The Company occupies facilities in Portland, Maine, which consist of eight owned facilities totaling 968,000 square feet of office space and 250 acres of land, a portion of which has been developed for employee parking. In addition, approximately 103,900 square feet of office space is leased and occupied in two buildings.
The Company owns and occupies facilities totaling 341,000 square feet in Worcester, Massachusetts, with approximately 5.6 acres of surrounding property used primarily for parking. In addition, the Company leases 13,000 square feet in Auburn, Massachusetts.
The following discusses the Company’s restatement of financial information, critical accounting policies and reviews the results of segment operating results, consolidated investments, the Company’s liquidity and capital resources, and current debt and financial strength ratings of the Company and its insurance subsidiaries.
The effect of these restatements increased net income $34.2 million in 2002 and decreased net income $38.0 million and $25.3 million in 2001 and 2000. Additional detail is presented below and in Note 1 of the “Notes to Consolidated Financial Statements” contained herein in Item 8.
The Company defers certain costs incurred in acquiring new business and amortizes (expenses) these costs over the life of the related policies.Deferred costs include commissions, other agency compensation, certain selection and policy issue expenses, and certain field expenses. Acquisition costs that do not vary with the production of new business, such as commissions on group products which are generally level throughout the life of the policy, are excluded from deferral. The Company uses its own historical experience and expectation of the future performance of its business in determining the expected life of the policies. Approximately 93 percent of the Company’s deferred policy acquisition costs relate to traditional non interest-sensitive products, for which the costs are amortized in proportion to the estimated premium income to be received over the life of the policies. The estimated premium income in the early years of the amortization period is higher than in the later years due to higher anticipated policy persistency in the early years, which results in a greater proportion of the costs being amortized in the early years of the life of the policy. Amortization of deferred costs on traditional products is adjusted to reflect the actual policy persistency as compared to the anticipated experience. The Company will experience accelerated amortization if policies terminate earlier than projected.
• Relevant industry conditions and trends relative to their historical cycles.
• Current Baa corporate bond spreads ranging from 1.26 percent to 2.87 percent plus an additional 30 basis points were added to the risk free rate to consider the lack of liquidity.
Changes in the fair value of fixed maturity securities, other than declines that are determined to be other than temporary, are reported as a component of other comprehensive income in stockholders’ equity. If it is subsequently determined that any of these securities are other than temporarily impaired, the impairment loss is reported as a realized investment loss in the consolidated statements of income. The recognition of the impairment loss does not affect total stockholders’ equity to the extent that the decline in value had been previously reflected in other comprehensive income.
The Company’s insurance subsidiary in the United Kingdom entered into an agreement during 2002 with Sun Life Financial of Canada (Sun Life) to acquire Sun Life’s United Kingdom group income protection business together with the renewal rights to the group life business at a price of £27.3 million (approximately $43.5 million). The transaction closed in the first quarter of 2003.
In 2001, the Company recognized a tax benefit of $35.2 million related to its investment in the foreign reinsurance operations, which lowered the 2001 tax rate below the U.S. federal statutory rate of 35 percent. Additionally, as a result of tax legislation enacted in the United Kingdom during 2000 that allows additional group tax relief among companies with common ownership, the Company began recognizing foreign tax benefits during 2001.
During 2000, the Company completed a series of strategic transactions designed to more closely focus its operations on its core businesses, increase its financial flexibility, support its present credit and claims-paying ratings, increase the risk-based capital ratios of the insurance subsidiaries involved, and lower its leverage ratios. The primary transaction involved agreements under which the Company reinsured on a 100 percent indemnity coinsurance basis substantially all of the individual life insurance and corporate-owned life insurance policies written by the Company’s insurance subsidiaries, as well as a small block of individually underwritten group life insurance. The reinsurance agreements were effective as of July 1, 2000.
Separately, the Company reinsured on a 100 percent indemnity coinsurance basis the future claim payments on one of the Company’s insurance subsidiaries’ long duration group long-term disability claims that were incurred prior to January 1, 1996. The agreement was effective January 1, 2000.
During 2000, the Company purchased a single premium annuity for its retirees, which allowed the release of the related pension plan liability and resulted in a net before-tax gain of $116.1 million. The pension plan transaction enabled the Company to provide a higher level of administrative service for its retirees while also locking in favorable pension plan performance.
The following table presents a reconciliation of each of the non-GAAP financial measures set forth in the preceding table to the most directly comparable GAAP financial measure.
Sales for Employee Benefits, on both a submitted and effective date basis, are as follows:
Fully insured sales, on a submitted date basis, for group long-term disability decreased $3.4 million in 2002 compared to the prior year. The Company’s U.S. operations reported a decrease of 3.8 percent, partially offset by a 19.4 percent sales increase in the Company’s United Kingdom operations. Sales in the U.S. operations declined in all case size markets, with the largest decrease occurring in the small case market. Group long-term disability ASO sales increased $26.8 million over 2001. Fully insured sales for short-term disability were down 21.0 percent in 2002 compared to the prior year due to a decline in sales in all case size markets, offset partially by a 62.6 percent increase in ASO sales. Group life 2002 sales, relative to the prior year, decreased in all case size markets. This was partially due to the Company’s strategic decision to focus on integrated sales of life and disability and less on stand-alone life. In addition, two large group life cases totaling approximately $41.7 million were sold during 2001.
The Company monitors persistency of its existing business and reflects adverse changes in persistency in the current period’s amortization of deferred policy acquisition costs. One way in which the Company monitors persistency is at the overall block of business level (i.e., group long-term disability, group short-term disability, group life, and accidental death and dismemberment). Persistency, at the overall block of business level, is the year-to-date rate at which existing business for all issue years in the block of business at the beginning of the period remains inforce at the end of the period. In determining whether additional amortization of deferred policy acquisition costs is required due to adverse persistency, the Company measures persistency by issue year (i.e., the rate at which existing business for that specific issue year at the beginning of the period remains inforce at the end of the period). The rate of persistency for an overall block of business may improve while individual issue years within the overall block of business may deteriorate and require additional amortization of deferred policy acquisition costs.
Operating revenue improved due to increases in both premium income and net investment income. The $193.1 million growth in premium income compared to the prior year is due to new sales growth in 2001 and 2002 and favorable renewal activity on the existing block of business, offset partially by terminations. Net investment income grew $50.5 million primarily due to the growth in invested assets supporting this line of business. Included in other income are ASO fees of $33.9 million for 2002 and $25.7 million for the prior year.
Persistency during 2002 on the overall block of group disability improved over 2001, with long-term disability persistency at 85.8 percent compared to 84.9 percent in 2001. Short-term disability persistency for 2002 was 81.5 percent versus 82.1 percent for the year 2001. Excluding the effects of cases that transferred from fully insured to ASO, short-term disability persistency was 82.6 percent for 2002. Although the overall blocks of group long-term and short-term business experienced favorable persistency in 2002 compared to 2001, certain issue year business did not persist at the levels expected when the business was issued, resulting in $12.9 million of additional amortization of deferred policy acquisition costs. The additional amortization for 2001 was $26.3 million.
