outlook on its current ratings. Duff & Phelps removed all ratings of the Company from its previous Rating Watch-Up status and reaffirmed the ratings at their current levels.
As are many other businesses in this country and abroad, the Company is affected in numerous ways, both by its own computer information systems and by third parties with which it has business relationships, in the processing of date data relating to the year 2000 and beyond. Failure to have adequately addressed and substantially resolved year 2000 issues could have had, and as to mission critical systems in certain circumstances would have had, a material adverse effect on the Company's business, results of operations, or financial condition. While there can be no assurance as to its long-term success, the Company completed a project which was intended and designed to avoid and/or mitigate any such material adverse effect from year 2000 issues. The Company's program for the year 2000 was organized into a number of phases for rectifying its internal computer systems, including assessment, code remediation, testing, and deployment. The program continues to monitor systems for year 2000 issues, including the ability to properly handle the dates of
February 29, March 31, June 30, October 10, and December 31, 2000 and February 28 and December 31, 2001. To date, no material issues have been identified.
The effort of internal business and systems personnel devoted to the project has been considerable. Temporary personnel and subject matter consultants were utilized, when appropriate, to assist full time personnel in some phases or aspects of the project. The Company utilized compensation programs to retain project personnel in order to keep the project on schedule. While the project required systems management to more closely scrutinize the prioritization of information technology projects, it is not believed that any deferral of information technology projects has had a material impact on the Company. The Company also had occasional contact with certain peer companies comparing approaches to year 2000 issues. Monitoring for and responding to year 2000 issues is now an integral part of the regular assignments of systems personnel.
In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of UnumProvident Corporation and subsidiaries at December 31, 1999 and 1998, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1999 after giving retroactive effect to the merger of Unum Corporation, as described in the notes to the consolidated financial statements, in conformity with accounting principles generally accepted in the United States. Also in our opinion, based on our audits and the report of other auditors, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
In our opinion, the consolidated balance sheets and the related consolidated statements of income, comprehensive income, stockholders' equity and cash flows present fairly, in all material respects, the financial position of the former Unum Corporation and its subsidiaries at December 31, 1998, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Corporation's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes 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. We believe that our audits provide a reasonable basis for the opinion expressed above.
The accompanying consolidated financial statements have been prepared on the basis of accounting principles generally accepted in the United States (GAAP). Such accounting principles differ from statutory accounting practices prescribed or permitted by state regulatory authorities (see Note 18). The consolidated financial statements include the accounts of UnumProvident Corporation and its subsidiaries. Material intercompany transactions have been eliminated.
Operations: The Company does business primarily in North America and operates principally in the life and health insurance business. The Employee Benefits segment includes group long-term and short-term disability insurance, group life insurance, accidental death and dismemberment coverages, group long-term care, and the results of managed disability. The Individual segment includes results from the individual disability, individual life, and individual long-term care lines of business. The Voluntary Benefits segment includes the results of products sold to employees through payroll deduction at the work site. These products include life insurance and health products, primarily disability, accident and sickness, and cancer. The Other operating segment includes results from products no longer actively marketed, including corporate-owned life insurance, group pension, health insurance, individual annuities, and reinsurance pools and management. The Corporate segment includes investment earnings on corporate assets not specifically allocated to a line of business, corporate interest expense, amortization of goodwill, and certain corporate expenses not allocated to a line of business. See Note 14 for further information on the operating segments.
Real Estate classified as investment real estate is carried at cost less accumulated depreciation. Real estate acquired through foreclosure is valued at fair value at the date of foreclosure. If investment real estate is determined to be permanently impaired, the carrying amount of the asset is reduced to fair value. Occasionally, investment real estate is reclassified to real estate held for sale when it no longer meets the Company's investment criteria. Real estate held for sale is valued net of a valuation allowance that reduces the carrying value to the lower of cost less accumulated depreciation or fair value less estimated cost to sell. Accumulated depreciation on real estate was $42.8 million and $48.5 million as of December 31, 1999 and 1998, respectively.
