The Company occupies two connected buildings totaling 840,000 square feet in Chattanooga, Tennessee. The office building and substantially all of the surrounding 23 acres of land used for employee parking are owned by the Company, including an employee parking garage and a 27-unit apartment building for corporate use. In addition, approximately 171,000 square feet of office space is leased and occupied in a nearby office building.
The Company owns and occupies seven facilities in Portland, Maine, with 850,000 square feet of office space and 250 acres of land, a portion of which has been developed for employee parking. During 2003, the Company sold a facility with office space totaling 116,000 square feet. As part of the transaction, the Company entered into a five year lease of the space it currently occupies in that building. In addition, approximately 164,000 square feet of office space is leased and occupied in two additional buildings.
The Company also owns office buildings in the United Kingdom which serve as the home offices of Unum Limited. The property in the United Kingdom is located in Dorking, with approximately 67,000 square feet of office space located on approximately 55 acres with a portion developed for employee parking. In addition, approximately 39,000 square feet of office space is leased and occupied in two office buildings located in Bristol and Basingstoke and another 14,000 square feet of leased office space serves five major city locations in England and Scotland.
(1) Includes the net increase in deferred policy acquisition costs, amortization of value of business acquired and goodwill, compensation expense, and other operating expenses.
(3) The Company adopted the provisions of Statement of Financial Accounting Standards No. 142 (SFAS 142), Goodwill and Other Intangible Assets effective January 1, 2002. Prior to January 1, 2002, goodwill was amortized on a straight-line basis over a period not to exceed 40 years. Had amortization of goodwill been excluded from expenses for the years ended December 31, 2001, 2000, and 1999, net income (loss) would have been $561.5 million, $560.3 million, and $(159.6) million, respectively, and net income (loss) per common share assuming dilution would have been $2.30, $2.31, and $(0.67), respectively.
In 2003, there were a number of areas of the business that met expectations, including the Company’s United Kingdom and Colonial operations, and its U.S. brokerage group life, voluntary, and individual income protection - recently issued business lines. Other areas, primarily the group income protection and individual income protection - closed block business lines, faced significant challenges, which the Company addressed over the course of the year, as described below.
• The Company’s experience has been that its U.S. group disability claim trends are correlated with consumer confidence levels and employment growth. In periods with falling or negative growth in employment, or low consumer confidence, the Company has experienced a corresponding increase in disability claim incidence and greater difficulty in returning disabled insureds to work. According to the U.S. Department of Labor, the United States economy lost 2.4 million jobs during the time period between December 2000 and December 2003 and experienced a change in the unemployment rate from 4.2 percent in January 2001 to 5.7 percent in December 2003. During the same period, the consumer confidence index, as measured by the Conference Board, fell from 115.7 to 91.7, a 20.7 percent decrease. From 2001 through 2003, the Company experienced an increase in submitted group income protection claims of approximately 6.6 percent. During 2003, claim resolution rates, which partially reflect the Company’s ability to return disabled insureds to work, were lower than in any year since 1999. The combined impact of higher claim incidence and lower than usual claim resolutions contributed to the Company’s reserve strengthening during 2003 for its group income protection reserves.
• An unfavorable investment environment has a detrimental effect on both the Company’s revenue and expenses. From the end of 2000 through the end of 2003 the yield on the benchmark 10-year U.S. Treasury note declined from 5.11 percent to 4.25 percent. This investment environment affected the Company in three ways. First, a large portion of the Company’s investment portfolio is invested in fixed income securities to pay future policyholder benefits. Falling investment yields increase the amount of reserves which must be established to pay future policyholder liabilities. Unless the Company can increase its prices to reflect these lower investment yields, the lower yields place pressure on profit margins. Second, cash flows from existing investments due to interest payments, sales and maturities of securities, or prepayments must be reinvested at lower current rates, which lower the net investment income earned on the investment portfolio. Third, falling investment yields have an impact on employee benefits costs in general, primarily the cost of providing pension benefits to employees. Along with rising medical costs, the investment environment since 2001 has put pressure on all employee benefits costs, including the price of products sold by the Company.
- Lowering the discount rate for reserves established for new group and individual income protection claims to levels consistent with today’s lower levels of interest rates; and,
In addition, the improving trend in the investment credit market as well as the reduction in below-investment grade securities reduced the Company’s level of unrealized losses in its fixed maturity bond portfolio from $1.1 billion at the end of 2002 to $491.0 million at the end of 2003. The Company also experienced improvement in the amount of unrealized losses on below-investment-grade securities in an unrealized loss position for over one year.
The Company has responded to this negative publicity by increasing its communication level with all of its constituents, to be sure all these individuals are equipped with the facts. The Company is also being responsive to all inquiries concerning its processes and practices, and while it responds to these various parties the Company has continued to review its existing processes and practices and has made refinements and improvement in procedures - an approach it has followed for many years. Although this adverse publicity has made it more difficult to compete in the marketplace, the Company has not experienced any material change in sales, persistency, or sales force personnel as a result of the negative attention. The Company believes that its strong relationships with its producers and customers, supported by consistent service and claim handling, have been significant factors in maintaining its strong reputation in the market.
- Selling $1.150 billion in equity and equity-related securities, with a portion of the proceeds used to reduce intercompany borrowing by $535.0 million and increase the capital level of the Company’s U.S. insurance subsidiaries through capital contributions of $510.0 million in cash; and,
The cumulative result of these efforts was to restore the Company’s risk-based capital ratio to 247 percent as of December 31, 2003. With the anticipated closing of the sale of the Canadian operation in the first half of 2004, the Company expects that its risk-based capital ratio will be approximately 277 percent, the highest level since the 1999 merger of Unum and Provident.
• Key elements to success in the Company’s U.S. brokerage group income protection business are appropriate underwriting and pricing. Beginning in the second half of 2003, the Company instituted more disciplined underwriting and pricing for both new and renewal business in this line. While this approach is believed to be best for the long term, it may result in lower sales and/or lower persistency of existing business in the near term. The
Despite these improvements in 2003, the Company’s U.S. brokerage group income protection business line continued to perform below expectations. The key actions to restore the U.S. brokerage group income protection profitability include:
While taking the actions needed to restore profitability in the Company’s U.S. brokerage group income protection business, the Company intends to continue to maintain, if not improve upon, the performance in its other lines of business and subsidiaries. The Company’s expectation is that over time the U.S. brokerage group income protection results will improve, and other areas will become more significant contributors to the Company’s overall results.
The remaining sections of Item 7 discuss the critical accounting policies, significant transactions and events, segment operating results, discontinued operations, consolidated investments, liquidity and capital resources, current debt and financial strength ratings, and other pertinent information for the Company and its insurance subsidiaries. This discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto contained herein in Item 8.
The two primary categories of liabilities for policy and contract benefits are policy reserves for claims not yet incurred and claim reserves for claims that have been incurred and have future benefits to be paid. Policy reserves equal the present value of the difference between future policy benefits and expenses and future premiums, allowing a margin for profit. These reserves are applicable for the majority of the Company’s business, which is traditional non interest-sensitive in nature. The claim payments are estimated using assumptions established when the policy was issued. Throughout the life of the policy, the reserve is based on the original assumptions used for the policy’s issue year. Ordinarily, generally accepted accounting principles require that these assumptions not be subsequently modified unless the policy reserves are determined to be inadequate.
A claim reserve is established when a claim is incurred or is estimated to have been incurred but not yet reported to the Company. Policy reserves for a particular policy continue to be maintained after a claim reserve has been established for as long as the policy remains in force. Claim reserves generally equal the Company’s estimate, at the current reporting period, of the present value of the liability for future benefits and expenses to be paid on claims incurred as of that date. A claim reserve for a specific claim is based on assumptions derived from the Company’s actual historical experience as to claim duration as well as the specific characteristics of the claimant such as benefits available under the policy, the covered benefit period, and the age and occupation of the claimant. Consideration is given to current and historical trends in the Company’s experience and to expected deviations from historical experience that result from changes in benefits available, changes in the Company’s risk management policies and procedures, and other economic, environmental, or societal factors. Reserves for claims that are estimated to have already been incurred but that have not yet been reported to the Company are based on factors such as historical claim reporting patterns, the average cost of claims, and the expected volumes of incurred claims.
The Company has liability for claims that have been incurred but not reported to the Company and must establish a liability for these claims equal to the present value of the expected benefit payments. In addition to the discount rate and claim resolution rate, the incidence rate is also a primary assumption in the IBNR reserve. The incidence rate is the rate at which new claims per thousand insured lives are submitted to the Company. The incidence rate is affected by many factors including the age of the insured, the insured’s occupation or industry, the benefit plan design, and certain external factors such as consumer confidence and levels of unemployment. The Company establishes the incidence assumption using a historical review of actual incidence results along with an outlook of future incidence expectations. As the actual claims are reported and claim reserves are established, the accuracy of the IBNR emerges. While the Company expects its IBNR reserve to be appropriate over the long term, it will not always equal, in a particular reporting period, the actual reserve established for a reported claim. For example, a 10 basis point deviation in the actual incidence rate from that assumed in the IBNR reserve would have resulted in an increase or decrease of approximately $10.0 million in claim reserves established during a quarter in 2003, relative to the IBNR reserve previously established to cover those claims.
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 certain commissions, other agency compensation, selection and policy issue expenses, and 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 94 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 in accordance with the provisions of Statement of Financial Accounting Standards No. 60, Accounting and Reporting by Insurance Enterprises. 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.
• Whether the security is current as to principal and interest payments.
• Current Baa corporate bond spreads ranging from 0.64 percent to 1.52 percent plus an additional 30 basis points were added to the risk free rate to consider the lack of liquidity.
Increasing the 30 basis points added to the risk free rate for lack of liquidity by 1.5 basis points, increasing the five basis points added to the risk free rates for foreign investments by one basis point, and increasing the additional basis points added to each industry considered to be of greater risk by one basis point would have decreased the December 31, 2003 net unrealized gain in the fixed maturity securities portfolio by approximately $2.4 million. Historically, the Company’s realized gains or losses on dispositions of its private placement fixed maturity securities have not varied significantly from amounts estimated under the valuation methodology described above.
• The economic outlook, either domestic or foreign, may be less favorable or may have a more significant impact on the borrower than anticipated, and as such, the security may not recover in value.
Goodwill is the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed. Goodwill is not amortized, but the Company reviews on an annual basis the carrying amount of goodwill for indications of impairment, with consideration given to financial performance and other relevant factors. In accordance with accounting guidance, the Company tests for impairment at either the operating segment level or one level below. In addition, certain events including, but not limited to, a significant adverse change in legal factors or the business environment, an adverse action by a regulator or rating agency, or unanticipated competition
The Company records a valuation allowance to reduce deferred tax assets to the amount that is more likely than not to be realized. The Company’s valuation allowance relates primarily to foreign net operating loss carryforwards. The Company has considered forecasted earnings, future taxable income, and prudent and feasible tax planning strategies in determining the need for a valuation allowance. In the event the Company determines that it might not be able to realize all or part of the net deferred tax assets in the future, an increase to the valuation allowance would be charged to earnings in the period such determination is made. Likewise, if it is later determined that it is more likely than not that the net deferred tax assets would be realized, the previously provided valuation allowance would be reversed.