For short-term disability, the 2002 benefit ratio was lower than in 2001. Paid claim incidence was marginally higher than 2001. The average weekly indemnity and premium per life continued to increase as expected, but the growth in premium per life was greater than the growth in the average weekly indemnity compared to the growth level relationships experienced in 2001. The average claim duration for closed short-term disability claims was lower than in 2001.
Group disability operating revenue was $3,352.7 million in 2001 compared to $3,200.4 million in 2000. Group disability reported operating income of $336.9 million for 2001 compared to $211.0 million for 2000. Operating income for 2001 includes $7.3 million for losses related to September 11, 2001. Included in the operating income for 2000 was an increase of $65.6 million for group long-term disability claim reserves, which represented approximately 1.2 percent of total group long-term disability claim reserves. The increase, which resulted from lengthening the projected average claim duration for certain of the Company’s group long-term disability claims, was not a result of deteriorating experience but was believed appropriate based on the Company’s assessment of the ultimate resolution of these claims.
As previously disclosed under “Results of Operations,” during 2000 the Company entered into a 100 percent indemnity coinsurance agreement to cede the future claim payments on one of its insurance subsidiaries’ long duration group long-term disability claims which were incurred prior to January 1, 1996. The agreement was effective January 1, 2000.
Group life reported an increase in operating income compared to the prior year. The improvement was attributable to a lower benefit ratio, lower commissions ratio, and an improved operating expense ratio. Submitted and paid claim incidence were both slightly higher than in 2001, but the rate trended downward throughout 2002 from the first quarter of 2002 high. The average paid claim size increased from 2001 and was high relative to historical levels. Incidence rates for group life waiver of premium coverage that results from a policyholder’s disability also increased slightly over 2001, but waiver recovery rates continued to increase as well. Group life 2001 results included a net increase in benefits of $3.0 million related to September 11, 2001.
Operating income for group long-term care increased in 2002 over 2001. The improvement resulted primarily from continued increases in premium income and a decrease in the benefit ratio. Submitted claim incidence exceeded 2001 levels, but decreased during the third and fourth quarters of 2002 from the high incidence experienced for the second quarter of 2002. The 2002 new claim rate exhibited a similar pattern, mostly due to an increase in the average size of new claims.
Group life, accidental death and dismemberment, and long-term care reported an increase in operating revenue for 2001 compared to 2000 due to increases in both premium income and net investment income. Premium growth was attributable to strong sales results in 2001 and improvements in persistency. Persistency for group life was 84.6 percent in 2001, an increase over the 81.5 percent for 2000. For accidental death and dismemberment, persistency was 83.0 percent and 79.5 percent for 2001 and 2000, respectively.
Group life 2001 benefits include estimated gross ultimate losses from reported and unreported claims of $17.0 million less an estimated $14.0 million recoverable from the Company’s reinsurers, for a net increase in benefits of $3.0 million related to September 11, 2001.
The 2001 benefit ratio for accidental death and dismemberment was higher than 2000 primarily due to a significant increase in the average paid claim amounts. The rate of claim incidence in 2001 did not change significantly over the prior year. The 2001 results for accidental death and dismemberment include estimated gross ultimate losses of $25.0 million less estimated reinsurance recoverables of $21.3 million, for a net increase in benefits of $3.7 million related to September 11, 2001. These losses relate to both accidental death and dismemberment and travel accident coverages.
Group long-term care reported a very slight decrease in the benefit ratio for 2001 compared to 2000, although the last two quarters of 2001 reported increasing benefit ratios relative to the first half of the year and to prior year quarters.
Operating revenue from the managed disability line of business, which includes the Company’s wholly-owned subsidiaries GENEX Services, Inc. and Options and Choices, Inc., totaled $174.8 million in 2002, compared to $150.6 million in 2001 and $126.1 million in 2000. Operating income continues to increase due to the growth in operating revenue and increases in operating margins.
New annualized sales in the individual disability line of business were $145.3 million in 2002, $145.1 million in 2001, and $116.1 million in 2000. Although sales were relatively flat between 2002 and 2001, it is expected that sales in the individual disability line should benefit from the focus on integrated disability sales in group and individual, as well as other sales initiatives discussed under “Employee Benefits Segment Operating Results.” The portion of individual disability sales attributable to multi-life business was approximately 73 percent of 2002 sales, compared to 70 percent for 2001. The persistency of existing individual disability business continues to be stable.
Operating revenue was $2,692.0 million for 2002 compared to $2,615.8 million in 2001. Premium income increased slightly less than one percent over the prior year, and net investment income increased 6.5 percent. Operating income in the individual disability line of business was $270.6 million in 2002 compared to $274.8 million in 2001. The benefit ratio for 2002 increased relative to the prior year. The interest adjusted loss ratio was 67.5 percent and 63.6 percent for 2002 and 2001, respectively. Submitted claim incidence for most of 2002 moderated after having increased throughout 2001, peaking in the first quarter of 2002. The increase in submitted incidence throughout 2001 and into the first quarter of 2002 has affected paid incidence, which was higher than 2001 and up significantly from 2000. The claim recovery rate remained below the level of 2001. Payments to settle claims in litigation increased in 2002 compared to 2001 while the number of new lawsuits filed decreased. Individual disability results benefited from an improvement in the operating expense ratio relative to 2001, somewhat offset by a slight increase in the commission ratio. Included in results for 2001 was an increase in net benefits of $10.0 million related to September 11, 2001.
Operating income in the individual long-term care line of business decreased to $2.4 million for 2002 compared to $15.9 million for 2001 due to an increase in the benefit ratio. The benefit ratio increase was driven primarily by the increase in active life reserves resulting from higher policy persistency and lower claim resolutions. The 2002 new claim rate, weighted by reserve dollar, exceeded the 2001 rate. The increase in the new claim rate over the prior year was driven by an increase in the average reserve size of new claims. Submitted incidence, by policy count rather than reserve dollar, decreased from the prior year. The claim recovery rate decreased from the prior year. The commission and operating expense ratios both improved relative to 2001.
The individual long-term care line of business reported a 35.0 percent increase in premium income for 2001 compared to 2000, primarily due to new sales growth. Net investment income continues to increase due to the growth in this line of business. Operating income in the individual long-term care line of business was $15.9 million in 2001 compared to $12.8 million for 2000, primarily due to an increase in operating revenue and an improvement in the commission and operating expense ratios. The benefit ratio increased when compared to 2000. The increase over the prior year resulted primarily from an increase in the active life reserve. Paid incidence was essentially unchanged from 2000, and the claim recovery rate increased.
Operating revenue in the Voluntary Benefits segment increased to $982.1 million in 2002 from $928.8 million in 2001 due to an increase in premium income in the disability and life product lines. The increase in 2002 was attributable to sales growth and favorable persistency. New annualized sales for 2002 were $336.6 million compared to $296.6 million for the prior year. The largest percentage increase year over year occurred in the critical illness product line, and the most significant growth in sales as measured by dollars of annualized premium occurred in disability. Management continues its efforts to increase sales through the sales initiatives discussed under “Employee Benefits Segment Operating Results.”