Option Contracts give the owner the right, but not the obligation, to buy or sell a financial instrument at an agreed-upon price on or before a specific date. The purchasing counterparty pays a premium to the selling counterparty for this right. The notional amounts of contracts represent the Company's involvement but not the future cash requirements, as the Company intends to close out contracts prior to the expiration date when the market price of the underlying financial instrument exceeds the option price or allow contracts to expire if the option price exceeds the market price. All of the Company's options contracts are accounted for as hedges. The book and fair values of options contracts are reported in the consolidated statements of financial condition in a manner similar to the underlying hedged item. Gains or losses on the termination of options contracts are accounted for in the same manner as interest rate swap agreements.
Value of Business Acquired: Value of business acquired represents the present value of future profits recorded in connection with the acquisition of a block of insurance policies. The asset is amortized based upon expected future premium income for traditional insurance policies and estimated future gross profits for interest-sensitive insurance policies, with the accrual of interest added to the unamortized balance at interest rates principally ranging from 5.55 percent to 7.60 percent. The accumulated amortization for value of business acquired was $133.2 million and $94.9 million as of December 31, 1999 and 1998, respectively. The Company periodically reviews the carrying amount of value of business acquired using the same methods used to evaluate deferred policy acquisition costs.
Goodwill: Goodwill is the excess of the amount paid to acquire a business over the fair value of the net assets acquired. Goodwill is amortized on a straight-line basis over a period not to exceed 40 years. The accumulated amortization for goodwill was $64.1 million and $63.8 million as of December 31, 1999 and 1998, respectively. The carrying amount of goodwill is reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount might not be recoverable. If estimated future undiscounted net cash flows expected to be generated from the operations to which the goodwill relates are less than the carrying amount of the unamortized goodwill, the carrying amount is reduced with a corresponding charge to expense.
Disabled lives reserves for future policy and contract benefits on disability policies are calculated based upon assumptions as to interest and claim termination rates that are currently appropriate. Claim termination rate assumptions are based upon industry standards adjusted as appropriate to reflect actual Company experience. The assumptions vary by year of claim incurral and may include a provision for adverse deviation. The interest rate assumptions used for discounting claim reserves are based on projected portfolio yield rates, after consideration for defaults and investment expenses, for the assets supporting the liabilities for the various product lines. The assets for each product line are selected according to the specific investment strategy for that product line to produce asset cash flows that follow similar timing and amount patterns to those of the anticipated liability payments.
retirement that were appropriate at the date of issue. Mortality assumptions are based upon industry standards adjusted as appropriate to reflect actual Company experience. The assumptions vary by year of issue and include a provision for adverse deviation.
The interest rate assumptions used to calculate reserves for future policy and contract benefits are as follows:
Interest assumptions for active life reserves are generally graded downward over a period of years. Reserves for future policy and contract benefits on interest-sensitive products are principally policyholder account values determined on the retrospective deposit method.
Translation of Foreign Currency: Revenues and expenses of the Company's foreign operations, principally Canada and the United Kingdom, are translated at average exchange rates. Assets and liabilities are
translated at the rate of exchange on the balance sheet date. The translation gain or loss is generally reported in accumulated other comprehensive income (loss), net of deferred tax.
Accounting for Stock-Based Compensation: The Company measures compensation cost for stock-based compensation under the expense recognition provisions of Accounting Principles Board Opinion No. 25 (Opinion 25), Accounting for Stock Issued to Employees. Under this method, compensation cost is the excess, if any, of the quoted market price at grant date or other measurement date over the amount an employee must pay to acquire the stock.
The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation as follows:
Statement of Position 98-7 (SOP 98-7), Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk
On June 30, 1999, prior to the completion of the merger, each outstanding share of Provident common stock was reclassified and converted into 0.73 of a share of Provident common stock. Immediately after this reclassification, the merger was completed, and each share of Unum common stock issued and outstanding immediately prior to the merger was converted into one share of the Company's common stock, and the par value was reduced from $1.00 to $0.10 per share. In the merger, the shares of Provident common stock were not further affected, but thereafter became shares of the Company's common stock. Unum common stock held in treasury was retired. Stockholders' equity and per share amounts have been adjusted to reflect these items.