Furthering its goal of divesting its non-core operations, during 2003, the Company reinsured on a 100 percent indemnity coinsurance basis for non-New York policies and a 90 percent indemnity coinsurance basis for New York policies certain of its insurance policies sold through trade associations and ceded approximately $121.0 million of reserves to the reinsurer. The annual premium on the block reinsured was approximately $40.0 million and related primarily to individual income protection policies. The transaction had an effective date of April 1, 2003.
Transition to the provisions of FIN 46 required the Company to consolidate four special purpose entities whose purposes are to support the Company’s investment objectives. Prior to December 31, 2003, these entities were accounted for as fixed maturity securities in the available for sale portfolio and carried at fair value which was derived from the fair value of the underlying assets. These entities are securitized asset trusts and contain specific financial instruments that do not include the Company’s common stock or debt. Three of these entities are trusts holding forward contracts to purchase unrelated equity securities. Each of these trusts also holds a defeasance swap contract for highly rated bonds to provide principal protection for the investments. The fair value of the underlying forward and swap contracts was $133.9 million at the time of transition to FIN 46, which was equivalent to the fair value at which they would have been reported as fixed maturity securities prior to the adoption of FIN 46. The
Effective October 1, 2003, the Company adopted the provisions of Statement of Financial Accounting Standards No. 133 Implementation Issue B36 (DIG Issue B36), Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposure That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor Under Those Instruments. DIG Issue B36 addresses financial accounting and reporting for embedded derivatives in modified coinsurance contracts that incorporate credit risk exposure unrelated to the credit risk of the counterparty to the reinsurance contract and requires the bifurcation of any such derivative from the host reinsurance contract. The change in the fair value of the derivative is reported as a realized investment gain or loss during the period of change.
The Company has two reinsurance contracts for which DIG Issue B36 is applicable. Transition to the provisions of DIG Issue B36 required the Company to value the credit risk provisions in these contracts as derivatives. The derivatives are now reported in the Company’s consolidated statements of financial condition at their current fair values, with the change in fair value since inception of the reinsurance contracts up to the date of adoption reported as a cumulative effect of accounting principle change. The Company includes in miscellaneous assets a deposit asset for one of the applicable reinsurance contracts. The deposit asset is comprised of the Company’s experience layer and previously included unrealized gains or losses on the marketable securities held in the trust. Under the provisions of DIG Issue B36, the Company will no longer report the unrealized gains or losses on the marketable securities held in the trust as an adjustment to the value of the deposit asset. The unrealized gain or loss is now attributed to the value of the embedded derivative and is reported as such.
provisions of Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation - Transition and Disclosure. The adoption increased before tax operating expenses for 2003 approximately $0.9 million.
The Company’s net periodic benefit cost for its U.S. and foreign pension plans, which is calculated in accordance with SFAS 87, increased in 2003 due to the decline in the stock market and the general decline in overall corporate bond yields used to establish the discount rate for projecting the benefit obligation. The net periodic benefit cost for 2003 was $51.8 million compared to a $2.7 million net periodic benefit cost for 2002. Based on projections as of December 31, 2003, the Company estimates its net periodic benefit cost for 2004 will be in the range of $56.0 million to $60.0 million. See “Pension and Postretirement Benefits Plans” contained herein for further discussion.
In 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.
During 2002, the Company acquired whereiwork, a provider of online solutions for insurance enrollment, communications, administration, and analysis, at a price of $2.8 million. This acquisition has served to strengthen and broaden the Company’s internet-based benefits services currently offered to brokers and employers.
The September 11, 2001 tragedy resulted in a 2001 before-tax charge of $24.0 million, or $15.6 million after tax. This charge included estimated gross ultimate losses from reported and unreported claims of $65.0 million less an estimated $41.0 million recoverable from the Company’s reinsurers. The charge did not include any indirect costs which the Company incurred in developing specialized procedures for filing claims resulting from the attacks and in providing additional support to affected policyholders and group clients. The Company’s reinsurance program
provided a significant layer of catastrophic coverage for its individual disability and its group life, accidental death and dismemberment, travel accident, long-term disability, and short-term disability lines of business.
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 Company redeemed its $172.5 million par value 8.8% monthly income debt securities (junior subordinated debt), which were due in 2025 but callable at par in 2000 and thereafter. This early redemption was expected to lower the Company’s financing costs in 2002 through the use of commercial paper available at lower interest rates. The early extinguishment of debt resulted in a write-off of the remaining deferred debt cost of $4.5 million associated with the issuance of the securities, which decreased net income $2.9 million.
During 2003, the Company introduced a distribution model for the sale of individual income protection and individual long-term care insurance products reported in the income protection segment whereby independent brokers and consultants are provided direct access to a sales support center centrally located in the Company’s corporate offices. Previously, sales of most single policies had been handled through the Company’s field sales organization. The Company intends to maintain its focus on workplace customers and increased integration between individual multi-life and group offerings by continuing to provide highly focused field support.
Existing market share, as well as trends in new sales, are indicators of the Company’s potential for growth in its respective markets and the level of market acceptance of price changes and new products. Sales may fluctuate significantly due to case size and timing of sales submissions. Negative media attention or downgrades in the financial strength ratings of the Company’s insurance subsidiaries may adversely affect the Company’s ability to grow sales and renew its existing business.
These non-GAAP financial measures of “operating revenue” and “operating income” or “operating loss” differ from revenue and income (loss) from continuing operations before income tax and cumulative effect of accounting principle changes as presented in the Company’s consolidated operating results reported herein and in income statements prepared in accordance with GAAP due to the exclusion of before tax realized investment gains and losses. The Company measures segment performance for purposes of Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information, excluding realized investment gains and losses because management believes that this performance measure is a better indicator of the ongoing businesses and the underlying trends in the businesses. The Company’s investment focus is on investment income to support its insurance liabilities as opposed to the generation of realized investment gains and losses, and a long-term focus is necessary to maintain profitability over the life of the business. Realized investment gains and losses are dependent on market conditions and not necessarily related to decisions regarding the underlying business of the Company’s segments. However, income or loss excluding realized investment gains and losses does not replace net income or net loss as a measure of the Company’s overall profitability. Due to factors discussed under “Risk Factors - Investments” contained herein in Item 1 and the Company’s exposure to below-investment-grade fixed maturity securities, as discussed in a subsequent section of this Management’s Discussion and Analysis, the Company may experience realized investment losses. The realization of investment gains and losses will affect future earnings levels as the underlying business is long-term in nature and requires that the Company be able to earn the assumed interest rates in its liabilities. A reconciliation of total operating revenue by segment to total consolidated revenue and total operating income or loss by segment to consolidated net income or loss is as follows.
Group long-term income protection sales on a fully insured basis decreased 0.4 percent during 2003 compared to 2002. The slight net decline occurred in the Company’s U.S. market, with a decline in the large-employer market more than offsetting growth in the small and mid-employer markets. Sales increased in the mid-employer market during 2003 as the Company began to shift its focus to this market, which is comprised of groups of 500 to 1,999 lives. The decrease in the U.S. sales was partially offset by growth of 42.9 percent in the Company’s United Kingdom operations. The Company also offers accounts handled on an administrative services only (ASO) basis, with the risk and responsibility for funding claim payments remaining with the customer. The Company reports the fee income on ASO business in “other income.” For ASO business, sales increased 35.4 percent for group long-term income protection relative to the prior year. Group short-term income protection sales for fully insured business decreased 1.6 percent while the ASO business decreased 28.7 percent in 2003 compared to 2002. The comparative decline for 2003 versus 2002 in short-term income protection ASO sales was primarily due to a large case sold in 2002.
As previously discussed, during 2003, the Company introduced a new distribution model for the sale of individual income protection and individual long-term care insurance products which will enable the Company to maintain its focus on workplace customers and increased integration between individual multi-life and group offerings. The Company also introduced changes in the individual long-term care product offering during 2003. These actions may slow the growth in sales of non multi-life individual income protection and individual long-term care insurance relative to historical trends.
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 income protection, group short-term income protection, and individual income protection). 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.
The benefit ratio for group income protection increased from 83.5 percent in 2002 to 121.5 percent in 2003. Excluding the impact of the 2003 reserve strengthening for group income protection, the benefit ratio was 92.0 percent for 2003. Group income protection experienced a decrease in its commission ratio, offset by an increase in operating expenses. There was no additional amortization of deferred policy acquisition costs related to persistency for 2003, but expected amortization, as determined when the costs were initially capitalized, continues to increase year over year due to the continued growth in the deferred policy acquisition cost asset balance related to new sales growth in the block of business and acceleration of expected amortization for costs capitalized in 2002 and subsequent years. For 2002, the additional amortization related to persistency was $12.9 million.
Group income protection operating revenue was $3,473.5 million in 2002 compared to $3,243.2 million in 2001. Group income protection reported operating income of $350.4 million for 2002 compared to $354.2 million for 2001.
Persistency during 2002 on the overall block of group income protection improved over 2001, with long-term income protection persistency for the Company’s U.S. business at 86.5 percent compared to 84.5 percent in 2001. Short-term income protection persistency for the Company’s U.S. business was 81.5 percent in 2002 versus 82.0 percent in 2001. Excluding the effects of cases that transferred from fully insured to ASO, short-term income protection persistency was 82.6 percent for 2002. Although the overall block of group income protection 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.
The benefit ratio in 2002 was essentially flat compared to 2001. Both submitted and paid claim incidence for group long-term income protection increased from 2001, with a portion of the increase attributable to industries affected by the weaker economy. Claim resolution rates for group long-term income protection in 2002 were lower than 2001. Payments to settle claims in litigation increased in 2002 compared to 2001, as did the number of new lawsuits.
Operating revenue was $528.5 million for 2002 compared to $485.5 million in 2001. Operating income in the individual income protection - recently issued line of business was $146.8 million in 2002, an increase of $9.3 million over the prior year. The benefit ratio of 57.1 percent for 2002 increased from the 2001 ratio of 53.7 percent. The
The individual income protection - closed block generally consists of those policies in force prior to the Company’s substantial changes in product offerings, pricing, distribution, and underwriting. These changes generally occurred during the period 1994 through 1998. The Company is reviewing various strategies for this block, including but not limited to reinsurance, separate segment reporting, or other internal and external alternatives. Some of these strategies could result in the write-down or partial write-down of intangible assets such as goodwill, value of business acquired, or deferred policy acquisition costs. The book value of goodwill, value of business acquired, and deferred policy acquisition costs attributed to the individual income protection - closed block was approximately $207.1 million, $367.1 million, and $282.2 million, respectively, at December 31, 2003.
Operating revenue was $1,948.6 million for 2003 compared to $2,006.5 million in 2002. Premium income decreased $77.8 million, or 7.0 percent, relative to the prior year, due to the expected decline in this closed block of business and also due to a reinsurance transaction. As previously discussed, during 2003, the Company reinsured a block of individual income protection policies previously sold through trade associations. The transaction, which closed during the fourth quarter of 2003 with an effective date of April 1, 2003, reduced 2003 premium income in the individual income protection - closed block by approximately $16.1 million. The $31.2 million before-tax loss on this transaction, of which $29.6 million related to individual income protection - closed block, was deferred and is being amortized into income based upon expected future premium income on the policies ceded.