Operating revenue in the Voluntary Benefits segment increased to $928.8 million in 2001 from $859.3 million in 2000 primarily due to the increase in premium income attributable to sales growth and favorable persistency. New annualized sales for 2001 were $296.6 million, an increase of 11.9 percent over the prior year.
The Other operating segment includes results from products no longer actively marketed, including individual life and corporate-owned life insurance, reinsurance pools and management operations, group pension, health insurance, and individual annuities. It is expected that operating revenue and income in this segment will decline over time as these business lines wind down. Management expects to reinvest the capital supporting these lines of business in the future growth of the Employee Benefits, Individual, and Voluntary Benefits segments. The closed blocks of business have been segregated for reporting and monitoring purposes.
During 2001, the Company entered into an agreement to limit its liabilities pertaining to the Lloyd’s syndicate participations. Separately, the Company also reinsured 100 percent of the group disability reinsurance reserves and all future business underwritten and managed by Duncanson and Holt Services, Inc., a subsidiary of D&H. The transaction, in which reserves of approximately $323.8 million were ceded to the reinsurer, had an effective date of January 1, 2001. In a separate but related transaction, the Company also sold the reinsurance management operations of Duncanson and Holt Services, Inc. and divested the remaining assets of that facility during 2001.
The reinsurance pools and management operations reported an operating loss of $3.2 million in 2002. Premium income was $16.7 million compared to $61.3 million and $398.7 million in 2001 and 2000. The premium income decline will continue as the Company exits from this business.
As previously discussed, during 2000 the Company reinsured substantially all of the individual life and corporate-owned life insurance blocks of business. The Company ceded approximately $3.3 billion of reserves to the reinsurer. The $388.2 million before-tax gain on these transactions was deferred and is being amortized into income based upon expected future premium income on the traditional insurance policies ceded and estimated future gross profits on the interest-sensitive insurance policies ceded. The unamortized balance of the deferred gain was $313.8 million at December 31, 2002 and $343.9 million and $373.5 million at the end of 2001 and 2000, respectively. The Company recognized a 2000 before-tax realized investment loss of $25.9 million on the fixed maturity securities transferred to the reinsurer. In connection with this realized loss, the Company retrospectively adjusted deferred policy acquisition costs and value of business acquired related to interest-sensitive individual life policies with credits to current period amortization of $9.4 million and $1.5 million, respectively, to reflect investment experience.
The Corporate segment includes investment income on corporate assets not specifically allocated to a line of business, corporate interest expense, amortization of goodwill (prior to 2002), and certain corporate expenses not allocated to a line of business.
Interest and debt expense was $162.4 million in 2002, $169.6 million in 2001, and $181.8 million in 2000. Interest in 2003 is expected to increase relative to 2002 due to the issuance of two long-term debt offerings during the second quarter of 2002 which were used to refinance existing commercial paper borrowings. See “Liquidity and Capital Resources” for further information on the debt offerings.
• The long-term nature of the Company’s insurance liabilities also allows it to invest in less liquid investments to obtain superior returns. A maximum of 10 percent of the total investment portfolio may be invested in below-investment-grade investments, two percent in equity type instruments, and up to 35 percent in private placements. The remaining assets can be held in mortgage-backed securities, asset-backed securities, and municipal securities. The Company does not currently intend to invest in additional commercial mortgages or real estate.
• The weighted average rating of the portfolio should be BBB or higher.
To allow the Company flexibility during the current challenging environment, the board of directors at its September 2002 meeting modified the above investment guidelines to establish an individual credit over-exposure limit at 5 percent of invested assets and a below-investment-grade over-exposure limit of 5 percent of invested assets.
Excluding the net investment income reported in the Other segment, which continues its expected decline as these product lines are sold, reinsured, or wind down, 2002 net investment income increased 6.2 percent over the previous year. The overall yield in the portfolio was 7.76 percent as of December 31, 2002, compared to 8.02 percent and 8.06 percent at the end of 2001 and 2000, respectively. The Company expects that the portfolio yield will continue to gradually decline, due to yields on new purchase activity, until the level of market rates increases. The Company is actively marketing selected properties in its real estate and mortgage loan portfolios for replacement with longer duration securities.
Approximately 62 percent of the 2002 write-downs occurred in the communications industry. The following list includes write-downs representing five percent or greater of the total 2002 write-downs, the circumstances that contributed to the write-downs, the length of time the security had been in a continual loss position, whether it was investment-grade or below-investment-grade at the time of initial purchase and at the time of the write-down, and how the circumstances of the write-down might cause impairments in other material investments held by the
• $51.1 million loss during the second quarter of 2002 on securities issued by a Canadian telecommunications company engaged in transporting voice and data over its global fiber optic network. This company had an investment-grade rating of Baa3 immediately prior to the time its parent company unexpectedly withdrew its support for the subsidiary in April 2002. The investment was subsequently downgraded to below-investment-grade in the second quarter of 2002. Prior to its write-down, the investment had been in an unrealized loss position for a period of greater than two years but less than three years. The Company owns fixed maturity securities issued by another regulated subsidiary under common ownership, but this investment has not been negatively impacted, is not considered impaired, and was in an unrealized gain position at December 31, 2002.
The Company reported a before-tax net realized investment loss of $99.1 million in 2001. The loss was the net of gains of $150.6 million and losses of $249.7 million, including write-downs of $212.3 million recognized as a result of management’s determination that the value of certain fixed maturity securities had other than temporarily declined. Approximately 50 percent of the 2001 write-downs occurred in the communications sector. The following list includes write-downs representing five percent or greater of the total 2001 write-downs, the circumstances that contributed to the write-downs, and how those circumstances might cause impairments in other material investments held by the Company.
• $18.6 million loss during the second quarter of 2001 on securities issued by a global integrated web hosting, data, and telecommunications company, after the company unexpectedly declined to make an interest payment on another senior note in May 2001 even though the company had sufficient available cash. The investment was originally purchased as part of the Company’s below-investment-grade strategy. Prior to its write-down, the investment had been in an unrealized loss position for a period of greater than two years but less than three years. The circumstances of this impaired investment have no impact on other investments.
• $15.7 million loss during the fourth quarter of 2001 on a provider of local and long distance telephone service and internet service after the company reported in November 2001 that it might seek to restructure its debt. This investment was originally purchased as part of the Company’s below-investment-grade strategy. Prior to its write-down, the investment had been in an unrealized loss position for a period of greater than three years. The circumstances of this impaired investment have no impact on other investments.