During the second and third quarter of 1999, the Company recognized expenses related to the merger and the early retirement offer to employees as follows (in millions):
Employee related expense consists of employee severance costs, change in control costs, restricted stock costs which fully vested upon stockholder adoption of the merger agreement or upon completion of the merger, and outplacement costs to assist employees who have been involuntarily terminated. Severance benefits and change in control costs are $60.2 million, and costs associated with the vesting of restricted stock are $17.5 million. The Company estimates that in total approximately 1,615 positions will be eliminated over a twelve month period beginning June 30, 1999. Approximately 1,000 of these positions will be eliminated through the early retirement offer. As of December 31, 1999, approximately 800 and 580 positions have been eliminated as a result of the early retirement offer and involuntary terminations, respectively, and $26.5 million of the estimated $60.2 million has been paid for severance benefits and change in control costs.
Additionally during 1999, 0.5 million shares of outstanding restricted stock became unrestricted and stock options on 5.3 million shares became immediately exercisable effective with the merger, in accordance with Unum's and Provident's restricted stock and stock option plan provisions concerning a change in control. The expense related to restricted stock vesting has been included in merger related expenses. The Company applies Opinion 25 and related interpretations in accounting for the stock option plans. Accordingly, no compensation cost was recognized for stock option vesting.
Generally, because of the effort and time involved, reviews and updates of assumptions related to benefit liabilities are periodically undertaken over time and are reflected in the calculation of benefit liabilities as
completed. Many factors influence assumptions underlying reserves, and considerable judgment is required to interpret current and historical experience underlying all of the assumptions and to assess the future factors that are likely to influence the ultimate cost of settling existing claims.
Prior to the merger, Unum's process and assumptions used to calculate the discount rate for claim reserves of certain disability businesses differed from that used by Provident. While Unum's and Provident's methods were both in accordance with GAAP, management believed that the combined entity should have consistent discount rate accounting policies and methods for applying those policies for similar products. Unum's former methodology used the same investment strategy for assets backing both liabilities and surplus. Provident's methodology, which allows for different investment strategies for assets backing surplus than those backing product liabilities, was determined by management to be the more appropriate approach for the Company. Accordingly, at June 30, 1999 the Company adopted Provident's method of calculating the discount rate for claim reserves.
The review resulted in an increase in the benefits and reserves for future benefits for the Company's domestic and Canadian group long-term disability unpaid claim liabilities. As a result of the review, the Company increased its policy and contract benefit liabilities $359.2 million, which reduced 1999 earnings $359.2 million before tax and $233.5 million after tax during the third quarter.
The increase in policy and contract benefit liabilities primarily resulted from revisions to assumptions in the following three key components: claim termination rates, incurred but not reported (IBNR) factors, and discount rates. These components and their effect on the reserve increase are summarized and discussed below (in millions).
The updated assumptions will be reflected in new and renewal pricing actions, and a higher benefit ratio is expected over the next several quarters until the effect of pricing actions is reflected in premium income. Actual experience could fluctuate from these assumptions, and such fluctuations may have a material positive or negative effect on earnings.
Short-term Investments, Cash and Bank Deposits, and Deposit Assets: Carrying amounts for short-term investments, cash and bank deposits, and deposit assets approximate fair value.
At December 31, 1999, the total investment in below-investment-grade fixed maturity securities (securities rated below Baa3 by Moody's Investors Service or an equivalent internal rating) was $2,147.4 million or 8.1 percent of invested assets. The amortized cost of these securities was $2,205.3 million.
Deposit assets in the form of marketable securities held in trust are reported in other assets in the consolidated statements of financial condition. Unrealized gains (losses) on these securities were $(25.9) million and $211.6 million, respectively, at December 31, 1999 and 1998.
To help limit the credit exposure of the derivatives, the Company has entered into master netting agreements with its counterparties whereby contracts in a gain position can be offset against contracts in a loss
The Company has executed a series of cash flow hedges in the group disability, individual disability, and the group single premium annuities portfolios using interest rate swaps, forwards, futures, and options. The purpose of these hedges is to lock in the reinvestment rates on future cash flows and protect the Company from the potential adverse impact of declining interest rates on the associated policy reserves. The Company uses
In 1999, 1998, and 1997, the Company amortized into net investment income $3.1 million, $1.9 million, and $0.6 million, respectively, of the deferred gains from this program. Realized investment gains and losses from this program during 1999, 1998 and 1997 were immaterial.