Operating income in this block was $62.5 million in 2003 compared to $83.0 million in 2002. The benefit ratio for 2003 increased to 149.1 percent in 2003 relative to 139.6 percent in the prior year. The interest adjusted loss ratio was 82.7 percent and 78.1 percent for 2003 and 2002, respectively. Submitted claim incidence for 2003 decreased relative to 2002, after increasing throughout 2001 and peaking in the first quarter of 2002. The level of paid claim incidence was also lower in 2003 than the incidence rate level experienced in 2002. The net claim resolution rate decreased compared to the level of 2002. Payments to settle claims in litigation increased in 2003 compared to 2002 while the number of new lawsuits filed decreased. Individual income protection - closed block results benefited from an improvement in the commission ratio relative to 2002, somewhat offset by a slight increase in the operating expense ratio.
Operating revenue was $2,006.5 million for 2002 compared to $1,973.5 million in 2001. Operating income in the individual income protection-closed block line of business was $83.0 million in 2002, a decrease of 21.5 percent over the $105.7 million reported in the prior year. The benefit ratio of 139.6 percent for 2002 was slightly higher than the 2001 ratio of 129.5 percent. The interest adjusted loss ratio was 78.1 percent and 73.0 percent for 2002 and 2001, respectively. Submitted and paid claim incidence rates for individual income protection - closed block increased in 2002 compared to 2001. The net claim resolution rate for 2002 decreased compared to the 2001 results. The commission ratio increased slightly in 2002 compared to 2001, but the operating expense ratio declined year over year.
Year Ended December 31, 2003 Compared with Year Ended December 31, 2002
Submitted and paid claim incidence for individual long-term care decreased in 2003 from 2002 levels, while group long-term care experienced increased paid claim incidence and stable submitted incidence. The 2003 net claim resolution rate was lower than 2002 for individual long-term care, driven by lower claim recoveries. The net claim resolution rate increased for group long-term care in 2003 relative to 2002. Results for long-term care continue to be volatile due to the relatively small size of this block of business.
Operating revenue from disability management services, which includes the Company’s wholly-owned subsidiaries GENEX Services, Inc. and Options and Choices, Inc., totaled $173.0 million in 2003, compared to $174.8 million in 2002 and $150.6 million in 2001. Operating income totaled $17.2 million in 2003, compared to $18.9 million in 2002 and $13.7 million in 2001. Results for 2003 relative to 2002 were negatively impacted by lower customer retention levels in 2003. The Company expects that results will improve as new sales increase the customer base.
The Company’s primary focus in 2004 for Income Protection will be on enhancing profitability, with an emphasis on the core markets and a balanced mix of business. The Company does not expect significant sales growth in 2004, particularly in the large-employer market, as the Company continues with the strategy it implemented in 2003 to shift business mix from the large-employer market to the mid- and small-employer markets. The Company intends to take a disciplined approach to pricing, renewals, and risk selection, with a more conscious effort to balance growth and profitability. Although this strategy may cause a somewhat lower persistency or market share, historically the profitability of business that terminates has generally been less than the profitability of retained business. The Company also expects that its income protection product results will benefit if there is an improvement in overall economic conditions and a higher interest rate environment, although the improvement in results may lag behind the improvements in the economy and interest rate environment.
Premium growth in 2003 relative to 2002 was attributable to favorable renewal results, strong sales results in the United Kingdom operations, and stable persistency. Persistency for group life U.S. operations was less favorable during 2003 than in 2002, with persistency of 83.2 percent compared to 83.9 percent for 2002. For accidental death and dismemberment, persistency was 84.2 percent for 2003 and 82.5 percent for 2002. The amortization of deferred policy acquisition costs for 2002 includes $9.2 million of additional amortization due to the higher level of terminations for group life products experienced during 2002 than expected at the time the policies were written. There was no additional amortization of deferred policy acquisition costs in 2003. As previously discussed in the operating segment results for group income protection and as also applicable to group life and accidental death and dismemberment, the Company has accelerated the amortization of costs pertaining to certain of its lines of business into the early life of the policy by using lower premium persistency assumptions in determining its “scheduled” or expected amortization. Although persistency in the future may be lower than historical levels, particularly in certain issue years due to the Company’s increased emphasis on retaining profitable business, the acceleration of
Group life and accidental death and dismemberment reported a $6.0 million increase in operating income for 2003 compared to the prior year. The increase was partially attributable to a decrease in the benefit ratio for both group life and accidental death and dismemberment in 2003 relative to 2002. Group life and accidental death and dismemberment reported a lower commission ratio and a flat operating expense ratio for 2003 relative to the prior year.
Submitted and paid claim incidence for group life were both lower in 2003 relative to 2002. The average paid claim size for group life increased from 2002. The incidence rate for group life waiver of premium coverage that results from a policyholder’s disability decreased in 2003 compared to the prior year. Group life waiver recovery rates for 2003 also decreased from the levels of 2002. Both submitted and paid incidence for accidental death and dismemberment decreased in 2003 relative to the prior year.
The Company follows strict underwriting guidelines and implements pricing changes and other case specific remedial plans for under-performing business to improve profitability in group life. These actions may contribute to a lower rate of sales growth or higher level of terminations for this business.
Group life and accidental death and dismemberment reported operating income of $221.9 million in 2002 compared to $159.7 million in 2001.
Group life and accidental death and dismemberment reported an increase in operating revenue for 2002 compared to 2001 due to increases in both premium income and net investment income. Premium growth was attributable to renewal increases, strong sales results in prior periods, and stable persistency. Persistency for the U.S. operations group life was 83.9 percent in 2002 and 84.6 percent for 2001. For accidental death and dismemberment, persistency was 82.5 percent and 83.0 percent for 2002 and 2001, respectively.
Group life submitted and paid incidence was higher in 2002 than in 2001. The average paid claim size also increased compared to the prior year, and waiver incidence continued to be above recent levels. The claim recovery rate on waiver claims increased, somewhat mitigating the effect of the increase in waiver incidence. The 2002 benefit ratio for accidental death and dismemberment was lower than 2001.
Operating revenue in the brokerage voluntary life and other line increased to $254.7 million in 2003 from $215.9 million in 2002 primarily due to an increase in premium income. The increase was attributable to prior year new sales and favorable persistency. Operating income for 2003 was $36.9 million compared to $30.3 million in the prior year. Brokerage voluntary life and other reported an increase in the commission ratio relative to 2002, offset by higher capitalization of policy acquisition expenses. The operating expense ratio was slightly lower in 2003 relative to 2002. The benefit ratio for the life line of business decreased from 2002, primarily due to favorable mortality. The benefit ratio for the other line, primarily cancer and critical illness insurance, decreased relative to 2002. Brokerage voluntary other is a small block of business, and volatility in results may occur.
Operating revenue in brokerage voluntary life and other was $215.9 million in 2002 compared to $189.2 million in 2001 due to growth in premium income. Operating income was $30.3 million and $24.6 million in 2002 and 2001, respectively. The growth in operating income was due to the increase in revenue and a lower benefit ratio. The commission and operating expense ratios were slightly higher in 2002 compared to the prior year, partially eroding the profit margin.
(1) During 2003, the Company discontinued the sale of group long-term income protection products, and existing contracts were either renewed with another insurance provider or terminated as contractually provided. This exit strategy was complete as of the end of 2003, resulting in a decline in the 2003 persistency, relative to historical periods, for income protection and accident and sickness.
Operating revenue in the Colonial segment increased to $786.0 million in 2003 from $720.0 million in 2002 due to an increase in premium income in all product lines and an increase in net investment income. The premium income increase was attributable to prior year new sales and overall favorable persistency.
Operating revenue in the Colonial segment increased to $720.0 million in 2002 from $698.5 million in 2001 due to the increase in premium income attributable to sales growth and favorable persistency.
As previously discussed, during 2001 the Company reinsured on a 100 percent indemnity coinsurance basis certain cancer policies written in the Colonial segment. The transaction closed during the fourth quarter with an effective date of November 1, 2001. The Company ceded approximately $113.6 million of reserves to the reinsurer. The $12.3 million before-tax gain on this transaction was deferred and is being amortized into income based upon expected future premium income on the policies ceded. The Company will continue to market its other cancer products.
Service is used as a differentiator for the Colonial segment in the marketplace. The two key drivers for effective service delivery are trained service professionals and effective use of technology. These key drivers will be emphasized by seeking to increase innovation, productivity, and performance through leadership development and technological advances.
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 $283.1 million at December 31, 2003 and $313.8 million at the end of 2002.
Group pension, health insurance, individual annuities, and other closed lines of business had operating revenue of $150.4 million, $159.1 million, and $200.1 million in 2003, 2002, and 2001 and operating income (loss) of $(1.5) million, $7.0 million, and $14.3 million. Decreases in operating revenue and income are expected to continue as these lines of business wind down.
Included in these amounts are the Company’s operating results for its operation in Argentina, which produced operating revenue of $18.1 million, $18.4 million, and $47.1 million in 2003, 2002, and 2001, and operating income loss of $(13.4) million, $0.1 million, and $1.1 million in each of those three years. As previously discussed, during the fourth quarter of 2003, the Company recognized an impairment loss related to this operation, comprised of a foreign exchange loss of $6.4 million and the write-down of a $7.1 million receivable considered uncollectible. These charges decreased operating revenue and operating earnings in the Other segment by $6.4 million and $13.5 million, respectively. In 2001, the Company wrote off the remaining goodwill balance of $5.4 million related to its operation in Argentina. The 2001 goodwill write-off was included in the Corporate segment operating results.
As previously discussed, during the fourth quarter of 2003, the Company recognized an impairment loss of $1.2 million before tax on its Japanese operation.
In 2002 and 2001, income from discontinued operations was $11.4 million and $3.5 million, net of tax.
Investment activities are an integral part of the Company’s business, and profitability is significantly affected by investment results. Invested assets are segmented into portfolios that support the various product lines. Generally, the investment strategy for the portfolios is to match the effective asset cash flows and durations with related expected liability cash flows and durations to consistently meet the liability funding requirements of the Company’s business. The Company seeks to maximize investment income and total return and to assume credit risk in a prudent and selective manner, subject to constraints of quality, liquidity, diversification, and regulatory considerations. The Company’s overall investment philosophy is to invest in a portfolio of high quality assets that provide investment returns consistent with that assumed in the pricing of its insurance products. Assets are invested predominately in fixed maturity securities, and the portfolio is matched with liabilities so as to eliminate as much as possible the Company’s exposure to changes in the overall level of interest rates. The Company invests for the long term, with the weighted average duration of its liability portfolio approximately 9.65 years at December 31, 2003. The weighted average duration of the Company’s investment portfolio was 8.96 years at December 31, 2003, and the weighted average credit rating was A.
• 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 publicly traded investment-grade corporate securities, mortgage-backed securities, asset-backed securities, municipal securities, and commercial mortgages. The Company does not currently intend to invest in additional real estate.
• The weighted average credit quality rating of the portfolio should be BBB or higher.
• The maximum investment per issuer group is limited based on internal limits established by the Company’s board of directors and is more restrictive than the 5 percent limit generally allowed by the state insurance departments which regulate the type of investments the Company’s insurance subsidiaries are allowed to own. These internal limits are as follows:
• Asset mix guidelines and limits are established by the Company and approved by the board of directors.