Basic Industries: This sector is comprised of several cyclical, commodity-based industries, including sub-sectors of mining, chemicals, metals, and forest products. The down cycle in the economy reduced demand for many of these commodities, and the combination of low prices, low capacity utilization, and, in some cases, high raw material prices continue to pressure many of the companies in these sub-sectors. If the economy improves, these cyclical businesses should recover, and the bonds issued by these companies should recover as well. The Company has held these sub-sectors through several economic cycles and has the ability and intent to hold these investments until they recover in value or reach maturity. The portfolio should also benefit from the Company’s credit selection process which seeks to avoid the riskier credits in these sub-sectors.
Financial Institutions: This sector entered the recent economic slowdown with record capital levels and strong profitability. Bank balance sheets appear capable, in general, of withstanding the increased loan write-offs typically seen in past recessions. In addition to the communications industry, banks are now experiencing more loan write-offs from the energy and utility industries. Finance companies, both consumer and commercial, can also be expected to experience an increase in non-performing receivables. The degree of the economic slowdown will be a key determinant of the amount of credit degradation in the financial services sector.
The following table shows the length of time the Company’s below-investment-grade fixed maturity bonds had been in a gross unrealized loss position as of December 31, 2002. The carrying value and gross unrealized losses are categorized by the relationship of the current market value to amortized cost for those securities on December 31, 2002. The market value to amortized cost relationships are not necessarily indicative of the market value to amortized cost relationships for the securities throughout the entire time that the securities have been in an unrealized loss position nor are they necessarily indicative of the relationships subsequent to December 31, 2002.
As previously discussed under “Critical Accounting Policies” contained herein, in determining whether a decline in fair value below amortized cost of a fixed maturity security is other than temporary, the Company utilizes a formal, well-defined, and disciplined process to monitor and evaluate its fixed income investment portfolio. It includes certain members of senior management in addition to the day-to-day investment and accounting professionals. The process results in a thorough evaluation of problem investments and write-downs on a timely basis of investments determined to have an other than temporary impairment.
For those fixed maturity securities with an unrealized loss and on which the Company has not recorded an impairment write-down, the Company believes that the decline in fair value below amortized cost is temporary. The Company has the ability to hold its securities to the earlier of recovery or maturity and intends to hold all of its fixed maturity investments until maturity to meet its liability obligations. If information becomes available that changes the Company’s assessment as to whether the Company will receive contractual payments related to a fixed maturity security and the security is also not projected to recover in value, the related security is generally sold. The Company may also in certain circumstances sell a security because of industry or environmental issues, to extend the duration of the investment portfolio, due to mergers between issuers which result in positions in excess of the Company’s investment guidelines, and to take advantage of tender offers.
The following is a distribution of the maturity dates for fixed maturity bonds in an unrealized loss position at December 31, 2002.
The Company’s investment in mortgage-backed and asset-backed securities was approximately $5.0 billion and $3.8 billion on an amortized cost basis at December 31, 2002 and 2001, respectively. At December 31, 2002, the mortgage-backed securities had an average life of 5.0 years and effective duration of 2.7 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.
During 2002 and 2001, the Company invested in three special purpose entity trusts that have underlying assets consisting of unaffiliated equity securities. The investments in these trusts qualify as fixed maturity securities under generally accepted accounting principles and are reported at fair value in the consolidated statements of financial condition contained herein. The fair value of these investments was derived from the fair value of the underlying assets. The fair value and amortized cost of these investments were $84.4 million and $113.9 million, respectively, at December 31, 2002 and $50.5 million and $58.1 million at December 31, 2001.
At December 31, 2002 and 2001, impaired mortgage loans totaled $6.0 million and $13.1 million, respectively. Impaired mortgage loans are not expected to have a material impact on the Company’s liquidity, financial position, or results of operations.
Restructured mortgage loans totaled $7.8 million and $5.7 million at December 31, 2002 and 2001, respectively, and represent loans that have been refinanced with terms more favorable to the borrower. Interest lost on restructured loans was immaterial for 2002 and 2001.
Real estate was $37.1 million and $51.8 million at December 31, 2002 and 2001, respectively. 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 and may be classified as investment real estate if it meets the Company’s investment criteria. 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, which is valued net of a valuation allowance that reduces the carrying value to the lower of cost or fair value less estimated cost to sell, amounted to $8.2 million and $7.6 million at December 31, 2002 and 2001, respectively.
The Company uses a comprehensive rating system to evaluate the investment and credit risk of each mortgage loan and to identify specific properties for inspection and reevaluation. The Company establishes an investment valuation allowance for mortgage loans based on a review of individual loans and the overall loan portfolio, considering the value of the underlying collateral. Investment valuation allowances for real estate held for sale are established based on a review of specific assets. If a decline in value of a mortgage loan or real estate investment 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 recognized as a realized investment loss. Management monitors the risk associated with these invested asset portfolios and regularly reviews and adjusts the investment valuation allowance. As a result of management’s 2001 reviews of the overall mortgage loan portfolio and based on management’s expectations that delinquencies and problem loans would remain low, the valuation allowance on mortgage loans was reduced $10.5 million during 2001. The real estate valuation allowance was reduced $5.7 million during 2001 in conjunction with the sale of the associated property. No changes were made to the allowances during 2002. At December 31, 2002, the balance in the valuation allowances for mortgage loans and real estate was $2.4 million and $19.9 million, respectively.
Historically, the Company has utilized interest rate futures contracts, current and forward interest rate swaps, interest rate forward contracts, and options on forward interest rate swaps, forward treasuries, or forward contracts on specific fixed income securities to manage duration and increase yield on cash flows expected from current holdings and future premium income. Positions under the Company’s hedging programs for derivative activity that were open during 2002 involved current and forward interest rate swaps and forward contracts on credit spreads on specific fixed income securities, as well as currency swaps which are used to hedge the currency risk of certain foreign currency denominated fixed income securities. All transactions are hedging in nature and not speculative. Almost all transactions are associated with the individual and group long-term care and the individual and group disability product portfolios. All other product portfolios are periodically reviewed to determine if hedging strategies would be appropriate for risk management purposes.
The Company is dependent upon payments from its subsidiaries to pay dividends to its stockholders and to pay its expenses. These payments by the Company’s insurance and non-insurance subsidiaries may take the form of interest payments on amounts loaned to such subsidiaries by the Company, operating and investment management fees, and/or dividends. At December 31, 2002, the Company had outstanding from its insurance subsidiaries a $150.0 million surplus debenture due in 2006 with a weighted average interest rate during 2002 of 8.19 percent and a $100.0 million surplus debenture due in 2027 with a weighted average interest rate during 2002 of 8.25 percent. Semi-annual interest payments are conditional upon the approval by the insurance department of the state of domicile.
Restrictions under applicable state insurance laws limit the amount of ordinary dividends that can be paid to the Company from its insurance subsidiaries without prior approval by regulatory authorities. For life insurance companies domiciled in the United States, that limitation equals, depending on the state of domicile, either ten percent of an insurer’s statutory surplus with respect to policyholders as of the preceding year end or the statutory net gain from operations, excluding realized investment gains and losses, of the preceding year, depending on the state of domicile. Further, pursuant to the 1999 merger of Unum and Provident, the Company is required to obtain approval from the Maine Bureau of Insurance (Maine Bureau) regarding payment of ordinary dividends from the Company’s Maine domiciled insurance subsidiary until 2004.