In 1998 and 1997, the Company sold indexed annuity products whereby a portion of the crediting rate on the annuity was based on the performance of the S&P 500 stock index. In order to hedge this fluctuating credit rate, the Company purchased options with the S&P 500 stock index as the underlying item. These options will be settled with a net cash payment to the Company at the expiration date if the S&P 500 index moves above the option contract's strike price; otherwise, no cash payment will take place at expiration. At December 31, 1999, the outstanding notional amount of these options was $7.3 million, and the fair value and carrying amount were $5.9 million.
In 1997, the Company borrowed $168.3 million through a private placement with an investor in the United Kingdom. Upon issuance of the borrowing, the Company entered into foreign 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. The private placement issue was settled in 1999, and the hedging arrangement was terminated.
The deferred gain amortized into earnings in the consolidated statements of operations was $1.3 million, $1.3 million, and $2.0 million for the years ended December 31, 1999, 1998, and 1997, respectively.
In 1994, the Company announced that it would discontinue the sale of traditional GICs. At that time, the Company decided to convert from a duration matching investment approach to a cash flow matching investment approach for its GIC business. The Company hedged the risk that a rise in interest rates would reduce the price on future sales of assets which would be necessary to fund maturing liabilities by entering into forward interest rate swaps (receive variable/pay fixed).
At December 31, 1999, the Company had no open contracts under this program.
These studies, which were not available for the Paul Revere business at the time of the acquisition, allowed management to gain a greater understanding of the impact of the claims integration activities on the claim resolution rates of the Paul Revere business. These studies show that the Paul Revere business experienced a decline in its claim resolution rates from a base in 1995 of 100 percent to 90.4 percent in 1996 and 80.3 percent in 1997. Changes in morbidity and other factors were considered and reviewed to determine that a primary cause of the reduced claim resolution rates was the disruption caused by the change in the claims management process. Although the circumstances of the merger are very different from the Paul Revere acquisition, the claims integration activities are similar, and the Paul Revere experience is relevant. The primary circumstances that created claims disruption for Paul Revere were the initial lack of clarity of the organization, process, and structure, the need to plan for a significant transition to new claims processes, and the training and implementation related to those changes. All of those elements have impacted the Company as a result of the merger. One primary difference is that the duration of the potential disruption in the merger is not expected to be as long as was the case with the Paul Revere acquisition. The Company's revised claim resolution rates assumed for the first two quarters of 1999 were compared to the Paul Revere experience in 1996, the period preceding the acquisition. It was determined that the revised assumptions appeared to be reasonable. During the third and fourth quarters of 1999, the claims integration plans provide for increased activity due to training and implementation of new processes. The Company's revised claim resolution rates for the third and fourth quarters of 1999 were compared to the Paul Revere experience in 1997 during the implementation and training phase of the Paul Revere claims organization when claims resolution rates declined to 80.3 percent of prior levels. Management judged that it was reasonable to assume that the impact to the Company would be less than it was to Paul Revere since some of the Company's claims management practices will not change. The historical experience of Paul Revere provides a statistical reference for the expected experience for the Company when adjusted for the projected effects of the claims integration plans.
The Company has a $500.0 million revolving credit facility which expires October 31, 2000 and a $500.0 million revolving credit facility which expires October 1, 2001. The Company's commercial paper program, which was increased to $1.0 billion during 1999, is supported by the revolving credit facilities and is available for general liquidity needs, capital expansion, and acquisitions. The revolving credit facilities contain certain covenants that, among other provisions, require maintenance of certain levels of stockholders' equity and limits on debt levels. At December 31, 1999, approximately $396.0 million was available for additional financing under the Company's existing revolving credit facilities.
The weighted average assumptions used in the measurement of the Company's benefit obligation as of December 31, 1999 and 1998 are as follows:
The assumed health care cost trend rate has a significant effect on the amounts reported. A one percent change in the assumed health care cost trend rate would have the following effects:
The following table provides the components of the net periodic benefit cost (credit) and early retirement cost for the plans during 1999, 1998, and 1997.
In accordance with the restated certificate of incorporation, the Company has 25,000,000 shares of preferred stock authorized with a par value of $0.10 per share. No preferred shares have been issued to date.
The Company has several annual incentive plans for certain employees and executive officers that are designed to encourage achievement of certain goals. Compensation cost recognized in the consolidated statements of operations for annual incentive plans is $6.6 million, $38.1 million, and $43.6 million for 1999, 1998, and 1997, respectively.
Under the Stock Plan of 1999 (Stock Plan), the Company has available up to 7,500,000 shares of common stock for awards to its employees, officers, producers, and directors. Awards may be in the form of stock options, stock appreciation rights, restricted stock awards, dividend equivalent awards, or any other right or interest relating to stock. The number of shares available to be issued as restricted stock or unrestricted stock awards is limited to 2,250,000 shares. The exercise price for stock options issued under the Stock Plan shall not be less than the fair market value of the Company's stock as of the grant date. The options have a maximum term of ten years after the date of grant.
The Company granted 392; 145,180; and 419,639 shares of restricted stock to certain employees during 1999, 1998, and 1997 with a weighted average grant date fair value of $56.65, $52.05, and $38.11 per common share, respectively.
Substantially all of the Company's employees are eligible to participate in an ESPP. Under the plan, up to 1,460,000 shares of the Company's common stock are authorized for issuance. Stock may be purchased at the end of each financial quarter at a purchase price of 85 percent of the lower of its beginning or end of quarter market prices. The Company sold 86,497, 75,575 and 79,423 shares to employees with a weighted average exercise price of $31.71, $39.00, and $33.74 per share in 1999, 1998, and 1997, respectively.
Assumptions used in estimating compensation cost for Unum plans during 1998 and 1997 are as follows:
The following discloses the various layers in the agreement at December 31, 1999 (in millions):
under this agreement. All premiums, less amounts for management expenses and claim payments, are transferred to the trust account on a quarterly basis. The Company also acts as the investment manager for 80 percent of the assets in the trust with Centre Re managing the remaining 20 percent.
During the first quarter of 1999, the Company began a comprehensive strategic review of its reinsurance operations to determine the appropriateness of their fit within the context of the merged entity. These operations include the reinsurance management operations of the Company's subsidiary Duncanson & Holt, Inc. (D&H) and the risk assumption, which includes reinsurance pool participation; direct reinsurance which includes accident and health (A&H), long-term care (LTC), and long-term disability coverages; and Lloyd's syndicate participations. In April 1999, the strategic review was completed, and the Company concluded that these operations were not solidly aligned with the Company's strength in the disability insurance market. The Company decided to exit these operations through a combination of a sale, reinsurance, and/or placing certain components in run-off.
Provision for Losses on Retained Business--As a result of the review performed on the Lloyd's syndicates discussed above and other third party publicized reinsurance exposures, the Company undertook a periodic review of certain other reinsurance facilities related to new information regarding the ultimate cost of settling claims. The reinsurance pool business consists of more than 20 different pool facilities, the majority of which are managed by D&H and a few pools which are managed by third parties. Reserve assumptions are periodically reviewed to support the determination of the ultimate cost of settling claims for certain reinsurance pools. During the first quarter of 1999, the Company reviewed the actuarial assumptions used to set reserves for certain reinsurance facilities based on the most current information available from the reinsurance pool managers. The Company also received new information pertaining to a reinsurance pool managed by a third party that indicated a reserve increase was required. The Company relied primarily on the third party pool manager's judgement and recorded its portion of the reserve as reflected in the reinsurance pool statement from the third party pool manager. The new information received from the managed facilities and the third party facility indicated deterioration in loss experience, primarily related to a longer duration of claims and increased incidence of new claims in certain facilities. The result of these reviews was an increase to claim reserves of $28.6 million, which was recorded in the first quarter of 1999. The Company determined that the increase to reserves was needed based on revised actuarial assumptions to reflect current and expected trends in claims experience and expenses.
As a result of the impairment, the Company calculated the estimated fair value of these operations. In estimating the fair value, two valuation techniques were utilized, a discount free cash flow model and a multiple of earnings model. The Company believed that these valuation techniques were appropriate for this type of business as these techniques were what the Company would use in evaluating a potential acquisition of this type of business. The results of the two valuation techniques created a range of fair values from $47.0 million to $64.0 million. The Company evaluated the range of values produced by the valuation techniques and using internal management judgement of the potential liquidation value, the Company determined its best estimate of fair value of its investment to be the midpoint of the range, or $55.0 million. The estimated fair value of $55.0 million was compared to $82.0 million of book value for the investment, resulting in a write-down of goodwill in the amount of $27.0 million in the first quarter of 1999.
In the second quarter of 1999, the Company stated its intent to sell its reinsurance management operations, assuming the transaction would achieve the Company's financial objectives. The Company estimated the fair value of the operations using the held-for-sale model, which compares the carrying value of the asset with the fair value less costs to sell the asset. This resulted in an additional write-down of goodwill in the amount of $2.0 million before and after tax.
During the third quarter of 1999, the Company continued its efforts to sell its reinsurance management operations. No potential buyers expressed interest in acquiring the entire domestic and international reinsurance management operations. However, in October, the Company entered into an agreement to sell the reinsurance management operations of its A&H and LTC reinsurance facilities and to reinsure the Company's risk participation in these facilities.
Because of the limited interest expressed by potential buyers in the reinsurance management operations, the Company reevaluated its strategy to exit the reinsurance operations. At that time, the Company intended to continue to operate its North America long-term disability reinsurance operation and to refocus it with the objective of improving profitability. With respect to Lloyd's, the Company decided to implement a strategy which limits participation in year 2000 underwriting risks, ceases participation in Lloyd's underwriting risks after year 2000, and manages the run-off of its risk participation in open years of account of Lloyd's reinsurance syndicates. The Company also decided to discontinue its accident reinsurance business in London beginning in year 2000. During the third quarter, the Company recognized a charge of $222.0 million before tax and $204.3 million after tax related to its strategy for the reinsurance operations. The charge consisted of the following:
Loss on Sale of A&H and LTC Reinsurance Management Operations--In the third quarter of 1999 the Company entered into an agreement with American United Life Insurance Company (AUL) to sell the reinsurance management operations of its A&H and LTC reinsurance facilities and to reinsure the Company's risk participation in these facilities. Certain risks related to prior operations have not been assumed by AUL. The terms of the sale require the Company to continue to participate in certain of the reinsurance facilities in year 2000, thereby assuming underwriting risks. The sale closed effective January 1, 2000. A before-tax loss of $12.9 million was recognized in the third quarter of 1999 based upon the terms and conditions of the definitive agreement. The loss includes the write-off of $6.0 million of goodwill related to this portion of the operations.
Provision for Loss on Reinsurance of A&H and LTC Risk Participations-- The Company entered into a separate indemnity reinsurance agreement with AUL whereby AUL will assume the Company's existing risk participation in the A&H and LTC reinsurance facilities. As a result, the Company recognized a third quarter before-tax loss of $10.0 million.
Consistent with overall market trends, the loss estimates received from the underwriters of syndicates managed by a subsidiary of the Company indicated significant deterioration in the loss experience of open years of account from their previous estimate. This information was discussed with underwriters and used by the Company to update its review of liabilities related to its open syndicate years of account. The review resulted in revised estimates of the expected ultimate loss for each open year of account, which were significantly worse than the levels estimated in the first quarter of 1999. The resulting $141.0 million charge for the open syndicate years of account 1997 through 1999 was reflected in the Company's before-tax earnings in the third quarter of 1999.
In December 1999, the Company closed the remaining four Lloyd's syndicates. These syndicates have been placed in run-off whereby claims on past policies will be paid but no new business will be accepted.
Prior to the third quarter 1999 charge, the Company's unamortized goodwill related to its reinsurance operations was $53.7 million. Of the $31.0 million unamortized balance attributable to the A&H and LTC business being sold, $6.0 million was determined to be unrecoverable and was written off in the third quarter and is included in the loss on sale reported above. The balance of $25.0 million was recovered through the sales proceeds when the sale closed. The remaining unamortized balance of $22.7 million (including the balance of $2.4 million related to one of the Lloyd's syndicates for which the Company has entered into an agreement to sell) was determined to be unrecoverable based on revised earnings forecasts for the reinsurance operations and was also written off in the third quarter of 1999.
The Company has provided its best estimate of the cost of known losses. Under this exit strategy, the Company retained certain risks, including the exposure associated with disputes arising from reinsurance pools disclosed in Note 17. Presently, it is not reasonably possible to determine the liability for the retained risks.
Effective January 1, 2000, a subsidiary of the Company reinsured the inforce individual disability income block of business of the New York Life Insurance Company through a 100 percent indemnity modified coinsurance agreement. The Company paid a ceding commission of $88.0 million which will be amortized as earnings emerge from the business assumed.
On March 27, 1997, the Company acquired Paul Revere, a provider of life and disability insurance products, at a price of approximately $1.2 billion. The transaction was financed through common equity issued to Zurich Insurance Company, a Swiss insurer, and its affiliates in the amount of $300.0 million (13.9 million shares of common stock), common equity of $437.5 million (17.0 million shares of common stock) and cash of $2.5 million issued to Paul Revere shareholders, internally generated funds of $145.0 million, and borrowings on the Company's revolving credit facility of $305.0 million. The acquisition was accounted for by the purchase method. The fair values of the assets acquired and liabilities assumed were $6,667.9 million and $6,809.1 million, respectively. The purchase price has been allocated principally to the value of business acquired with the remainder being allocated to goodwill. The interest rate used to determine the value of
business acquired for traditional products was the reserve discount rate. The interest rate used for interest-sensitive products was based on the current interest rate credited on account values. The value of business acquired will be amortized with interest based on premium income for the traditional individual life and disability products and on the estimates of future gross profits for interest-sensitive individual life products. Goodwill will be amortized on a straight-line basis over a 40 year period. The consolidated financial statements include the operating results of Paul Revere from April 1, 1997.
The following pro forma results of operations for the year ended December 31, 1997 give effect to the acquisitions and the related financing arrangements, including the acquisition of debt and issuance of common stock equity. The pro forma results of operations, prepared from historical financial results of operations of the Company, Paul Revere, and GENEX, with such adjustments as are necessary to present the results of operations as if the acquisitions had occurred as of the beginning of the year, are as follows for the year ended December 31, 1997 (in millions, except share data):
In December 1997, the Company entered into an agreement with American General Corporation (American General) under which various affiliates of American General agreed to acquire certain assets and assume certain liabilities of Provident's individual and tax-sheltered annuity business. In addition, American General acquired a number of miscellaneous group pension lines of business which were no longer actively marketed by Provident. The sale was completed during the second quarter of 1998.
In the fourth quarter of 1996, the Company sold certain of Unum's tax- sheltered annuity businesses to various affiliates of Lincoln National Corporation (Lincoln). To effect the sale of this business, the Company transferred assets of approximately $2,690.0 million into a trust account held for the benefit of Lincoln. The sale resulted in a deferred before-tax gain of $80.8 million, of which $72.6 million before tax and $47.0 million after tax was recognized during 1997.
within the complex pool arrangements, including pools for which subsidiaries of the Company acted either as pool managers or underwriting agents, as pool members or as reinsurers. The Company's subsidiaries either have been or may in the future be brought into disputes, arbitration proceedings, or litigation with other pool members or reinsurers of the pools in the process of resolving the various claims, but it is unclear what exposure Company or its subsidiaries may ultimately have to share in the losses of pool members or reinsurers because of the subsidiaries' activities in placing insurance or otherwise.
The Company's insurance subsidiaries' statutory net income (loss), as reported in conformity with statutory accounting practices prescribed by state regulatory authorities, for the years ended December 31, 1999, 1998, and 1997, was $(233.7) million, $227.0 million, and $298.2 million, respectively. Statutory capital and surplus at December 31, 1999 and 1998, was $2,718.1 million and $2,582.1 million, respectively. Excluding the expenses related to the merger and early retirement offer and the changes in reserves as discussed in Note 2, the federal income tax refund activity, and the reinsurance operation charges, the Company's insurance subsidiaries' statutory net gain from operations was $21.0 million for the year ended 1999.
The following is a summary of unaudited quarterly results of operations for 1999 and 1998:
Included in the amounts in the preceding table were various items related to merger and early retirement costs (see Note 2), changes in reserves (see Notes 2 and 7), federal income tax refund activity (see Note 8), reinsurance operation changes (see Note 13), and the sales of portions of lines of business (see Note 16).