• $26.4 million loss during the first quarter of 2003 on securities issued by a related entity of a U.S. based energy company. The write-down represented 14.1 percent of the total write-downs for 2003. The securities were issued by a utility company that services an industrial site in England and whose 98 percent parent filed for insolvency in December 2001. This issuer was excluded from the parent’s insolvency filing due to the financial separation from the parent and was operating as a going concern during 2002. Despite the financial separation, the issuer’s securities were downgraded to below-investment-grade in the fourth quarter of 2001. The Company initially recognized an impairment loss on these securities at the time of the parent’s insolvency filing in 2001. These bonds were secured by a second lien on the real estate holdings of the company. The Company closely monitored this security and the value of the collateral during 2002. Following extensive negotiations during 2002 and the first quarter of 2003 with the company’s two other lenders, financial advisors, and counsel, it was determined that the investment was further impaired. Prior to its write-down in 2003, the investment had been in an unrealized loss position for a period of greater than 270 days but less than one year. The circumstances of this impaired investment have no impact on other investments.
• $11.3 million loss during the second quarter of 2003 on securities issued by a regulated natural gas pipeline company located in Argentina. The write-down represented 6.0 percent of the total write-downs for 2003. The write-down was taken following continued delays by the Argentine government in implementing tariff reform and the company’s default on its interest payment due during the second quarter. These securities
were investment-grade at the time of purchase but were downgraded to below-investment-grade in the second quarter of 2001. At the time of the write-down, these securities had been continuously 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.
• $11.1 million loss during the fourth quarter of 2003 on securities issued by a leading producer of performance products for the automotive industry and nylon fibers for the carpet industry. The write-down represented 5.9 percent of the total write-downs for 2003. The securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the first quarter of 2002. The issuer was current on its interest payments as of September 30, 2003, but filed for bankruptcy in December 2003, despite having implemented several successful measures which improved liquidity and reduced potential legal liabilities. At the time of the write-down, these securities had been continuously in an unrealized loss position for a period of greater than 1 year but less than two years. The circumstances of this impaired investment have no impact on other investments.
Approximately 48 percent of the 2002 write-downs in continuing operations occurred in the communications sector. 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 Company.
• $27.8 million loss during the second quarter of 2002 on securities issued by a U.S. based global telecommunications company providing global voice and data services. The write-down represented 6.3 percent of the total write-downs for 2002. It was discovered in June 2002 that the company had misclassified certain expenses, materially changing the reported financial condition and profitability of the business. The company had an investment-grade rating prior to its downgrade 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 one year but less than two years. The circumstances of this impaired investment have no impact on other investments.
• $25.1 million loss during the fourth quarter of 2002 on securities issued by a subsidiary of a U.S. based company engaged in the electricity business in the United Kingdom. The write-down represented 5.7 percent of the total write-downs for 2002. As this industry’s operating environment in the United Kingdom weakened over the past few years due to competitive pricing pressures, the company remained encumbered with a number of above-market price power purchase agreements resulting in significant operating losses. The parent company had previously provided equity support and had committed an additional $700.0 million to this subsidiary to be used primarily to renegotiate these contracts. The company had an investment-grade rating prior to the time the parent company unexpectedly withdrew its promised support in October 2002, which resulted in a downgrade to below-investment-grade. The company defaulted on its October interest payments, and the parent company was subsequently placed in administration in the United Kingdom. Prior to its write-down, the investment had been in an unrealized loss position for a period of greater than three years. The Company holds securities in a related subsidiary and has also recognized an other than temporary impairment loss on that related subsidiary.
• $23.2 million loss during the first quarter of 2002 on securities issued by the holding company of a large national wholesale communications company. The write-down represented 5.2 percent of the total write-downs for 2002. In the third quarter of 2001 the company reported sales of $298 million, a 42 percent increase over the comparable prior year period, and liquidity of $1.4 billion in cash equivalents. It was expected that the company would use the proceeds from the sale of non-core assets to further supplement liquidity. In January 2002, the company’s banks agreed to extend the negotiating period for an amendment to the credit agreement until the end of February 2002. During the first quarter of 2002, the company reported fourth quarter 2001 results, including an 11 percent increase in revenue to $330.3 million. The company had cash equivalents in excess of $1.0 billion, an indication that the company had sufficient liquidity to fund its business plan through 2003. However, late in the first quarter of 2002, the company’s banks unexpectedly refused to allow the company to draw on its credit lines. The company reported that it would seek bankruptcy protection. Both Moody’s and Standard & Poor’s downgraded the security during the first quarter of 2002. The investment was originally purchased as part of the Company’s below-investment-grade strategy. At the time of the write-down, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The circumstances of this impaired investment have no impact on other investments.
company that services an industrial site in England and whose 98 percent parent filed for insolvency in December 2001. The subsidiary was excluded from this insolvency filing due to the financial separation from the parent and was operating as a going concern during 2001. See previous discussion under “Write-downs During 2003” pertaining to the Company’s $26.4 million write-down of these securities during the first quarter of 2003.
• $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 write-down represented 8.8 percent of the total write-downs for 2001. 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. The write-down represented 7.4 percent of the total write-downs for 2001. 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.
• $28.1 million loss during the third and fourth quarters of 2003 on securities issued by a leading producer of performance products for the automotive industry and nylon fibers for the carpet industry, representing 19.6 percent of the realized investment loss on sales of fixed maturity securities in 2003. The company’s operations had been severely impacted by the increased price of raw materials and energy as well as a weakening demand for its products. In addition, the company was involved in an environmental pollution lawsuit with a potentially large negative impact. These securities had an investment-grade rating until downgraded to below-investment-grade in the first quarter of 2002. At the time of sale, the investment had been continuously in an unrealized loss position for a period of greater than three years. The circumstances of this investment have no impact on other investments.
• $25.2 million loss during the fourth quarter of 2003 on the sale of securities guaranteed by an Italian dairy company, representing 17.5 percent of the realized investment loss on sales of fixed maturity securities in 2003. The loss was incurred after it was revealed that the guarantor had engaged in massive fraud, ultimately leading to the company’s bankruptcy. The guarantor had been rated investment-grade until December 2003. At the time of the sale, the investment had been in an unrealized loss position for a period of less than 90 days. The Company also owns $22.5 million of fixed maturity securities of a wholly-owned Canadian subsidiary of the parent company. Although the financial and operating profiles of the subsidiary are separate from the parent and no other than temporary impairment was deemed to exist, in conjunction with the classification of the Canadian branch as an asset held for sale, the Company recognized a loss of $4.0 million to write down the value of these securities, which are held in the Canadian branch investment portfolio, to market value. This loss is included in the loss from discontinued operations.
• $9.2 million loss during the second and fourth quarters of 2003 on the sale of securities issued by a provider of phone, cable, and internet services, representing 6.4 percent of the realized investment loss on sales of fixed maturity securities in 2003. This company’s operations were severely impacted by the decline in the telecommunications market and thus, the decision was made to reduce the exposure to this company. These securities were originally purchased as part of the Company’s below-investment-grade strategy. At the time of sale, this security had been continuously in an unrealized loss position for a period of greater than three years. The circumstances of this investment have no impact on other investments.
Realized Investment Losses During 2002 - Sale of Fixed Maturity Securities
During the year ended December 31, 2002, the Company realized a loss of $62.1 million on the sale of fixed maturity securities in its continuing operations. These securities had a book value of $236.4 million and a fair value of $174.3 million at the time of sale and represented 42 different issuers. Realized investment losses representing five percent or more of the total loss recognized during 2002 are as follows:
an unrealized loss position for a period of greater than 90 days but less than 180 days. The circumstances of this investment have no impact on other investments.
Realized Investment Losses During 2001 - Sale of Fixed Maturity Securities
• The Company realized $3.0 million in losses on the sale of senior notes issued by a U.S. department store chain, representing 9.4 percent of the total realized investment loss on sales of fixed maturity securities in 2001. The Company sold these bonds in anticipation of further credit deterioration, price depreciation, and rating downgrades. At the time of sale, 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 investment have no impact on other investments.
• The Company realized $2.9 million in losses on the sale of securities issued by a U.S. based global long distance company, representing 9.1 percent of the total realized investment loss on sales of fixed maturity securities in 2001. The issuer’s long distance and data business was under severe pricing pressure, and the issuer’s liquidity was constrained. These circumstances were significant enough for the Company to reduce its exposure to this issuer. At the time of sale, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The circumstances of this investment have no impact on other investments.
• The Company realized $2.6 million in losses on the sale of unsecured notes issued by the holding company of a diversified group of television broadcasting, newspaper publishing, cable news, and interactive media operations, representing 8.1 percent of the total realized investment loss on sales of fixed maturity securities in 2001. The Company sold these bonds in anticipation of further credit deterioration, price depreciation, and rating downgrades due to the decrease in advertising revenues and the high leverage ratios of the issuer. At the time of sale, 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 investment have no impact on other investments.
The following table provides the distribution of invested assets for the periods indicated, excluding the fixed maturity securities reported as discontinued operations. Ceded policy loans of $2.7 billion and $2.5 billion as of December 31, 2003 and 2002, respectively, which are reported on a gross basis in the statements of financial condition contained herein in Item 8, are excluded from the table below. The investment income on these ceded policy loans is not included in income.
As of December 31, 2003, $338.7 million or 69.0 percent of the unrealized losses in the fixed maturity bond portfolio were concentrated in financial institutions, transportation, U.S. government agencies and municipalities, and utilities. The Company’s current view of risk factors relative to these four industries is as follows:
Financial Institutions: This sector entered the recent economic slowdown with record capital levels and strong profitability. Bank balance sheets withstood the increased loan write-offs through the recent economic cycle. Credit quality is now beginning to improve in the financial services sector. In general, fourth quarter of 2003 results showed little or no loan growth, stabilizing net interest margins, well-managed risk positions in corporate lending, and overall improvement in asset quality. Profitability is strong at most banks, brokers, and finance companies.
Transportation: This sector consists of airlines, airports, railroads, and shipping. The overall sector has encountered significant difficulties during the past two years, primarily in commercial aviation. Global and domestic economic weakness, war, and terrorism-related fears have contributed to reductions in demand for air travel. High cost structures and over-leveraged balance sheets at many of the airlines have also contributed to the deterioration of credit quality for many issuers of securities. The outlook for the airline/airport segment depends heavily on economic improvement, negotiations with labor unions, and continued expense reductions. Demand for railroad and shipping services is also highly correlated to the economy.
Utilities: This sector, which includes regulated electric utilities, gas transmission and distribution companies, and independent power projects, is showing signs of improvement from the difficult environment that has existed over the past few years. Many companies are de-emphasizing merchant power and energy trading operations and focusing instead on their core businesses. Balance sheets are being strengthened through the sale of non-core assets and the repayment of debt. Several companies with liquidity problems have either renewed bank facilities or obtained other forms of new financing. However, significant challenges still remain for parts of this industry. There
Of the $491.0 million in gross unrealized losses at December 31, 2003, $337.1 million, or 68.7 percent, are related to investment-grade fixed maturity bonds. Unrealized losses on investment-grade fixed maturity securities principally relate to changes in interest rates or changes in market or sector credit spreads which occurred subsequent to the acquisition of the securities. These changes are generally temporary and are not recognized as realized investment losses unless the securities are sold or become other than temporarily impaired. The gross unrealized loss on below-investment-grade fixed maturity bonds was $153.9 million at December 31, 2003, or 31.3 percent, of the total gross unrealized loss on fixed maturity bonds. Generally, below-investment-grade fixed maturity securities are more likely to develop credit concerns. The following table shows the length of time the Company’s investment-grade fixed maturity bonds had been in a gross unrealized loss position as of December 31, 2003. The Company has no unrealized losses in its Canadian branch fixed maturity bond portfolio.