The ability of the Company to continue to receive dividends from its insurance subsidiaries without regulatory approval will be dependent upon the level of earnings of its insurance subsidiaries as calculated under law. In addition to regulatory restrictions, the amount of dividends that will be paid by insurance subsidiaries will depend on additional factors, such as risk-based capital ratios, funding growth objectives at an affiliate level, and maintaining appropriate capital adequacy ratios to support the ratings desired by the Company. Regulatory
At December 31, 2002, the Company had short-term and long-term debt totaling $255.0 million and $1,914.0 million, respectively. The debt to total capital ratio was 29.5 percent at December 31, 2002 compared to 29.8 percent and 30.2 percent at December 31, 2001 and 2000. The debt to total capital ratio, when calculated allowing 50 percent equity credit for the Company’s company-obligated mandatorily redeemable preferred securities of subsidiary trust holding solely junior subordinated debt securities of the Company, was 27.7 percent at December 31, 2002 compared to 28.0 percent and 27.1 percent at December 31, 2001 and 2000.
During 2000, the Company filed with the Securities and Exchange Commission (SEC) a shelf registration on Form S-3 covering the issuance of up to $1.0 billion of securities in order to provide funding alternatives for its maturing debt. In the first quarter of 2001, the Company completed a long-term debt offering, issuing $575.0 million of 7.625% senior notes due March 1, 2011. In the second quarter of 2002, the Company completed two long-term offerings, issuing $250.0 million of 7.375% senior debentures due June 15, 2032 and $150.0 million of 7.250% public income notes due June 15, 2032. The public income notes are redeemable at the Company’s option, in whole or in part, on or after June 25, 2007. Proceeds from the offerings were used to refinance existing commercial paper borrowings.
On November 1, 2002, the Company filed with the SEC a shelf registration on Form S-3. When declared effective by the SEC, the shelf registration statement will allow the Company to issue various types of securities, including common stock, preferred stock, debt securities, depository shares, stock purchase contracts, units and warrants, or preferred securities of wholly-owned finance trusts, from time to time, up to an aggregate of $1.5 billion. The shelf registration will enable the Company to raise funds from the offering of any individual security covered by the shelf registration as well as any combination thereof, subject to market conditions and the Company’s capital needs.
During 2000, the Company issued $200.0 million of variable rate notes in a privately negotiated transaction. The notes were used to refinance other short-term debt and had a weighted average interest rate of 7.52 percent during the first quarter of 2001. The notes matured in April 2001.
In 1998, the Company completed a public offering of $200.0 million of 6.375% senior notes due July 15, 2005, and $200.0 million of 7.0% senior notes due July 15, 2018. In December 1998, the Company issued $250.0 million of 6.75% senior notes, which mature in 2028.
Contractual debt, Company-obligated mandatorily redeemable preferred securities commitments, and lease commitments are as follows (in millions of dollars):
The Company maintains separate U.S. and foreign pension plans and a U.S. post-retirement benefit plan. The U.S. pension plans comprise the majority of the total benefit obligation and pension expense for the company. The value of the benefit obligations is determined based on a set of economic and demographic assumptions that represent the Company’s best estimate of future expected experience. These assumptions are reviewed annually. Two of the economic assumptions are adjusted accordingly based on key external indices, the discount rate, and the long-term rate of return assumption. The assumptions are consistent for both the U.S. pension plans and the U.S. post-retirement benefit plan. The Company follows Statements of Financial Accounting Standards No. 87, Employer’s Accounting for Pensions (SFAS 87) and No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions (SFAS 106) in its financial reporting and accounting for its pension and post-retirement benefit plans.
The long-term rate of return assumption is the best estimate of the average annual assumed return that will be produced from the pension trust assets until current benefits are paid. For 2003, 2002, and 2001, the long-term return on asset assumption for the U.S. pension plans is 8.50 percent, 9.00 percent, and 9.00 percent, respectively. The determination of the best estimate is based on a “building block” approach. This methodology examines the various elements of the expected return for each asset class, such as inflation, dividends, real return, and risk premium. The expected return for each asset class is calculated as the sum of the individual components. The total expected return for the portfolio equals the weighted average of the return for each asset class, based on the plan’s asset allocation. The expected long-term rate of return assumption for the U.S. pension plans in 2002 is 9.00 percent. This assumption is based on an average expected return of about 6.00 percent annually for fixed income investments and 10.00 percent annually for equities. Based on the target asset allocation of 75 percent equities and 25 percent fixed income securities, this equates to a weighted average return of 9.00 percent. The Company’s expectations for future investment returns in the plans are based on a combination of historical market performance and the Company’s evaluations of investment forecasts prepared by outside consultants and economists. Since 1926, the average real return (before inflation) has been about 8.00 percent for equities and 2.5 percent for bonds. The Company has not relied extensively on the historical market performance of the U.S. pension plans in setting the expected long-term rate of return assumption. This is because the current plan is composed of three plans that were merged to create one plan in 2000. Furthermore, in 2000, annuities were purchased for all existing retirees. Due to the nature of these changes, the historical performance of these plans is not a reliable indicator of future expected performance. In calculating the average return over the lifetime of the plan, the duration of the projected benefit obligation, at approximately 23 years, also has been considered, as well as the effect of active management of the plans’ assets.
The market related value equals the fair value of assets, determined as of the measurement date. The assets are not smoothed for purposes of SFAS 87. The expected return on assets, therefore, fully recognizes all asset gains and losses through the measurement date.
The U.S. Pension plans experienced a negative pension expense in 2002, 2001, and 2000 that has increased before tax income in the amount of $2.6 million, $17.7 million, and $164.1 million, respectively. Approximately $116.1 million of the negative pension expense in 2000 is due to a single premium annuity purchase to fund the Company’s retirement benefit obligation for approximately 3,000 retirees.
The end of the year value of the assets in the U.S. Pension plans has declined from $515.0 million in 2000, to $458.0 million in 2001, and to $350.0 million in 2002. The decrease in assets, coupled with the liability increase due to declining discount rates, has reduced the year end funding level in the plan from a surplus of $246.0 million in 2000, to a surplus of $139.0 million in 2001, and to a deficit of $114.0 million as of December 31, 2002. The Company contributes to the U.S. Pension plans in accordance with the minimum funding requirements of ERISA. The Company was not required to make a minimum required contribution in 2002, nor will it be required to make a contribution in 2003. Based on projections performed by the Company’s actuaries, it is anticipated that contributions may not be required in 2004, but will be required in 2005 and/or 2006. The Company may decide to contribute an amount above the minimum required amount.
We have audited the accompanying consolidated statements of financial condition of UnumProvident Corporation and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of UnumProvident Corporation and subsidiaries at December 31, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, effective January 1, 2002, the Company changed its method of accounting for goodwill and other intangible assets.
The accompanying consolidated financial statements for the years ended December 31, 2001 and 2000 have been restated, as discussed in Note 1.