The Company’s investment in mortgage-backed and asset-backed securities was approximately $4.0 billion and $5.0 billion on an amortized cost basis at December 31, 2003 and 2002, respectively, including those securities reported as discontinued operations. At December 31, 2003, the mortgage-backed securities had an average life of 4.7 years and effective duration of 5.8 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 with the possibility of reinvesting the funds in a lower interest rate environment. 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.
The Company’s exposure to below-investment-grade fixed maturity securities at December 31, 2003, was $2,442.7 million, representing 7.8 percent of the fair value of invested assets excluding ceded policy loans and fixed maturity securities reported as discontinued operations, below the Company’s internal limit for this type of investment. The comparable measure at December 31, 2002 was $2,872.8 million or 10.4 percent. As previously discussed, the Company initiated a program during the first quarter of 2003 to reduce its risk exposure to below-investment-grade fixed maturity securities. 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. The Company expects that additional downgrades of investment grade securities may occur during 2004, but the Company does not anticipate any liquidity problem caused by its 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 mortgage loan portfolio was $474.7 million and $599.9 million at December 31, 2003 and 2002, respectively. The mortgage loan portfolio continues to be well diversified geographically and among property types. The incidence of problem mortgage loans and foreclosure activity remains low, and management expects the level of delinquencies and problem loans to remain low in the future. The Company sold mortgage loans with a book value of $95.1 million during 2002, resulting in a before-tax realized investment gain of $1.2 million.
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 2003 involved current and forward interest rate swaps, forward contracts on credit spreads on specific fixed income securities, and currency swaps which are used to hedge the currency risk of certain foreign currency denominated fixed income securities. The Company also opened certain currency forward contracts to hedge the anticipated foreign currency proceeds from the sale of the Canadian branch. 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 income protection product portfolios. All other product portfolios are periodically reviewed to determine if hedging strategies would be appropriate for risk management purposes.
During 2003, the Company took advantage of the rise in interest rates and the steepening of the yield curve to hedge future period cash flows in the Company’s individual long-term care and individual income protection product lines. Approximately $2.8 billion of forward starting interest rate swaps (receive fixed) were executed at average expected yields in excess of 7.00%. These transactions produced a margin of 50 to 80 basis points above the Company’s reserve discount rates and lengthened the duration of the Company’s investment portfolio by approximately 0.5 years. See Note 5 of the “Notes to Consolidated Financial Statements” for further discussion of the Company’s use of derivatives.
The Company has an investment program wherein it simultaneously enters into repurchase agreement transactions and reverse repurchase agreement transactions with the same party. The Company nets the related receivables and payables in the consolidated statements of financial condition as these transactions meet the requirements for the right of offset. As of December 31, 2003, the Company had $499.3 million face value of these agreements in an open position that were offset. The Company also uses the repurchase agreement market as a source of short-term financing. The Company had no contracts for this purpose outstanding at December 31, 2003.
The Company’s liquidity requirements are met primarily by cash flows provided from operations, principally in its insurance subsidiaries. Premium and investment income, as well as maturities and sales of invested assets, provide the primary sources of cash. The Company’s offerings of debt and/or securities, as discussed under “Debt and Capital,” provide an additional source of liquidity. Cash is applied to the payment of policy benefits, costs of acquiring new business (principally commissions), operating expenses, and taxes, as well as purchases of new investments. The Company has established an investment strategy that management believes will provide for adequate cash flows from operations.
The Company’s policy benefits are primarily in the form of claim payments, and the Company therefore has minimal exposure to the policy withdrawal risk associated with deposit products such as individual life policies or annuities. The Company’s cash flows from operations could be negatively impacted by a decrease in demand for the Company’s insurance products or an increase in the incidence of new claims or the duration of existing claims. Cash flow could also be negatively impacted by a deterioration in the credit market whereby the Company’s ability to liquidate its positions in certain of its fixed maturity securities would be impacted such that the Company might not be able to dispose of these investments in a timely manner. The Company’s cash resources are sufficient to meet its liquidity requirements for the next twelve months.
The Company continues to evaluate additional actions to strengthen its business and financial position. This may include, but not be limited to, further product rationalization, reinsurance opportunities, and asset sales. Such actions might impact future capital resources and financial results.
Net cash provided by operating activities was $1,345.2 million for the year ended December 31, 2003, as compared to $1,786.7 million and $1,770.6 million for the comparable periods of 2002 and 2001. During 2003, by mutual consent the Company amended existing reinsurance contracts with one of its reinsurers to transform the contracts from coinsurance to modified coinsurance arrangements. In conjunction with those amendments, the Company, as the assuming reinsurer, transferred to the ceding reinsurer cash equal to the statutory disabled life reserves of approximately $286.2 million and established a corresponding receivable. The ceding reinsurer will retain the assets backing the statutory disabled life reserves and will credit interest at a 7.00 percent effective annual rate to the Company. This 2003 cash disbursement is included in cash flows from operations. Excluding this transfer, cash flows from operations were $1,631.4 million for the year ended December 31, 2003.
During 2003, the Company had $152.5 million of cash outflows related to the disposition, through reinsurance ceded, of a block of policies previously sold through trade associations and cash inflows of $110.0 million related to the acquisition of Sun Life. The Company also received fixed maturity securities of approximately $118.4 million and other miscellaneous assets and liabilities of approximately $20.3 million and assumed reserves of approximately $285.9 million relative to the Sun Life acquisition, for a net purchase price of $37.2 million.
In 2002, the Company had cash outflows of $2.8 million to acquire whereiwork, compared to 2001 cash outflows of $19.2 million related to the acquisition of EmployeeLife.com and Resource Opportunities, Inc. Net cash outflows in
2001 also included $382.9 million in disbursements related to reinsurance transactions through which the Company disposed of two blocks of business. The Company disbursed $288.3 million in conjunction with the reinsurance transaction wherein it ceded its group disability reinsurance reserves underwritten and managed by Duncanson and Holt Services, Inc. and $94.6 million in disbursements to cede a block of cancer policies.
Net cash used by financing activities increased $161.9 million in 2002 from 2001. The Company received proceeds of $400.0 million from the issuance of long-term debt in 2002 compared to $575.0 million in 2001. The proceeds from these offerings were used primarily to refinance existing commercial paper borrowings of $397.0 million in 2002 and $254.2 million in 2001. During 2002, the Company used $45.0 million in cash to repurchase its common stock. During 2001, the Company also redeemed long-term debt of $172.5 million.
The Company is dependent upon payments from its subsidiaries to pay dividends to its stockholders, to pay its debt obligations, 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, 2003, the Company had outstanding from its insurance subsidiaries a $150.0 million surplus debenture due in 2006 with a weighted average interest rate during 2003 of 8.32 percent and a $100.0 million surplus debenture due in 2027 with a weighted average interest rate during 2003 of 8.25 percent. Semi-annual interest payments are conditional upon the approval by the insurance department of the applicable 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 in any 12-month period 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. 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 July of 2004.
The payment of ordinary dividends to the Company from its insurance subsidiaries is further limited to the amount of statutory surplus as it relates to policyholders. Based on the restrictions under current law, during 2004, $384.8 million is available for the payment of ordinary dividends to the Company from its domestic insurance subsidiaries. Of this amount, $117.7 million is conditional upon approval from the Maine Bureau.
The Company also has the ability to draw a dividend from its United Kingdom-based affiliate, Unum Limited. Such dividends are limited in amount, based on insurance company law in the United Kingdom, which requires a minimum solvency margin. Approximately $135.0 million will be available for the payment of dividends from Unum Limited during 2004.
The amount available during 2003 for the payment of ordinary dividends from the Company’s domestic insurance subsidiaries was $328.5 million, including $113.1 million available with approval from the Maine Bureau. Of the total available, $20.0 million was utilized, and no amounts were requested by the Company from the Maine Bureau. The amount available during 2003 from Unum Limited was $94.6 million, none of which was utilized.
At December 31, 2003, the Company had long-term debt totaling $2,789.0 million. The Company had no short-term debt. As previously discussed, effective December 31, 2003, the Company adopted the provisions of FIN 46. Transition to the provisions of FIN 46 resulted in the de-consolidation of a trust that currently holds $300.0 million of junior subordinated debt securities of the Company and has issued a similar amount of mandatorily redeemable preferred securities. The impact of the de-consolidation was the elimination of the company-obligated mandatorily redeemable preferred securities of subsidiary trust holding solely junior subordinated debt securities of the company included in the consolidated statements of financial condition and the inclusion of the $300.0 million junior subordinated debt securities in long-term debt.
During the fourth quarter of 2002, the Company filed with the Securities and Exchange Commission (SEC) a shelf registration on Form S-3. The shelf was declared effective in April 2003. The shelf registration allowed 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 up to an aggregate of $1.5 billion. The shelf registration enabled 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. On May 7, 2003, the Company issued 45,980,000 shares of common stock, par value $0.10 per share, in a public offering and received approximately $476.3 million in proceeds from the sale of the shares of common stock after deducting underwriting discounts. Also on May 7, 2003, the Company issued 20,000,000 8.25% adjustable conversion-rate equity security units (units) in a public offering. The Company received approximately $485.0 million in proceeds from the sale of the units after deducting underwriting discounts. Each unit has a stated amount of $25 and will initially consist of (a) a contract pursuant to which the holder agrees to purchase, for $25, shares of the Company’s common stock on May 15, 2006 and (b) a 1/40, or 2.5%, ownership interest in a senior note issued by the Company due May 15, 2008 with a principal amount of $1,000. On May 14, 2003, the Company sold 6,897,000 additional shares of common stock pursuant to the exercise of the underwriters’ overallotment option relating to the above offering. The net proceeds to the Company were approximately $71.4 million after deducting underwriting discounts. Also on May 14, 2003, the Company sold 3,000,000 additional units pursuant to the exercise of the underwriters’ overallotment option relating to the above offering. The net proceeds to the Company were approximately $72.8 million after deducting underwriting discounts. The proceeds from these offerings were used primarily to increase the capitalization of the Company’s insurance subsidiaries and to repay amounts loaned to the Company from its insurance subsidiaries. No additional funding capacity remains on the shelf registration. Upon settlement of the common stock purchase contract and
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.
The Company has an agreement with an outside party wherein the Company is provided computer data processing services and related functions. The contract was renegotiated effective January 1, 2004, and under the revised terms, the contract will expire in 2013, but the Company may cancel the agreement effective January 2006 or later upon payment of applicable cancellation charges. The aggregate noncancelable contractual obligation remaining under this agreement, as amended, was $115.2 million at January 1, 2004, with no annual payment expected to exceed $53.4 million. Immediately preceding the effective date of the renegotiation, the aggregate noncancelable contractual obligation remaining under the agreement was $101.1 million.
Standard & Poor’s Corporation (S&P), Moody’s Investors Service (Moody’s), Fitch, Inc. (Fitch), and A.M. Best Company (AM Best) are among the third parties that provide the Company assessments of its overall financial position. Ratings from these agencies for financial strength are available for the individual U.S. domiciled insurance company subsidiaries. Financial strength ratings are based primarily on U.S. statutory financial information for the individual U.S. domiciled insurance companies. Debt ratings for the Company are based primarily on consolidated financial information prepared using generally accepted accounting principles. Both financial strength ratings and debt ratings incorporate qualitative analyses by rating agencies on an ongoing basis. If the Company were to experience negative operating trends, it could result in a downgrade of the current ratings, which might affect the Company’s ability to sell and retain its business. In the first quarter of 2004, the ratings from Moody’s and Fitch were placed under review for a possible downgrade due to concerns expressed about the Company’s fourth quarter of 2003 reserve strengthening for group income protection and the profitability for this line of business. Management intends to meet with each rating agency during March and April of 2004 to respond to these concerns and outline the Company’s financial and business plans for 2004. See “Risk Factors - Debt and Financial Strength Ratings” contained herein in Item 1 for further discussion.
These ratings are not directed toward the holders of the Company’s securities and are not recommendations to buy, sell, or hold such securities. Each rating is subject to revision or withdrawal at any time by the assigning rating organization, and each rating should be evaluated independently of any other rating.
The discount rate is an interest assumption used to convert the benefit payment stream to a present value. The discount rate was determined based on a review of long-term fixed income securities that receive one of the two highest ratings given by a recognized rating agency. In setting the assumption, the Company also has considered the change in the level of interest rates on these securities since the prior year end and the duration of the fixed income indices relative to the duration of the plans’ liabilities. Historically, the Company has used the Moody’s Aa corporate bond index as one of the primary benchmarks in selecting a discount rate. As of December 31, 2003, 2002, and 2001, this index was 6.01 percent, 6.52 percent, and 7.08 percent, respectively. The Company has estimated that the duration of the index is approximately 13 years. The majority of the obligations in the U.S. pension plans, however, is related to active and deferred vested employees, and duration, therefore, is significantly longer, at approximately 21 years. The Company therefore adjusted the Moody’s index upward by approximately 25 basis points to arrive at the discount rate assumption of 6.25 percent, 6.75 percent, and 7.35 percent as of December 31, 2003, 2002, and 2001, respectively. Studies matching the benefit cash flows of the pension plans to publicly traded bonds supported the rates assumed by the Company. Using a similar methodology applied to the
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 2004, 2003, and 2002, the long-term return on asset assumption for the U.S. pension plans is 8.50 percent, 8.50 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. During 2003, the Company revised the investment policy which resulted in a target asset allocation of 70 percent equities and 30 percent fixed income securities as compared to a target asset allocation of 75 percent equities and 25 percent fixed income securities in 2002. The expected long-term rate of return assumption for the U.S. pension plans in 2003 is 8.50 percent. This assumption is based on a weighted average expected return of approximately 5.40 percent annually for fixed income investments and 10.0 percent annually for equities, which equates to a weighted average return of 8.63 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 evaluation of investment forecasts prepared by outside consultants and economists. Since 1926, the average real return (before inflation) has been approximately 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 21 years, also has been considered, as well as the effect of active management of the plans’ assets.
The end of the year value of the assets in the funded U.S. pension plans declined from $458.0 million in 2001 to $349.6 million in 2002 and increased to $423.9 million in 2003. 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 $139.0 million in 2001 to a deficit of $99.0 million in 2002 and a deficit of $113.2 million as of December 31, 2003. 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 2003, nor will it be required to make a contribution in 2004. Based on projections performed by the Company’s actuaries, it is anticipated that contributions will be required in 2005 and/or 2006. The Company may decide to contribute an amount above the minimum required contribution.
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, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, 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.
During 2003, the Company entered into an agreement to sell its Canadian branch and expects to close the transaction during the first half of 2004. The Canadian branch is accounted for as an asset held for sale at December 31, 2003 and meets the accounting criteria of a discontinued operation. The results of the Canadian branch are reported as income (loss) from discontinued operations in the consolidated statements of operations and the related assets and liabilities are presented as discontinued in the statements of financial position for each year presented. Except where noted, the information presented in the notes to consolidated financial statements excludes the Canadian branch. See Note 2 for further discussion.
Continuing Operations: The Company is the largest provider of group and individual income protection products in the United States and the United Kingdom. It markets its integrated and complimentary portfolio of products primarily to employers interested in providing benefits to their employees. The Income Protection segment includes group long-term and short-term income protection insurance, individual income protection insurance, group and individual long-term care insurance, and disability management services. The Life and Accident segment includes insurance for life, accidental death and dismemberment, cancer, and critical illness. The Colonial segment includes insurance for life, income protection, accident and sickness, cancer, and critical illness marketed by the Company’s subsidiary Colonial Life & Accident Insurance Company. 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. The Corporate segment includes investment earnings 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. See Note 14 for further information on the operating segments.
Many factors influence the assumptions upon which reserves for policy and contract benefits are based, including historical trends in the Company’s experience and expected deviations from historical experience. Considerable judgment is required to interpret actual historical experience and to assess the future factors that are likely to influence the ultimate cost of settling existing claims. Given that insurance products contain inherent risks and uncertainties, the ultimate liability may be more or less than such estimates indicate.
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 5.60 percent to 8.13 percent. The accumulated amortization for value of business acquired was $281.5 million and $239.7 million as of December 31, 2003 and 2002, 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. The carrying amount of goodwill is reviewed for impairment annually or whenever events or changes in circumstances indicate that the carrying amount might not be recoverable. If the fair value of the operations to which the goodwill relates is less than the carrying amount of the unamortized goodwill, the carrying amount is reduced with a corresponding charge to expense. Effective January 1, 2002, goodwill is no longer amortized. Prior to that time, goodwill was amortized on a straight-line basis over a period not to exceed 40 years.
Policy and Contract Benefits Liabilities: Active life reserves for future policy and contract benefits on traditional life and accident and health products have been provided on the net level premium method. The reserves are calculated based upon assumptions as to interest, withdrawal, morbidity, and mortality that were appropriate at the date of issue. Withdrawal assumptions are based on actual Company experience. Morbidity and mortality assumptions are based upon industry standards adjusted as appropriate to reflect actual Company experience. The assumptions vary by plan, year of issue, and policy duration and include a provision for adverse deviation.
Interest assumptions for active life reserves may be graded downward over a period of years. Reserves for future policy and contract benefits on interest-sensitive products are principally policyholder account values.
Deferred Gain or Loss on Reinsurance: The Company is a party to various reinsurance agreements. Where applicable, gains or losses on these transactions are deferred and amortized into earnings based upon expected future premium income for traditional insurance policies and estimated future gross profits for interest-sensitive insurance policies. The deferred gain on reinsurance included in other liabilities in the consolidated statements of financial condition at December 31, 2003 and 2002 was $264.9 million and $325.4 million, respectively.
Translation of Foreign Currency: Revenues and expenses of the Company’s continuing and discontinued foreign operations 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 Participating Individual Life Insurance: Participating policies issued by one of the Company’s subsidiaries prior to its 1986 conversion from a mutual to a stock life insurance company will remain participating as long as the policies remain in force. A Participation Fund Account (PFA) was established for the benefit of all such individual participating life and annuity policies and contracts. The assets of the PFA provide for the benefit, dividend, and certain expense obligations of the participating individual life insurance policies and annuity contracts. The PFA was $352.3 million and $369.5 million at December 31, 2003 and 2002, respectively, and represented approximately 0.7 percent and 0.8 percent of consolidated assets and 0.8 percent and 0.9 percent of consolidated liabilities for December 31, 2003 and 2002, respectively.
Accounting for Stock-Based Compensation: The Company has various stock-based employee compensation plans. Prior to 2003, the Company accounted 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 prior to 2003 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.
The expense recognized in 2003 for stock-based employee compensation is less than that which would have been recognized if the fair value method had been applied to all option awards granted after the original effective date of SFAS 123. Had the Company applied the fair value recognition provisions of SFAS 123 as of its original effective date, pro forma net income (loss) and net income (loss) per share would be as follows:
Effective October 1, 2003, the Company adopted the provisions of Statement of Financial Accounting Standards No. 133 Implementation Issue B36 (DIG Issue B36), Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposure That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor Under Those Instruments. DIG Issue B36 addresses financial accounting and reporting for embedded derivatives in modified coinsurance contracts that incorporate credit risk exposure unrelated to the credit risk of the counterparty to the reinsurance contract and requires the bifurcation of any such derivative from the host reinsurance contract. The Company has two reinsurance contracts for which DIG Issue B36 is applicable. The adoption of DIG Issue B36 resulted in an increase in fixed maturity securities of $61.3 million to record the fair value of the embedded derivatives, a decrease of $116.1 million in miscellaneous assets, $18.4 million in reinsurance receivable, and $134.5 million in accumulated other comprehensive income (net unrealized gain on securities) to eliminate the previously reported adjustment to fair value of the marketable securities held in the trust and the related effects on claim reserves, and a $39.9 million cumulative effect of accounting principle change ($0.14 per common share, basic and assuming dilution), net of $21.4 million in tax. The change in the fair value of the embedded derivatives is reported as a realized investment gain or loss during the period of change.
Adoption of FIN 46 also resulted in the de-consolidation of a trust that currently holds $300.0 million of junior subordinated debt securities of the Company and has issued a similar amount of mandatorily redeemable preferred securities. The impact of the de-consolidation was the elimination of the company-obligated mandatorily redeemable preferred securities of subsidiary trust holding solely junior subordinated debt securities of the company included in the consolidated statements of financial condition and an increase of $300.0 million in long-term debt.
related to the Canadian branch for impairment and determined that the balance of $190.9 million was impaired, based on fair value measurements which used the quoted market value of the Canadian branch. The Company also recognized a before tax loss of $9.3 million to write down the value of bonds in the Canadian branch investment portfolio to market value. These two charges, which equal $200.2 million before tax, are included in the $145.8 million before tax loss reported for discontinued operations in 2003. The total charge after tax related to these write-downs was $196.9 million.
Assets and liabilities for discontinued operations as reported in the accompanying consolidated statements of financial condition are comprised of the following:
These assets and liabilities are included with Corporate in the assets by segment disclosure. See Note 14 for additional segment information.
Long-term Debt and Company-Obligated Mandatorily Redeemable Preferred Securities: Fair values were obtained from independent pricing services or discounted cash flow analyses based on current incremental borrowing rates for similar types of borrowing arrangements.
The amortized cost and fair values of securities by security type are shown as follows. The fixed maturity securities reported as discontinued operations in the consolidated statements of financial condition are included. The Company does not expect the exclusion of the securities transferred to the buyer of the Canadian branch to materially change the distribution by security type.
The following chart indicates the length of time the Company’s investment-grade and below-investment- grade fixed maturity bonds had been in a gross unrealized loss position as of December 31, 2003. The fair value and gross unrealized losses are categorized by the relationship of the current fair value to amortized cost for those securities on December 31, 2003. The fair value to amortized cost relationships are not necessarily indicative of the fair 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, 2003. The Company has no unrealized losses in its Canadian branch fixed maturity bond portfolio.
• The Company’s ability and intent to retain the security for a sufficient period of time for it to recover.
The amortized cost and fair values of fixed maturity securities by maturity date are shown as follows. The maturity dates have not been adjusted for possible calls or prepayments. The fixed maturity securities reported as discontinued operations in the consolidated statements of financial condition are included. The Company does not expect the exclusion of the securities transferred to the buyer of the Canadian branch to materially change the distribution by maturity date.