Basis of Presentation: The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). Such accounting principles differ from statutory accounting principles (see Note 15). The consolidated financial statements include the accounts of UnumProvident Corporation and its subsidiaries (the Company). Material intercompany transactions have been eliminated. Certain prior year amounts have been reclassified to conform to current year presentation.
Policy Loans are presented at unpaid balances directly related to policyholders. Included in policy loans are $2,548.0 million and $2,329.3 million of policy loans ceded to reinsurers at December 31, 2002 and 2001, respectively.
Other Long-term Investments are carried at cost plus the Company’s equity in undistributed net earnings since acquisition.
Foreign currency exposure hedge. To the extent it is effective, changes in the fair value of the derivative are reported in other comprehensive income as part of the foreign currency translation adjustment and reclassified into earnings in the same period or periods during which remeasurement of the hedged foreign currency asset affects earnings. The ineffective portion of the hedge, if any, is recognized in current operating earnings during the period of change in fair value. The gain or loss on the termination of an effective foreign currency exposure hedge is reported in other comprehensive income as part of the foreign currency translation adjustment and reclassified into earnings in the same period or periods during which remeasurement of the hedged foreign currency asset affects earnings.
The Company follows the periodic method of accounting for its Lloyd’s of London (Lloyd’s) business in which premiums are recognized as revenue over the policy term, and claims, including an estimate of claims incurred but not reported, are recognized as they occur. Premiums for the Lloyd’s business are based on participation in the individual syndicate underwriting years that generate premiums over a three year period of time. The Company uses its historical experience and information obtained from its managing agents to estimate revenues, losses, expenses, and the related assets and liabilities.
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 on 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
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 or loss, net of deferred tax.
Accounting for Stock-Based Compensation: The Company has various stock-based employee compensation plans and accounts for those plans under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25 (Opinion 25), Accounting for Stock Issued to Employees, and related Interpretations. All options granted under the stock-based employee compensation plans had an exercise price equal to the market value of the underlying common stock on the date of grant. If the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation (SFAS 123), to stock-based employee compensation, the effect on net income and earnings per share would be as follows:
Effective January 1, 2002, the Company adopted the provisions of SFAS 141. SFAS 141 addresses financial accounting and reporting for business combinations and requires that all business combinations initiated after June 30, 2001 be accounted for using the purchase method. The adoption of SFAS 141 had no material impact on the Company’s financial position or results of operations.
Effective January 1, 2002, the Company adopted the provisions of SFAS 142. SFAS 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets. In accordance with SFAS 142, goodwill is no longer amortized but is subject to annual impairment tests. Prior to January 1, 2002, goodwill was amortized on a straight-line basis over a period not to exceed 40 years. Other intangible assets continue to be amortized over their useful lives.
Transition to the provisions of SFAS 142 required the Company to complete, within the year of adoption, impairment tests of goodwill existing at January 1, 2002, measured as of that date using a fair value approach. The Company had previously, prior to the adoption of SFAS 142, used undiscounted cash flows to determine if goodwill was recoverable. Goodwill impairment is deemed to occur if the net book value of a reporting unit exceeds its estimated fair value. The Company’s reporting units are generally operating segments, as defined in Note 13, or one level below the operating segment if that reporting unit constitutes a business.
The Company reclassified its January 1, 2002 goodwill asset balance of $663.7 million from the Corporate segment to the segments expected to benefit from the originating business combinations. The reclassification increased the Employee Benefits segment and Individual segment assets by $78.2 million and $585.5 million, respectively.
Statement of Financial Accounting Standards No. 144 (SFAS 144), Accounting for the Impairment or Disposal of Long-Lived Assets
Statement of Financial Accounting Standards No. 148 (SFAS 148), Accounting for Stock-Based Compensation - Transition and Disclosure
SFAS 143 addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The Company will adopt the provisions of SFAS 143 effective January 1, 2003. The adoption of this pronouncement is not expected to have an impact on the Company’s financial position or results of operations.
SFAS 146 requires companies to recognize a liability for the costs associated with exit or disposal activities at the time the liability is incurred rather than at the commitment date. It also establishes that fair value should be the initial measurement basis for the liability. The Company plans to adopt SFAS 146 effective January 1, 2003 as required. Adoption of SFAS 146 is not expected to have an impact on the Company’s financial position or results of operations.
Fixed Maturity Securities: Fair values are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services or, in the case of private placements, are estimated by discounting expected future cash flows using a current market rate applicable to the yield, credit quality, and maturity of the investments. See Note 3 for the amortized cost and fair values of securities by security type and by maturity date.
Derivatives:Fair values are based on market quotes or pricing models and represent the net amount of cash the Company would have received or paid if the contracts had been settled or closed on December 31.
At December 31, 2002, 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 $2,872.8 million or 10.0 percent of invested assets excluding ceded policy loans. The amortized cost of these securities was $3,670.3 million.
Deposit assets in the form of marketable securities held in trust are reported in miscellaneous assets in the consolidated statements of financial condition. Unrealized gains on these securities were $149.6 million and $44.2 million, respectively, at December 31, 2002 and 2001.
At December 31, 2002, the Company had capital commitments of $18.8 million to fund certain of its private placement fixed maturity securities. The funds are due upon satisfaction of contractual notice from the issuer. These amounts may or may not be funded during the term of the security.
The following table summarizes the timing of anticipated settlements of interest rate swaps outstanding at December 31, 2002, whereby the Company receives a fixed rate and pays a variable rate. The weighted average interest rates assume current market conditions.
The Company has executed a series of cash flow hedges using forward contracts on credit spreads. Forward contracts on credit spreads are used to hedge fluctuations in the credit risk rate and to improve the matching of assets and liabilities. A forward contract on credit spreads is an agreement in which the Company agrees with other parties to settle for cash, at a specified future date, the computed value of the change in credit spreads of a specific bond. The Company intends to purchase this specific bond at its current market value at the same time the forward contract is terminated. By entering into the forward contract, the Company is able to lock in the credit spread component of this specific bond’s purchase yield. The settlement dates of the forward contracts correspond to the settlement dates of the previously mentioned forward interest rate swap agreements. This combination of derivative instruments allows the Company to lock in the interest rate component and the credit spread component of yields on future bond purchases.
During 2002, the Company recognized net gains of $45.4 million upon the termination of cash flow hedges and reported $42.1 million of these gains in other comprehensive income and $3.3 million in operating earnings as realized investment gains. During 2001, the Company recognized net gains of $87.6 million upon the termination of cash flow hedges and reported $85.6 million of these gains in other comprehensive income and $2.0 million in operating earnings as realized investment gains.
The Company amortized $12.4 million and $9.1 million of net deferred gains into earnings during 2002 and 2001, respectively. The estimated amount of net deferred gains that will be amortized into operating earnings during 2003 is $12.5 million. The notional amount of derivatives outstanding under the hedge programs was $1,382.8 million at December 31, 2002.