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 $116.7 million at December 31, 2002. Pursuant to the provisions of DIG Issue B36, the Company no longer reports the unrealized gains on the marketable securities held in the trust as an adjustment to the value of the deposit asset. The net unrealized gain is now attributed to the value of the embedded derivative and included in fixed maturity securities at December 31, 2003. Any net unrealized loss will be attributed to the marketable securities held in the trust and reported as an adjustment to the deposit asset.
Mortgage loans are impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. The Company did not have any impaired mortgage loans at December 31, 2003. The reported investment in mortgage loans considered to be impaired was $6.0 million at December 31, 2002. Included in the impaired loans at December 31, 2002 were loans of $6.0 million that had a related allowance for losses of $2.4 million.
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 2003, the Company entered into a forward treasury lock which, by taking a long position on the forward treasury lock, allowed the Company to lock in the interest rate on the future purchase of a specific U.S. Treasury bond. This derivative was identified as a cash flow hedge and was used to minimize the interest rate risk related to the settlement price on the reinsurance of an existing block of in force business. Because the settlement price of the ceded reinsurance transaction was partially determined by the change in the interest rate of a specific five year U.S. Treasury bond, the forward treasury lock allowed the Company to hedge the interest rate used in the calculation of the settlement price. The Company terminated the treasury lock, for cash, at the same time the reinsurance transaction settled.
During 2003, the Company entered in a foreign currency forward contract whereby the Company agreed to pay its counterparty a specific Canadian dollar denominated notional amount in exchange for a specific U.S. dollar denominated notional amount. This derivative is identified as a cash flow hedge and is being used to eliminate the variability of functional currency cash flows associated with the anticipated proceeds from the expected sale of the Canadian branch. The Company will terminate the currency forward, for cash, at the time of the closing of the Canadian branch transaction.
As discussed in Note 1, effective October 1, 2003, the Company adopted the provisions of DIG Issue B36. The adoption of DIG Issue B36 resulted in an increase in fixed maturity securities of $61.3 million to record the fair value of embedded derivatives related to the credit risk provisions of certain reinsurance contracts. The fair value of the embedded derivatives related to these reinsurance contracts was $62.1 million as of December 31, 2003. The change in fair value of DIG Issue B36 derivatives is reported in operating earnings as a realized investment gain or loss.
In April 2003, the Company completed an analysis of its assumptions related to its group long-term income protection claim reserves. Included in the analysis was a review of active claim reserves, incurred but not reported (IBNR) reserves, and claim reopen reserves. An active claim reserve is established for future benefit payments when a claim is incurred and reported to the Company. IBNR reserves are established on claims which are estimated to have been incurred but not yet reported to the Company. Claim reopen reserves are established for those claimants who have previously recovered but who are anticipated to return to disabled status under the same disability and within a specified period of time, as contractually allowed by the disability policy. The analysis was initiated based on lower claim resolution rates observed during the first quarter of 2003. The claim resolution rate is the rate of probability that a disability claimant will recover, die, or reach maximum benefit limits and no longer receive benefit payments from the Company. Generally, claim resolution rates vary by the age of the claimant at the time of disability, duration or length of time since the disability initially occurred, and claim diagnosis. The claim resolution rates for group long-term income protection during the first quarter of 2003 were below levels anticipated for reserves and were lower than those experienced in the full years 2002, 2001, and 2000. The analysis indicated not only a decrease in overall claim resolution rates, but also a change in claim resolution rates by claim duration. The analysis of emerging claim resolution rates and the reasons driving the changes resulted in a reduction in the Company’s long-term expectations with respect to claim resolution rates. The Company’s long-term expectations applied to all claims incurred regardless of the date of incurral. In addition, the Company reviewed the reserve discount rate, which is the interest rate at which future cash flows for benefit and expenses to be paid are discounted to determine the current value of those cash flows. The Company concluded at that time that a change in its discount rate assumptions was not warranted. Based on the April 2003 analysis, in the first quarter of 2003 the Company increased its group long-term income protection claim reserves by $454.0 million before tax, or $295.1 million after tax, to reflect its current estimate of future benefit obligations. The active claim reserve for claims already reported to the Company and still in open claim status was increased by $516.0 million, the IBNR reserve was decreased by $23.0 million, and the reopen reserve was decreased by $39.0 million before tax. The first quarter 2003 change represented a 6.5 percent increase in total net group long-term income protection reserves as of March 31, 2003, which for continuing operations equaled $7.017 billion prior to this increase and equaled $6.618 billion as of December 31, 2002.
A reconciliation of the income tax (benefit) attributable to income (loss) from continuing operations computed at U.S. federal statutory tax rates to the income tax expense (benefit) as included in the consolidated statements of operations is as follows:
The Company has not provided for deferred taxes on basis differences in its foreign subsidiaries that are permanent in duration or on the unremitted earnings of its domestic subsidiaries which are not expected to result in taxable or deductible amounts. However, the Company has provided for a $6.8 million deferred tax asset on basis differences in the Japanese operations as a result of the pending sale of this subsidiary as of December 31, 2003.
For most of the Company’s subsidiaries, tax years through 1995 are closed to further assessment by the Internal Revenue Service (IRS). During 2003, 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.
Federal income taxes paid (refunded) during 2003, 2002, and 2001 were $(43.4) million, $27.5 million, and $127.3 million, respectively.
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. 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 that 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. 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 was similarly reduced in size to $472.5 million. Since the primary function of this credit facility was to provide support for the Company’s commercial paper program and the Company had been unable to access the commercial paper markets, on May 1, 2003 the Company terminated this facility in connection with the previously discussed combined offering. There were never any borrowings under the credit facility. The Company’s commercial paper program was similarly terminated.
Of the $2,789.0 million of long-term debt at December 31, 2003, $227.0 million will mature in 2005, $575.0 million will mature in 2008, and $1,987.0 million will mature in 2011 and thereafter.
Interest paid on short-term and long-term debt and related securities during 2003, 2002, and 2001 was $182.2 million, $161.0 million, and $159.3 million, respectively.
The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets were $698.2 million, $603.7 million, and $486.5 million, respectively, as of December 31, 2003, and $577.0 million, $503.0 million, and $392.6 million, respectively, as of December 31, 2002.
For measurement purposes at December 31, 2003, the annual rate of increase in the per capita cost of covered health care benefits assumed for 2004 was 10.0 percent for benefits payable to retirees prior to Medicare eligibility and 12.0 percent for benefits payable to Medicare eligible retirees. The rate range was assumed to change gradually to a rate of 5.0 percent for 2008 and remain at that level thereafter. For measurement purposes at December 31, 2002, the annual rate of increase in the per capita cost of covered health care benefits for 2003 was 8.5 percent for benefits payable to retirees prior to Medicare eligibility and 10.0 percent for benefits payable to Medicare eligible retirees and was assumed to gradually decrease to a rate of 5.0 percent in 2008 and remain at that level thereafter.
A one percent increase or decrease in the assumed health care cost trend rate at December 31, 2003 would have increased (decreased) the net periodic postretirement benefit cost by $0.5 million and $(0.5) million, respectively, and the postretirement benefit obligation by $7.6 million and $(11.7) million, respectively.
In December 2003, Medicare was expanded, primarily to add a prescription drug benefit for Medicare-eligible retirees starting in 2006. The Company is reviewing these expanded provisions of Medicare to determine the impact, if any, on its benefit design after 2006. Due to uncertainty regarding some of the new Medicare provisions and a related lack of authoritative accounting guidance, Financial Accounting Standards Board Staff Position 106-1 allows for the deferral of the recognition of any impact attributable to the new Medicare provisions. The issuance of final accounting guidance could require changes to previously reported information.
The Company’s U.S. pension plan weighted average asset allocations, by asset category, are as follows:
The Company’s funding policy for its U.S. qualified defined benefit plans is to contribute annually an amount at least equal to the minimum annual contribution required under the Employee Retirement Income Security Act and other applicable laws, and generally, not greater than the maximum amount that can be deducted for federal income tax purposes. The Company does not expect to contribute to its U.S. pension plan in 2004. Based on projections performed by the Company’s actuaries, it is anticipated that contributions may be required in 2005 and/or 2006. The funding policy for non-qualified defined benefit plans and postretirement plans is to contribute the amount of the benefit payments made during the year.
The Company accounts for the effect on the number of weighted average common shares, assuming dilution, using the treasury stock method. As discussed in Note 9, the purchase contract element of the adjustable conversion-rate equity security units issued in 2003 contributes to the number of weighted average common shares, assuming dilution, when the average market price of the Company’s common stock is above the threshold appreciation price of $13.27 per share and the Company has income from continuing operations. Because the average market price of the Company’s common stock during the year was above the threshold appreciation price, 2.0 million issuable shares would have been included in the computation of earnings per share assuming dilution for the year ended December 31, 2003, had the Company not reported a net loss from continuing operations.
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 income for annual incentive plans is $29.9 million, $27.5 million, and $27.0 million for 2003, 2002, and 2001, respectively.
Under the stock plan of 1999, the Company has available up to 17,500,000 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 3,500,000 shares. The options have a maximum term of ten years after the date of grant. The Company granted 1,347,874 shares and 2,500 shares of restricted stock during 2003 and 2002 to certain employees with a weighted average grant date value of $10.64 and $28.90, respectively, per common share.
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. This plan was terminated for purposes of any further grants in February 2004. 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.
Pro forma information regarding net income (loss) and net income (loss) per share, as presented in Note 1, is required by SFAS 123, as amended by SFAS 148, and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS 123 upon its initial effective date. The fair value for these options was estimated at the date of grant using a Black-Scholes options-pricing model.
In the following segment financial data, “operating revenue” excludes net realized investment gains and losses. “Operating income” or “operating loss” excludes net realized investment gains and losses, income tax, results of discontinued operations, and cumulative effects of accounting principle changes. These are considered non-GAAP financial measures. These non-GAAP financial measures of “operating revenue” and “operating income” or “operating loss” differ from revenue and income (loss) from continuing operations before income tax and cumulative effect of accounting principle changes as presented in the Company’s consolidated statements of operations due to the exclusion of before tax realized investment gains and losses. The Company measures segment performance for purposes of Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information, excluding realized investment gains and losses because management believes that this performance measure is a better indicator of the ongoing businesses and the underlying trends in the businesses. The Company’s investment focus is on investment income to support its insurance liabilities as opposed to the generation of realized investment gains and losses, and a long-term focus is necessary to maintain profitability over the life of the business. Realized investment gains and losses are dependent on market conditions and not necessarily related to decisions regarding the underlying business of the Company’s segments.
During 2003, the Company’s insurance subsidiary in the United Kingdom, Unum Limited, entered into an agreement with Swiss Life (UK) plc (Swiss Life) wherein Unum Limited will become responsible for the ongoing administration and management of the United Kingdom portion of Swiss Life’s group income protection claims portfolio, and Swiss Life will also reinsure this portfolio to Unum Limited. Unum Limited will also become a multi-national pooling partner for Swiss Life Insurance & Pension Company with respect to business written in the United Kingdom. The arrangement became effective January 1, 2004.
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 that the Act was violated is contrary to both the law and the facts of the case and plans to appeal after the judgment is made final.
In addition, the same plaintiffs’ attorney who had initially filed the class action lawsuits filed approximately 50 (including the two individual career agents who brought the class action referenced above) individual lawsuits on behalf of current and former Paul Revere sales managers alleging various breach of contract claims. Of the 48 general manager cases, one was arbitrated and all the others have been settled. UnumProvident and affiliates believe that they have strong defenses for the two individual career agent cases and plan to vigorously defend their position in the remaining cases. Management does not currently expect these suits to materially affect the financial position or results of operations of the Company.
On May 22, 2003, UnumProvident, several of its subsidiaries, and some of their officers and directors filed a motion with the Judicial Panel on Multidistrict Litigation seeking to transfer more than twenty class actions and derivative suits now pending against them in various federal district courts to a single district for coordinated or consolidated pre-trial proceedings. Each of these actions, discussed below, contends, among other things, that the defendants engaged in improper claims handling practices in violation of the Employee Retirement Income Security Act (ERISA) or various state laws or failed to disclose the effects of those practices in violation of the federal securities laws. On September 2, 2003, the Judicial Panel on the Multidistrict Litigation entered an order transferring these cases, described below, to the U.S. District Court for the Eastern District of Tennessee for coordinated or consolidated pretrial proceedings. These lawsuits are in a very preliminary stage, and the outcome is uncertain. Reserves have not been established for these matters. An adverse outcome in one or more of these actions could, depending on the nature, scope, and amount of the ruling, materially affect the Company’s results of operations or financial position in a period.
Apart from certain preliminary discovery in the Keir and Rombeiro cases, described below, no discovery has yet to take place in these actions.
and damages. Plaintiff alleges these acts violated, among other things, their fiduciary duties of good faith and loyalty.
On February 12, 2003, the first of five virtually identical alleged securities class action suits styled Knisley v. UnumProvident Corporation, et al., was filed in the United States District Court for the Eastern District of Tennessee. On February 27, 2003, a sixth complaint entitled Martin v. UnumProvident Corporation, et al., was filed in the United States District Court for the Southern District of New York, and later was transferred to the Eastern District of Tennessee by agreement of the parties. In two orders dated May 21, 2003 and January 22, 2004, the district court consolidated these actions under the caption In re UnumProvident Corp. Securities Litigation. On November 6, 2003, the district court entered an order appointing a Lead Plaintiff in the consolidated action.
On January 9, 2004, the Lead Plaintiff filed its consolidated amended complaint. The Lead Plaintiff seeks to represent a putative class of purchasers of UnumProvident Corporation publicly traded securities between March 30, 2000 and April 24, 2003. The plaintiffs allege, among other things, that the Company issued misleading financial statements, improperly accounted for certain impaired investments, failed to properly estimate its disability claim reserves, and pursued 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. The defendants have not yet answered or otherwise responded to the complaint. The Company strongly denies the allegations in these complaints and will vigorously defend the litigation.
On May 7, 2003, Azzolini v. CorTs Trust II for Provident Financial Trust, et al., was filed in the Southern District of New York. This is a federal securities law class action brought by the plaintiff on behalf of himself and a purported Class consisting of all persons who purchased UnumProvident Corporate-Backed Trust Securities (CorTs) certificates pursuant to an initial public offering on or about April 18, 2001 through March 24, 2003. Plaintiff seeks to recover damages caused by UnumProvident’s and certain underwriter defendants’ alleged violations of the Securities Act of 1933 and the Securities Exchange Act of 1934. Plaintiff asserts that UnumProvident issued and/or failed to correct false and misleading financial statements and press releases concerning the Company’s publicly reported revenues and earnings directed to the investing public. Three additional actions alleging similar claims and purporting to be class actions were filed, two in the Southern District of New York, Strahle v. CorTs Trust II for Provident Financing Trust I, et al., and Finke v. CorTs Trust II for Provident Financing Trust I, et al., filed on March 23, 2003 and May 15, 2003, respectively, and the third in the Eastern District of New York, Bernstein v. CorTs for Provident Financing Trust I, et al., filed on July 7, 2003. These actions all have been transferred to the Eastern District of Tennessee for coordinated pre-trial proceedings. On February 18, 2004, the Court consolidated each of these actions other than the Bernstein action.
On July 15, 2002, the case of Rombeiro v. Unum Life Insurance Company of America, et al., was filed in the Superior Court of Sonoma County, California. It was subsequently removed to the United States District Court for
the Northern District of California. On January 21, 2003, a First Amended Complaint was filed, purporting to be a class action. This complaint alleges that plaintiff individually was wrongfully denied disability benefits under a group long-term disability plan and alleges breach of state law fiduciary duties on behalf of himself and others covered by similar plans whose disability benefits have been denied or terminated after a claim was made. The complaint seeks, among other things, injunctive and declaratory relief and payment of benefits. On April 30, 2003, the court granted in part and denied in part the defendants’ motion to dismiss the complaint. On May 14, 2003, the plaintiff filed a Second Amended Complaint seeking injunctive relief on behalf of a putative nationwide class of long-term disability insurance policyholders. The Company denies the allegations in the complaint and will vigorously defend the litigation and any attempt to certify the putative class. This action was transferred to the Eastern District of Tennessee as part of the multidistrict litigation transfer order.
On February 11, 2003, the case of 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 on behalf of a putative class of policyholders. Alternatively, the complaint alleges violations of ERISA. The complaint seeks injunctive and declaratory relief as well as restitution and punitive damages. On April 4, 2003, the case was removed to the United States District Court for the Southern District of Illinois. The Company denies the allegations in the complaint and will vigorously defend the litigation and any attempt to certify the putative class. This action was transferred to the Eastern District of Tennessee as part of the multidistrict litigation transfer order.
On February 25, 2003, the case of Davis, et al. v. UnumProvident Corporation, et al., was filed in the United States District Court for the Eastern District of Pennsylvania. The plaintiffs are seeking representative status as a class of disability participants insured under ERISA plans. The complaint alleges that these claimants had their claims improperly denied or terminated and that the Company breached certain fiduciary duties owed to these participants in ERISA plans. The complaint also alleges violations under the federal Racketeer Influenced and Corrupt Organizations Act (RICO). The complaint seeks reversal of claim denials or contract rescissions and re-determination by an independent person of claims of the named plaintiffs and others similarly situated, appointment of a master to oversee certain claim handling matters, and treble damages under RICO. The Company denies the allegations in the complaint and will vigorously defend the litigation and any attempt to certify the putative class. This action was transferred to the Eastern District of Tennessee as part of the multidistrict litigation transfer order.
On April 30, 2003, the case of Taylor v. UnumProvident Corporation, et al., was filed in the Circuit Court for Shelby County, Tennessee in the Thirteenth Judicial District at Memphis. The plaintiff seeks to represent all individuals who were insured by long-term disability policies issued by subsidiaries of UnumProvident and who did not obtain their coverage through employer sponsored plans and who had a claim denied, terminated, or suspended by a UnumProvident subsidiary after January 1, 1995. Plaintiff alleges that UnumProvident Corporation and its subsidiaries employed various unfair claim practices in assessing entitlement to benefits by class members during
this period and, as a result, wrongfully denied legitimate claims. The plaintiff and the class seek contractual, equitable, and injunctive relief. On June 9, 2003, the defendants removed this action to the United States District Court for the Western District of Tennessee. The Company denies the allegations in the complaint and will vigorously defend the litigation and any attempt to certify the putative class. This action was transferred to the Eastern District of Tennessee as part of the multidistrict litigation transfer order.
On December 11, 2003, the case of Jewel. et al. v. UnumProvident Corporation. et al., was filed in the Worcester County Superior Court, Commonwealth of Massachusetts. The Company received services of this matter on March 8, 2004. Plaintiffs seek to represent all individual long-term disability policyholders and all participants in group long-term disability plans which are not covered by ERISA who (a) had coverage issued by an insuring subsidiary and (b) whose claim for long-term disability benefits were denied, or whose payments of long-term disability benefits were terminated or suspended, on or after July 1, 1999. Plaintiffs allege that the defendants employed various unfair claim practices and seek declaratory, contractual, and injunctive relief. The Company denies the allegations in the complaint and will vigorously defend the litigation and any attempt to certify the putative class.
On October 2, 2003, the court issued an order consolidating these cases for all purposes. On January 9, 2004, plaintiffs filed their consolidated amended complaint against UnumProvident, several of its Officers and Directors, and several Plan fiduciaries, purportedly on behalf of a putative class of Plan participants and beneficiaries during the period since November 17, 1999. Plaintiffs allege that the named defendants violated the fiduciary provisions of ERISA by making direct and indirect communications to Plan participants that included material misrepresentations and omissions regarding investment in UnumProvident stock. Further, the plaintiffs allege the defendants failed to take action to protect participants from losses sustained from investment in the Plan’s UnumProvident Stock Fund. On February 26, 2004, the defendants filed a motion to dismiss contending that the complaint failed to state a valid claim under ERISA. The defendants strongly deny the allegations in the complaints and will vigorously defend the litigation.
On April 2, 2003, a jury in Phoenix, Arizona Federal Court in the case of Ciemo v. General American Life Insurance Company, Provident Life and Accident Insurance Company, and The Paul Revere Life Insurance Company returned a verdict of $85.6 million against General American Life Insurance Company and two subsidiaries of UnumProvident, Provident Life and Accident Insurance Company and The Paul Revere Life Insurance Company. This verdict included an award of $79.0 million in punitive damages. The Company filed all of the required post-trial motions. On September 17, 2003, the trial court ordered a reduction of the punitive damage verdict from $79.0 million to $7.0 million in punitive damages. The court’s ruling as to the reduction in punitive damages was based on the United States Supreme Court’s decision in State Farm Mutual Automobile Insurance Company v. Campbell. The remainder of the verdict was upheld and the court awarded the plaintiff $0.6 million in attorneys’ fees. The Company has filed a notice of appeal to the Ninth Circuit 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.
In certain reinsurance pools associated with the Company’s reinsurance businesses there are disputes among the pool members and reinsurance participants concerning the scope of their obligations and liabilities 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 or 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.
The Company’s insurance subsidiaries’ statutory combined net income (loss), as reported in conformity with statutory accounting principles as prescribed by the National Association of Insurance Commissioners (NAIC) and adopted by the applicable state laws, for the years ended December 31, 2003, 2002, and 2001, was $22.7 million, $(209.7) million, and $221.1 million, respectively. Statutory combined net gain from operations was $214.8 million, $220.7 million, and $353.2 million for the years ended December 31, 2003, 2002, and 2001, respectively. Statutory capital and surplus at December 31, 2003 and 2002, was $3,706.3 million and $3,253.0 million, respectively.
At December 31, 2003, the Company’s insurance subsidiaries had on deposit with regulatory authorities securities with a book value of $1,742.8 million held for the protection of policyholders, including $1,429.7 million held in trust for Canadian regulatory authorities.
During the fourth and first quarters of 2003, the Company incurred net charges of $440.0 million and $454.0 million before tax, respectively, and $286.0 million and $295.1 million after tax, respectively, related to reserve strengthening for group income protection. Additionally, during the fourth quarter of 2003, the Company incurred charges of $200.2 million before tax and $196.9 million after tax for write-downs related to its discontinued operations. See Notes 2 and 7 for further discussion of these charges.