For the year ended December 31, 2002, there was no material ineffectiveness related to the Company’s derivative holdings, and there was no component of the derivative instruments’ gain or loss excluded from the assessment of hedge effectiveness.
For most of the Company’s subsidiaries, tax years through 1995 are closed to further assessment by the Internal Revenue Service (IRS). During 2002, the IRS continued its examination of subsequent tax years. Management believes any future adjustments that may result from IRS examinations of tax returns will not have a material impact on the financial position, liquidity, or results of operations of the Company.
During 2002, the Company’s valuation allowance decreased by $11.1 million related to its investment in foreign operations.
During 2000, the Company filed with the Securities and Exchange Commission a shelf registration statement on Form S-3 covering the issuance of up to $1.0 billion of securities in order to provide funding alternatives for its maturing debt. In 2001, the Company completed a long-term debt offering, issuing $575.0 million of 7.625% senior notes due March 1, 2011. In 2002, the Company completed two long-term debt offerings, issuing $250.0 million of 7.375% senior debentures due June 15, 2032, and $150.0 million of 7.250% public income notes due June 15, 2032. The public income notes are redeemable at the Company’s option, in whole or in part, on or after June 25, 2007. Proceeds from the offerings were used to refinance existing commercial paper borrowings.
During 2000, the Company entered into $1.0 billion senior revolving credit facilities with a group of banks. The facilities are split into five-year revolver and 364-day portions. Interest is variable based upon a London Interbank Offered Rate (LIBOR) plus a margin or an alternate base rate. The Company received a 90-day extension on the 364-day portion of the credit facilities which was to expire on October 29, 2002. In connection with this extension, the Company elected to reduce the size of the credit facilities from $1.0 billion to $750.0 million and reduce the size of the commercial paper program to $750.0 million. At December 31, 2002, approximately $750.0 million was available for additional financing under the Company’s revolving credit facilities. On January 27, 2003, the Company elected not to renew the 364-day portion of the credit facilities upon the expiration date for the 90-day extension, retaining only the $472.5 million five-year revolver portion. The Company’s commercial paper program has been similarly reduced in size to $472.5 million.
The Company sponsors several defined benefit pension and postretirement plans for its employees, including non-qualified pension plans. Continued declines in the performance of equity investment markets combined with steadily increasing pension liabilities have reduced the Company’s pension plan’s funding level. In the fourth quarter of 2002, in accordance with the provisions of Statement of Financial Accounting Standards No. 87, Employer’s Accounting for Pensions, the Company recorded a $145.0 million non-cash minimum pension liability adjustment, net of deferred federal income tax, to accumulated other comprehensive income in stockholders’ equity.
The following tables provide the changes in the benefit obligation and fair value of plan assets and statements of the funded status of the plans. Certain prior year amounts have been adjusted for the pension plans of the foreign affiliates.
The funded status amounts in the pension benefits columns above combine plans with projected benefit obligations in excess of plan assets and plans with plan assets in excess of projected benefit obligations. The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for the pension plans with accumulated benefit obligations in excess of plan assets were $577.0 million, $503.0 million, and $392.6 million, respectively, as of December 31, 2002.
The weighted average assumptions used in the measurement of the Company’s benefit obligation are as follows. Certain prior year amounts have been adjusted for the pension plans of the foreign affiliates.
The following table provides the components of the net periodic benefit cost (credit) and early retirement cost for the plans described above. Certain prior year amounts have been adjusted for the pension plans of the foreign affiliates.
During 2000, the Company, through its defined benefit pension plan, purchased a single premium annuity to fund the Company’s retirement benefit obligation for approximately 3,000 retirees. This transaction resulted in a gain of $116.1 million before tax, or $75.5 million after tax.
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.
The computations of earnings per common share and earnings per common share assuming dilution are as follows:
In computing earnings per share assuming dilution, only potential common shares that are dilutive (those that reduce earnings per share) are included. Potential common shares are not used when computing earnings per share assuming dilution if the results would be antidilutive, such as when options are out of the money. Approximately 15.3 million, 10.2 million, and 10.7 million options for the years ended December 31, 2002, 2001 and 2000, respectively, were not considered dilutive due to the options being out of the money.
Note 11 - Incentive Compensation and Stock Purchase Plans - Continued
Under the broad-based stock plan of 2002, the Company has available up to 2,390,000 shares of common stock for awards to its employees, officers, consultants, and producers, excluding certain senior officers and directors. For the stock plan of 1999, the broad-based stock plan of 2001, and the broad-based stock plan of 2002, the exercise price for stock options issued shall not be less than the fair market value of the Company’s stock as of the grant date.
Summaries of the Company’s stock options issued under the various plans are as follows:
The Company applies Opinion 25 and related interpretations in accounting for the stock option plans and ESPP. Accordingly, no compensation cost has been recognized for these plans. Compensation cost for the Company’s stock option plans and ESPP under the fair value approach defined in SFAS 123 was estimated as of the grant date using Black-Scholes option pricing models and is disclosed in Note 1.
Premium income assumed was $511.3 million, $513.3 million, and $618.1 million during 2002, 2001, and 2000, respectively.
In 1996, the Company executed a definitive reinsurance agreement with Centre Life Reinsurance Limited (Centre Re), a Bermuda-based reinsurance specialist, for reinsurance coverage of the existing United States noncancelable individual disability active life reserves of one of the Company’s insurance subsidiaries, Unum Life Insurance Company of America. This agreement reinsures all claims incurred on or after January 1, 1996. The Company has the right, but no obligation, to recapture the business after six years without penalty. Under the agreement, Centre Re has an obligation to absorb losses within a defined risk layer. The Company retains the risk for all experience up to Centre Re’s defined risk layer, or attachment point. Once the attachment point is reached, Centre Re assumes the risk for all experience up to a contractually defined risk limit. Any experience above Centre Re’s defined risk limit reverts back to the Company. As of December 31, 2002, the attachment point had not been reached.
The following discloses the various layers in the agreement at December 31, 2002 (in millions of dollars):
The Company’s insurance subsidiary in the United Kingdom entered into an agreement during 2002 with Sun Life Financial of Canada to acquire its United Kingdom group income protection business together with the renewal rights to the group life business at a price of £27.3 million (approximately $43.5 million). The transaction closed in the first quarter of 2003.
In 1997 two alleged class action lawsuits were filed in Superior Court in Worcester, Massachusetts (Superior Court) against UnumProvident Corporation (UnumProvident) and several of its subsidiaries, The Paul Revere Corporation (Paul Revere), The Paul Revere Life Insurance Company, The Paul Revere Variable Annuity Insurance Company, and Provident Life and Accident Insurance Company. One purported to represent independent brokers who sold certain individual disability income policies with benefit riders that were issued by subsidiaries of Paul Revere and who claimed that their compensation had been reduced in breach of their broker contract and in violation of the Massachusetts Consumer Protection Act (the Act). A class was certified in February 2000. In April 2001, the jury returned a complete defense verdict on the breach of contract claim. Notwithstanding the jury verdict, the judge was obligated to rule separately on the claim that UnumProvident and its affiliates violated the Act. In September 2002, the judge ruled that Paul Revere violated the Act and awarded double damages plus attorneys’ fees. Most of the issues concerning how to calculate the damages have been determined but several remain outstanding before an appeal can be perfected. Complicating the matter was the unexpected death of the trial judge. In March 2003, a new judge was assigned to the case so the parties can proceed to conclude matters before the trial court. The Company feels strongly that the judge’s ruling is contrary to both the law and the facts of the case and plans to appeal after the judgment is made final.
On November 22, 2002 the case of Joan Ferrari, Derivatively on Behalf of Nominal Defendant UnumProvident Corporation v. William L. Armstrong, et al., was filed in the State of Tennessee Chancery Court of Hamilton County. This is a shareholder’s derivative action brought for the benefit of nominal defendant UnumProvident Corporation against its Board of Directors and certain executive officers seeking to remedy alleged breaches of fiduciary duties and other violations of claims paying law. Plaintiff alleges the Individual Defendants established and perpetuated an illegal and improper policy of denying legitimate disability claims by individuals. Further, plaintiff alleges as a result of their responsibility for and knowledge of the Company’s policies and practices, the Individual Defendants knew that the Company was violating various state and federal laws, thus exposing the Company to liability and damages. Plaintiff alleges these acts violated their fiduciary duties of good faith and loyalty. The lawsuit was removed to the United States District Court for the Eastern District of Tennessee on December 27, 2002. Subsequently, two additional shareholder’s derivative actions have been filed in the United States District Court for the Eastern District of Tennessee alleging, among other things, breach of fiduciary duties involving aspects of claims handling and financial reporting. The defendants strongly deny the allegations in the complaints and will vigorously defend both the substantive and procedural aspects of the litigation.
On February 12, 2003 an alleged securities class action suit entitled Frank W. Knisley v. UnumProvident Corporation, et al. was filed in the United States District Court for the Eastern District of Tennessee. The plaintiffs in this case seek to represent purchasers of UnumProvident Corporation publicly traded securities between May 7, 2001 and February 4, 2003. Further, the plaintiffs allege that the Company caused its shares to trade at artificially high levels by, among other things, issuing misleading financial statements, improperly accounting for impaired investments, and pursuing certain improper claims handling practices. The complaint asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Four additional alleged securities class action lawsuits have been filed in the United States District Court for the Eastern District of Tennessee alleging similar causes of action. On February 27, 2003, a sixth complaint entitled Richard Martin v. UnumProvident Corporation, et al., was filed in the United States District Court for the Southern District of New York alleging similar causes of action. The Company strongly denies the allegations in these complaints and will vigorously defend the litigation.
On March 5, 2003, a shareholder’s derivative action, Yoram Levy, Derivatively on Behalf of UnumProvident Corporation v. J. Harold Chandler, et al., was filed in State of Tennessee Chancery Court of Hamilton County against the Board of Directors, certain former directors, and certain executive officers alleging breaches of fiduciary duties in connection with misrepresenting financial results from May 2001 to present through failure to pay certain claims for insureds and failure to record impaired investment assets on a timely basis in order to inflate the price of the Company’s stock. The complaint also alleges abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment. On March 11, 2003, a substantially similar shareholder’s derivative action, Guy Patterson, Derivatively on Behalf of UnumProvident Corporation v. J. Harold Chandler, et al., was filed in State of Tennessee Chancery Court of Hamilton County. The defendants strongly deny the allegations in the complaint and will vigorously defend both the substantive and procedural aspects of the litigation.
The Company and its insurance subsidiaries, as part of their normal operations in managing disability claims, are engaged in claim litigation where disputes arise as a result of a denial or termination of benefits. Most typically those lawsuits are filed on behalf of a single claimant or policyholder, and in some of these individual actions punitive damages are sought, such as claims alleging bad faith in the handling of insurance claims. For claim litigation, the Company and its insurance subsidiaries maintain reserves based on experience to satisfy judgments and settlements in the normal course. Management expects that the ultimate liability, if any, with respect to claim litigation, after consideration of the reserves maintained, will not be material to the consolidated financial condition of the Company. Nevertheless, given the inherent unpredictability of litigation, it is possible that an adverse outcome in certain claim litigation involving punitive damages could, from time to time, have a material adverse effect on the Company’s consolidated results of operations in a particular reporting period.
On January 23, 2003 a jury in California State Court in Marin County, in the case of Chapman v. UnumProvident et al., returned a verdict of $31.6 million against UnumProvident and two of its subsidiaries, The Paul Revere Life Insurance Company and Provident Life and Accident Insurance Company. The largest portion of the verdict was $30.0 million in punitive damages. The Company strongly disagreed with the verdict because the evidence did not support it. The Company filed post-trial motions which challenged, among other things, the excessiveness of the punitive damage award. On March 25, 2003, the court entered an order reducing the punitive damage award to $5.0 million, thereby reducing the total award to $6.1 million. The Company is assessing whether or not it will appeal the verdict to the California Court of Appeals.
Additionally, from time to time class action allegations are pursued where the claimant or policyholder purports to represent a larger number of individuals who are similarly situated. Since each insurance claim is evaluated based on its own merits, there is rarely a single act or series of actions which can properly be addressed by a class action. Nevertheless, the Company monitors these cases closely and defends itself appropriately where these allegations are made. Five such purported class actions are described below.
On November 4, 2002 the case of Theresa Keir et al. v. UnumProvident Corporation et al. (Keir) was filed in the United States District Court for the Southern District of New York. This case purports to be a class action. The plaintiffs in Keir are seeking representative status of a class of group long-term disability participants insured under ERISA plans whose claims were denied or terminated on or after June 30, 1999. The amended complaint alleges that these claimants had their claims improperly challenged and allege that the Company and its insurance subsidiaries breached certain fiduciary duties owed to these participants in ERISA plans in which the Company is the claims adjudicator. The Company maintains that the allegations are false and that the claims, as framed, are not permissible under ERISA’s carefully structured avenues of relief. A substantive motion to dismiss has been filed, and the Company is awaiting a ruling on that motion. In addition, the Company does not believe that a class action should be certified under these circumstances. The Company will vigorously defend against any future attempt to certify the class in Keir.
On February 11, 2003, the case of Marcia Harris, et al. v. UnumProvident Corporation, et al., was filed in the Circuit Court of St. Clair County, Illinois. This case purports to be a class action. The complaint alleges that individuals were wrongfully denied benefits and alleges causes of action under breach of contract, breach of the covenant of good faith and fair dealing, violation of the Illinois Consumer Fraud Act, common law fraud, intentional misrepresentation, and breach of fiduciary duty. Alternatively, the complaint alleges violations of ERISA. The complaint seeks injunctive and declaratory relief as well as restitution and punitive damages. The Company strongly denies the allegations in the complaint and will vigorously defend the litigation.
The following is a summary of unaudited quarterly results of operations for 2002 and 2001: