Principal properties owned by Standard and used by the Company consist of two office buildings in downtown Portland, Oregon: the Standard Insurance Center, with approximately 459,000 square feet; and the Standard Plaza, with approximately 216,000 square feet. In addition, Standard leases 146,000 square feet of office space in a third office building, also located in downtown Portland, Oregon, and 49,000 square feet of offsite storage. The Company also leases offices under commitments of varying terms to support its sales and regional processing offices throughout the United States.
Includes operating expenses, commissions and bonuses, premium taxes, interest expense and the net increase in deferred acquisition costs and value of business acquired.
StanCorp, through its subsidiaries, is a leading provider of selected insurance and retirement plan products. StanCorp was incorporated under the laws of Oregon in 1998 as a parent holding company and completed its initial public offering of common stock on April 21, 1999. We conduct business in all 50 states through our subsidiaries, including Standard Insurance Company (“Standard”); The Standard Life Insurance Company of New York; StanCorp Mortgage Investors, LLC (“StanCorp Mortgage Investors”); and StanCorp Investment Advisers, Inc.
changes in interest rates or the condition of the national economy;
declines in asset credit quality and delinquencies on bonds and commercial mortgage loans;
achievement of financial objectives, including growth of premiums, earnings, assets under management, return on equity, or expense management objectives; and
Effective October 1, 2002, Standard acquired the group disability and group life insurance business of Teachers Insurance and Annuity Association (“TIAA”), through a reinsurance transaction. This block of business includes approximately 1,800 group insurance contracts, representing 650,000 insured individuals, and generated approximately $180 million in premiums in 2001. Acquiring the block of business expanded our presence in the Eastern United States, increased our market share in the education and research sectors and allowed us to appropriately reflect the value of business through the ceding commission. Standard paid a ceding commission of approximately $75 million for the block of business from TIAA and received approximately $705 million in assets and corresponding statutory liabilities. Approximately $60 million in value of business acquired (“VOBA”) was recorded upon closing of the acquisition.
StanCorp filed a $1.0 billion shelf registration statement with the Securities and Exchange Commission (“SEC”), which became effective on July 23, 2002, registering common stock, preferred stock, debt securities, and warrants. On September 25, 2002 we completed an initial public debt offering of $250.0 million of 6.875%, 10-year senior notes, pursuant to the shelf registration statement. The principal amount of the senior notes is payable at maturity and interest is payable semi-annually in April and October, beginning in 2003. Approximately $200 million of the debt offering proceeds were used to fund the acquisition by Standard of the TIAA block of business, including the $75 million ceding commission and $125 million to maintain Standard’s risk-based capital at the Company’s targeted level. The remaining proceeds were used to pay our annual dividend to shareholders, to fund a modest level of share repurchases and for general corporate purposes.
Effective October 1, 2000, Standard acquired a block of individual disability insurance business, for which the Company possesses economies of scale, market differentiation and expertise, from Minnesota Life Insurance Company (“Minnesota Life”). Certain policies acquired with the Minnesota Life block of business have maximum retention limits of $6,000 monthly benefit per individual. The retention limits for the Minnesota Life block of business were established by a reinsurance agreement entered into effective July 1, 2002.
For securities expected to be sold, an other than temporary impairment charge is recorded if we do not expect the realizable market value of a security to recover to amortized cost prior to the expected date of sale. Once an impairment charge has been recorded, we continue to review the other than temporarily impaired securities for further potential impairment on an ongoing basis.
In particular, our group long term disability reserves are sensitive to assumptions regarding the following factors:
Certain costs related to obtaining new business and acquiring blocks of business have been deferred to accomplish matching against related future premiums and gross profits. We normally defer certain acquisition related commissions and incentive payments, certain costs of policy issuance and underwriting, certain printing costs and certain variable field office expenses. Assumptions used in developing the amount of deferred acquisition costs to be amortized each period include expected future persistency, interest rates and profitability, which is significantly affected by premium renewal assumptions. These estimates are modified to reflect actual experience when appropriate. If actual persistency, interest rates, or profitability are inconsistent with our assumptions, we could be required to make adjustments to deferred acquisition costs and related amortization.
Growth in premiums is targeted to be 10% to 12% per year. Premiums from acquisitions are excluded in the measurement of growth for this objective for the first 12 months after the acquisition closed. Premium growth was 9.5% for 2002 compared to 2001, when adjusted for experience rated refunds on certain large group insurance contracts and reinsurance premium payments on two new reinsurance agreements. We reaffirm this objective for 2003, and expect to be at the lower end of the range due to continuing economic uncertainties.
Growth in operating income per diluted common share is targeted to be 12% to 15% per year. Operating income growth per diluted common share was 20.6% for 2002 compared to 2001. The objective was exceeded primarily due to favorable claims experience in the Employee Benefits-Insurance segment (see “-Selected Segment Information”). We reaffirm this objective for 2003, and expect to be at the lower end of the range due to continuing economic uncertainties.
The following table sets forth consolidated results of operations for the years ended December 31:
Premiums increased $151.6 million, or 12.3%, in 2002 compared to 2001, and $129.7 million, or 11.8%, in 2001 compared to 2000. Our premium growth target range is 10% to 12%, and is measured excluding adjustments for experience rated refunds on certain large group insurance contracts, and excludes premiums from acquisitions for the first 12 months after the acquisition closes (see “-Financial Objectives”). By that measure, premiums increased 9.5% in 2002 compared to 2001, and
Net investment income decreased $9.8 million, or 2.7%, in 2001 compared to 2000. The decrease primarily related to a $290 million net reduction of average invested assets, which resulted from the combined effect of the two transactions in the Individual Insurance segment (see “-Selected Segment Information-Individual Insurance Segment”), as well as lower portfolio yields. The portfolio yield for fixed maturity securities decreased to 6.79% at December 31, 2001 from 7.01% at December 31, 2000. The portfolio yield for commercial mortgage loans decreased to 8.22% at December 31, 2001 from 8.34% at December 31, 2000. Declines for both comparable periods reflect the general downward trend in interest rates.
Net capital losses occur as a result of impairment or sale of the Company’s invested assets and include net gains and losses from the sale of fixed maturity securities, commercial mortgage loans and real estate. Net capital losses for fixed maturity securities were $33.9 million, $4.0 million, and $6.3 million in 2002, 2001, and 2000, respectively. Net capital losses in 2002 included $17.2 million related to WorldCom. Commercial mortgage loan sales contributed net capital gains of $13.2 million, $2.4 million, and $1.2 million in 2002, 2001, and 2000, respectively. Real estate sales contributed net capital gains of $1.0 million, $1.6 million, and $3.3 million in 2002, 2001, and 2000, respectively. (See “-Liquidity and Capital Resources -Investing Cash Flows.”)
Operating expenses increased $42.5 million, or 21.1%, in 2002 compared to 2001, and $14.8 million, or 7.9%, in 2001 compared to 2000. The increases for both comparative periods were primarily from operating expense growth to support business growth as evidenced by premium growth. The increase for 2002 was greater than planned primarily due to the addition of operating expenses related to the acquisition of the TIAA block of business. While the business is administered by TIAA, duplicate expenses are incurred as we pay TIAA administration fees while simultaneously building our infrastructure to assume administration of the business. The integration is expected to be completed by the end of the second quarter of 2003.
Net Increase in Deferred Acquisition Costs and Value of Business Acquired
Adjustments on certain large group insurance contracts that are based on claims experience.
Benefits to policyholders and interest credited increased $102.2 million, or 11.0%, for 2002 compared to 2001, and increased $132.3 million, or 16.5%, for 2001 compared to 2000. Beyond premium growth, the most significant drivers of policyholder benefits are claims experience and the assumptions used to establish related reserves. We measure these factors for this segment with a benefit ratio, which is calculated as policyholder benefits plus interest credited, both divided by premiums. Our expected benefit ratio for this segment is 82% to 84%. For 2002, 2001, and 2000, the benefit ratios for this segment were 80.5%, 82.1% and 82.1%. The decrease in this ratio in 2002 resulted from very favorable claims experience. Claims experience can fluctuate widely from period to period.
An increase or decrease in the discount rate affects the required revenue contribution for long term disability products and as a result is a consideration for rate adjustments. Theoretically, premium increases or decreases from rate adjustments should offset related changes in policyholder benefits over time, resulting in a neutral impact to the benefit ratio. Should reinvestment rates ultimately prove to be lower than provided for in the margin between the new money investment rate and the reserve discount rate, the overall margin between the portfolio investment yield and the weighted average reserve discount rate would not be adequate, resulting in required increases to reserves and therefore policyholder benefits. The duration of our invested assets is well-matched to the duration of our liabilities in total and on a product segregated portfolio basis. Our investments are generally not callable or have prepayment penalties. Based on these factors, we believe the current margin in our overall block of business between our invested assets yield and weighted average reserve discount rate of approximately 50 basis points is adequate to cover potential reinvestment risk. (See “-Liquidity and Capital Resources.”)
This segment also sells business overhead expense coverage, which reimburses a business for covered operating expenses when the insured is disabled and business equity buy-out coverage, which provides funds for the purchase, by other owners or partners, of the insured’s ownership interest in a business in the event of total disability.
Two transactions were completed in 2000 and 2001 for this segment. Effective October 1, 2000, Standard acquired a block of individual disability insurance business from Minnesota Life for which the Company possesses economies of scale, market differentiation and expertise. Effective January 1, 2001, Standard sold its individual life insurance product line, for which Standard did not possess economies of scale (see “Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 16-Acquisition and Disposition of
Blocks of Business”). The timing of the two transactions was such that the fourth quarter of 2000 included results from both blocks of business, influencing growth trends when comparing 2001 results to 2000 results. Also, the individual life insurance block of business sold was larger than the disability insurance block of business acquired, resulting in overall decreases in revenues, benefits and expenses in 2001 compared to 2000.
Except for certain policies acquired with the Minnesota Life block of business, the maximum retention for individual disability policies is generally $3,500 monthly benefit per individual. Certain policies acquired with the Minnesota Life block of business have maximum retention limits of $6,000 monthly benefit per individual. The retention limits for the Minnesota Life block of business were established by a reinsurance agreement entered into effective July 1, 2002. As a result of this reinsurance agreement and depending on claims experience, premiums may be decreased up to $13 million annually and benefits to policyholders may be decreased $12 million annually. We estimate the overall effect of the reinsurance agreement may reduce income before taxes by approximately $1 million annually.
The following table sets forth selected financial data for the Individual Insurance segment for the years ended December 31:
Excludes after-tax capital gains or losses and special items in 2000, which consisted of severance costs associated with disposition of the individual life product line.
Net investment income increased $8.1 million, or 8.2%, in 2002 compared to 2001, primarily due to growth in average invested assets supporting this segment, offset in part by declines in portfolio yields (see “-Consolidated Results of Operations-Net Investment Income”). Asset growth came primarily from annuity deposits. Net investment income decreased $29.1 million, or 22.7%, in 2001 compared to 2000, primarily due to decreased average invested assets supporting the segment as a result of the net effect of the two transactions discussed above.
The net reduction in expenses for deferred acquisition costs and VOBA was $11.1 million in 2002, $11.8 million in 2001 and $1.2 million in 2000. The increases for 2002 and 2001 compared to 2000 were primarily a result of the sale of the individual life insurance block of business, the acquisition of a block of individual disability insurance business and the growth in new sales.
The Retirement Plans segment offers full-service 401(k) plans, and other pension plan products and services. The segment’s primary sources of revenues include plan administration fees, fees on separate account assets under management and investment margin on general account assets under management. The investment margin is the excess of net investment income over the related interest credited to policy holders. In addition, the segment’s premiums and benefits to policyholders reflect the conversion of retirement plan assets into life contingent annuities, which can be designated by plan participants at the time of retirement.
Excluding net capital gains and losses this segment essentially broke even for the three years 2002, 2001, and 2000. Because this type of business provides diversity from a risk-based capital perspective, the related capital required to be maintained for this segment is not currently significant (see “-Liquidity and Capital Resources-Financing Cash Flows-Risk-Based Capital”). Developing significant future profitability from the segment is dependent upon increases in assets under management to improve economies of scale. Management estimates that this segment will reach sustainable profitability when assets under management reach approximately $2.5 billion.
Premiums for this segment include plan administration fees and fees based on average market values of assets under management and premiums for life contingent annuities sold. Premiums decreased $2.0 million, or 9.5%, in 2002 compared to 2001 and $2.7 million, or 11.4%, in 2001 compared to 2000. The decreases in both comparable years were due primarily to decreases in premiums for life contingent annuities, which resulted in corresponding decreases in reserves and benefits to policyholders. Fees for assets under management were relatively stable for the comparative periods shown, as declines in equity market values in the separate account assets under management were mostly offset by net retention of new deposits.
Other businesses primarily include results from StanCorp Mortgage Investors, holding company expenses and interest on long-term debt. Income before income taxes for other businesses was $2.1 million, $5.3 million, and $13.9 million, for 2002, 2001, and 2000, respectively. The decrease of $3.2 million for 2002 compared to 2001 was primarily due to $4.4 million of interest expense on long-term debt, which was issued late in the third quarter of 2002 (see “-Liquidity and Capital Resources-Financing Cash Flows”). The decrease of $8.6 million in 2001 compared to 2000 was primarily due to due to lower net investment income and lower capital gains in 2001. Net investment income decreased $4.2 million in 2001 compared to 2000, as a result of lower average invested assets allocated to this segment. Net capital gains decreased $2.3 million in 2001 compared to 2000. Net capital gains in 2000 included gains on sales of real estate, which may or may not continue into the future.
Including intercompany transactions, StanCorp Mortgage Investors contributed income of $7.7 million, $6.6 million, and $5.9 million for 2002, 2001, and 2000, respectively. Results for StanCorp Mortgage Investors in 2002 reflected record commercial mortgage loan originations totaling $570.8 million, including originations for affiliated entities, up almost 33% compared to 2001. Over $280 million in commercial mortgage loans were sold to outside investors in 2002. For 2003, we expect mortgage originations to continue to grow to support increased outside investor demand and to fund Standard’s needs. Actual loan originations will depend on demand from borrowers and outside investors.
Operating cash inflows consist primarily of premiums, annuity deposits and net investment income. Operating cash outflows consist primarily of benefits to policyholders, operating expenses, commissions and taxes. Net cash provided by operating activities was $380.4 million, $264.8 million, and $282.6 million for 2002, 2001, and 2000, respectively. Adjustments to reconcile net income to net cash provided by operating activities in 2002 included net capital losses of $19.7 million and the refund of $20.0 million in federal income taxes as a result of changes in temporary differences associated with a change in the tax return filing status in 2000.
The insurance laws of the states of domicile and other states in which the insurance subsidiaries conduct business regulate the investment portfolios of the insurance subsidiaries. Relevant laws and regulations generally limit investments to bonds and other fixed maturity securities, mortgage loans, common and preferred stock, and real estate. Decisions to acquire and dispose of investments are made in accordance with guidelines adopted and modified from time to time by the insurance subsidiaries’ boards of directors. The Company does not currently use derivatives, such as interest rate swaps, currency swaps, futures or options, to manage interest rate risk or for speculative purposes, but may use such instruments to manage interest rate risk in the future. Each investment transaction requires the approval of one or more members of senior investment staff, with increasingly higher approval authorities required for more significant transactions. Transactions are reported quarterly to the Finance & Operations Committee of the board of directors for Standard and to the Audit Committee of the board of directors for The Standard Life Insurance Company of New York.
At December 31, 2002, fixed-rate commercial mortgage loans totaled $1.99 billion and represented 32.1% of the total invested assets. The average loan to value ratio on the overall portfolio was less than 60% at December 31, 2002, and the average loan size was $0.7 million. The Company receives personal recourse on almost all loans. At December 31, 2002, there were no delinquent loans or loans in the process of foreclosure. The delinquency and loss performance of the Company’s commercial mortgage loan portfolio have been consistently better than industry averages as reported by the American Council of Life Insurance. The performance of the Company’s commercial mortgage loan portfolio may fluctuate in the future. Should the delinquency rate or loss performance of the Company’s commercial mortgage loan portfolio increase, the increase could have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
To date, the delinquency rate of our California-based commercial mortgage loans has been substantially below
Under the laws of certain states, contamination of a property may give rise to a lien on the property to secure recovery of the costs of cleanup. In some states, such a lien has priority over the lien of an existing mortgage against such property. As a commercial mortgage lender, we customarily conduct environmental assessments prior to making commercial mortgage loans secured by real estate and before taking title through foreclosure on real estate collateralizing delinquent commercial mortgage loans held by us. Based on our environmental assessments, we believe that any compliance costs associated with environmental laws and regulations or any remediation of affected properties would not have a material adverse effect on our results of operations or financial condition. However, we cannot provide assurance that material compliance costs will not be incurred by us.
From time to time, the board of directors has authorized share repurchase programs. Share repurchases are to be effected in the open market or in negotiated transactions in compliance with the safe harbor provisions of Rule 10b-18 under regulations of the Securities Exchange Act of 1934. Execution of the share repurchase program is based upon management’s assessment of market conditions for its common stock and other potential growth opportunities. During 2002, the Company repurchased 853,000 shares of its common stock at a total cost of $45.5 million, for a volume-weighted-average price of $53.34 per common share. At December 31, 2002, approximately 400,000 shares were remaining under the currently authorized share repurchase program, which expires December 31, 2003.
Beginning in 2002, StanCorp’s board of directors approved paying annual, rather than quarterly, dividends to shareholders. The declaration and payment of dividends in the future is subject to the discretion of StanCorp’s board of directors and it is anticipated that annual dividends will be paid in December of each year depending on StanCorp’s financial condition, results of operations, cash requirements, future prospects, regulatory restrictions on the payment of dividends by the insurance subsidiaries and the ability of the insurance subsidiaries to maintain adequate capital and other factors deemed relevant by StanCorp’s board of directors. On November 4, 2002, the board of directors of StanCorp declared an annual dividend of $0.40 per share of common stock. The dividend was paid on December 6, 2002 to shareholders of record on November 15, 2002. The dividend represented a 33% increase from total dividends paid in 2001.
Our ratio of earnings to fixed charges for the years ended December 31, 2002 and December 31, 2001 was 8.9x and 7.8x, respectively. Our debt to total capitalization was 20% at December 31, 2002.
It is management’s objective to generally align the cash flow characteristics of assets and liabilities to ensure that the Company’s financial obligations can be met under a wide variety of economic conditions. In meeting the objectives, management may choose to liquidate certain investments and reinvest in alternate investments to better match the cash flow characteristics of assets to currently existing liabilities. (See “-Liquidity and Capital Resources-Investing Cash Flows.”)
The low level of current interest rates results in a relatively small change when rates are increased 10%. An additional sensitivity was therefore performed to look at the change in fair market value when rates were increased 100 basis points. The resulting hypothetical reduction in fair value of the Company’s financial assets was estimated to be $265 million and $220 million at December 31, 2002 and 2001, respectively.
Financial strength ratings, which rate claims paying ability, are an important factor in establishing the competitive position of insurance companies. Ratings are important to maintaining public confidence in our Company and in our ability to market our products. Rating organizations continually review the financial performance and condition of insurance companies, including our Company. In addition, our debt ratings on our long-term debt are tied to our financial strength ratings. A ratings downgrade could increase our surrender levels, adversely affect our ability to market our products, and could also increase future debt costs. Financial strength ratings are based primarily on statutory financial information. Standard & Poor’s, Moody’s Investors Service, Inc., Fitch, Inc. and A.M. Best Company are among the third parties that provide assessments of our overall financial position.
The National Association of Insurance Commissioners (“NAIC”) has implemented a tool to aid in the assessment of the statutory capital and surplus of life and health insurers. This tool, known as Risk-Based Capital (“RBC”), augments statutory minimum capital and surplus requirements. RBC employs a risk-based formula that applies prescribed factors to the various risk elements inherent in an insurer’s business to arrive at minimum capital requirements in proportion to the amount of risk assumed by the insurer.
Our internal target for RBC ratios for the Company’s insurance subsidiaries is 275% of the company action level, which is 550% of the authorized control level. At December 31, 2002, the RBC level of the Company’s insurance subsidiaries was 303% of the company action level, well in excess of that which would require corrective action by the insurance subsidiaries or regulatory agencies and in excess of the Company’s internal target.
Company maintained a reserve of $0.9 million for future assessments with respect to currently impaired, insolvent or failed insurers.
The Company’s business is subject to comprehensive state regulation and supervision throughout the United States primarily to protect policyholders, not shareholders. The United States federal government does not directly regulate the insurance industry. Federal legislation and administrative policies in certain areas can, however, significantly and adversely affect the insurance industry. These areas include pension and employee welfare benefit plan regulation, financial services regulation and federal taxation.
The laws of the various states establish insurance departments with broad powers such as: licensing companies to transact business; licensing agents; mandating certain insurance benefits; regulating premium rates; approving policy forms; regulating fair trade and claims practices; establishing statutory reserve requirements and solvency standards; fixing maximum interest rates on life insurance policy loans and minimum surrender values; restricting certain transactions between affiliates; and regulating the types, amounts and valuation of investments. State insurance regulators and the NAIC continually reexamine existing laws and regulations and may impose changes in the future that could have a material adverse effect on the Company’s business, financial position, results of operations, or cash flows.
See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 17, Contingencies and Commitments.”
Consolidated Statements of Income and Comprehensive Income for the years ended December 31, 2002, 2001 and 2000
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2002, 2001 and 2000
Consolidated Statements of Cash Flows for the years ended December 31, 2002, 2001 and 2000
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of StanCorp Financial Group, Inc. and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.
Organization and principles of consolidation. We were incorporated as a parent holding company in 1998 and completed our initial public offering of common stock on April 21, 1999. We conduct business through our subsidiaries, including Standard Insurance Company (“Standard”); The Standard Life Insurance Company of New York; StanCorp Mortgage Investors, LLC (“StanCorp Mortgage Investors”); and StanCorp Investment Advisers, Inc. We are based in Portland, Oregon and have the authority to underwrite insurance products in all 50 states.
Our largest subsidiary, Standard, underwrites group and individual disability insurance and annuity products, and group life and dental insurance. Founded in 1906, Standard is domiciled in Oregon and licensed in 49 states, the District of Columbia and the U.S. Territories of Guam and the Virgin Islands.
The Standard Life Insurance Company of New York was organized in 2000, and is licensed to provide long term and short term disability, life, and accidental death and dismemberment insurance for groups in New York.
StanCorp Investment Advisers, Inc. is a Securities and Exchange Commission registered investment adviser providing performance analysis, fund selection support and model portfolios to our retirement plan clients.
Investments. For all investments, capital gains and losses are recognized using the specific identification method. Net investment income and capital gains and losses related to separate accounts are included in the separate account assets and liabilities. For all investments, we record impairments when it is determined that the decline in fair value of an investment below its amortized cost basis is “other than temporary.” We reflect impairment charges in net capital gains or losses and permanently adjust the cost basis of the investment to reflect the impairment. Factors considered in evaluating whether a decline in value is other than temporary include: (i) the length of time and the extent to which the fair value has been less than amortized cost, (ii) the financial condition and near-term prospects of the issuer, and (iii) our intent and ability to retain the investment for a period of time sufficient to allow for any anticipated recovery in market value. For securities expected to be sold, an other than temporary impairment charge is recognized if we do not expect the realizable market value of a security to recover to amortized cost prior to the expected date of sale. Once an impairment charge has been recorded, we continue to review the other than temporarily impaired securities for further potential impairment on an ongoing basis.
Investment securities include fixed maturity securities. Investment securities are categorized as trading, stated at fair value with changes in fair value reflected as net capital gains and losses; or available-for-sale, stated at fair value with net unrealized gains and losses recorded as an increase or decrease to other comprehensive income or loss, net of tax. At the end of 2002 all investments were categorized as available-for-sale.
Real estate held for investment is stated at cost less accumulated depreciation. Depreciation generally is provided on the straight-line method, with property lives varying from 30 to 40 years. Accumulated depreciation totaled $25.5 million and $27.0 million at December 31, 2002 and 2001, respectively. Real estate acquired in satisfaction of debt is stated at the lower of cost or fair value less estimated costs to sell.
Deferred acquisition costs. Acquisition costs related to the production of new business have been deferred to accomplish matching against related future premiums and gross profits. Such costs may include certain commissions and incentive payments, certain costs of policy issuance and underwriting and certain variable field office expenses. Various assumptions are used in developing the amounts to be amortized each period, including future interest rates and expected future profitability. These estimates are modified to reflect actual experience when appropriate. Deferred acquisition costs for group disability and group life insurance products are amortized in proportion to future premiums generally over five years. Deferred acquisition costs for individual disability insurance products are amortized in proportion to future premiums over the life of the contract averaging 20 to 25 years with approximately 15% and 50% expected to be amortized by years 10 and 15, respectively. Deferred acquisition costs for individual deferred annuities are amortized in proportion to expected gross profits generally over 30 years with approximately 50% and 90% expected to be amortized by years 5 and 15, respectively. Deferred acquisition costs for group annuity products are amortized in proportion to expected gross profits over 10 years with approximately 10% expected to be amortized by year five. Deferred acquisition costs are charged to current earnings to the extent it is determined that future premiums or gross profits are not adequate to cover the amounts deferred.
Value of business acquired. Value of business acquired (“VOBA”) represents the discounted future profits of blocks of business acquired through reinsurance transactions. The VOBA will be amortized in proportion to future premiums or future profits as appropriate over the remaining life of the contracts underlying the reinsurance agreement. For the VOBA associated with the Minnesota Life Insurance Company (“Minnesota Life”) block of business the amortization period is 30 years. For the VOBA associated with the Teachers Insurance and Annuity Association of America (“TIAA”) block of business, the amortization period is 10 years for VOBA amortized in proportion to premiums and 20 years for VOBA amortized in proportion to expected gross profits, although approximately 75% is expected to be amortized by year five. The revenues and expenses generated by the acquired blocks of business are included in the Company’s consolidated financial statements. A reconciliation of VOBA and the related intangible is as follows:
Separate account. Separate account assets and liabilities represent segregated funds held for the exclusive benefit of contract holders. The activities of the account primarily relate to contract holder-directed 401(k) contracts. Standard charges the separate account asset management and plan administration fees associated with the contracts. Separate account assets and liabilities are carried at fair value.
Other policyholder funds. Other policyholder funds are liabilities for universal life-type and investment-type contracts and are based on the policy account balances including accumulated interest.
Recognition of premiums and benefits to policyholders. Premiums from group life, group and individual disability, and traditional life insurance contracts are recognized as revenue when due. Benefits and expenses are matched with recognized premiums to result in recognition of profits over the life of the contracts. The match is accomplished by recording a provision for future policy benefits and unpaid claims and claim adjustment expenses and by amortizing deferred acquisition costs. Universal life-type and investment-type contract premiums and other policy fee revenues consist of charges for policy administration and surrender charges assessed during the period. Charges related to services to be performed are deferred until earned. The amounts received in excess of premiums and fees are included in other policyholder funds in the consolidated balance sheets. Experience rated refunds are computed in accordance with the terms of the contracts with certain group policyholders and are accounted for as an adjustment to premiums.
Income taxes. The provision for income taxes includes amounts currently payable, deferred amounts that result from temporary differences between financial reporting and tax bases of assets and liabilities as measured by current tax rates and laws, and estimated amounts provided for potential adjustments related to Internal Revenue Service examinations of open years. Although estimated amounts are adjusted when appropriate, amounts required to be provided upon the settlement of an examination may differ from amounts previously estimated. Years currently open for audit by the Internal Revenue Service are 1996 through 2001.
Stock-based Compensation. The Company applies Accounting Principles Board Opinion No. 25, “Accounting
For purposes of determining the pro forma expense, the fair value of each option is estimated on the grant date using the Black-Scholes option pricing model with the following assumptions:
In November 2002, the FASB issued Interpretation No. 45 (“FIN 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees.” FIN 45 required that a liability be recognized at the inception of certain guarantees for the fair value of the obligation, including the ongoing obligation to stand ready to perform over the term of the guarantee. Guarantees, as defined in FIN 45, include contracts that contingently require a company to make payments to a guaranteed party based on certain changes related to an asset, liability or equity security of the guaranteed party, performance guarantees, indemnification agreements or indirect guarantees of indebtedness of others. This interpretation is effective for certain guarantees issued or modified after December 31, 2002. We do not expect FIN 45 to have a material impact on our financial statements.
In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities.” FIN 46 addresses consolidation by business enterprises of
variable interest entities that generally have equity investment risk not sufficient to permit the entity to finance activities without additional subordinated financial support and equity investors that lack controlling financial interests. This interpretation applies to variable interest entities created after January 31, 2003. We do not expect FIN 46 to have a material impact on our financial statements.
The computation of dilutive weighted-average earnings per share does not include options with an option exercise price greater than the average market price because they are antidilutive (would increase earnings per share). For the years ended December 31, 2002, 2001 and 2000, antidilutive options were immaterial.
We operate through three segments: Employee Benefits-Insurance, Individual Insurance and Retirement Plans. Performance assessment and resource allocation are done at the segment level. The Employee Benefits-Insurance segment sells group life and disability insurance, group dental insurance, and accidental death and dismemberment insurance. The Individual Insurance segment sells disability insurance to individuals and markets a full line of immediate and deferred fixed-rate annuities. The Retirement Plans segment sells full-service 401(k), defined benefit, money purchase, profit sharing and deferred compensation plan products and services to small and medium-sized employers.
Amounts reported as “Other” primarily include return on capital not allocated to the product segments, other financial service businesses, holding company expenses, interest on long-term debt and adjustments made in consolidation. Other financial service businesses are generally non-insurance related and include our commercial mortgage lending and other investment management subsidiaries.
For the year ended December 31, 2002, we recorded net capital losses on bonds totaling $33.9 million, including $17.2 million related to WorldCom bonds.
Capital gains (losses) were as follows for the years ended December 31:
The commercial mortgage loan valuation allowance is estimated based on evaluating known and inherent risks in the loan portfolio. The allowance is based on management’s analysis of factors including changes in the size and composition of the loan portfolio, actual loan loss experience, economic conditions, and individual loan analysis. A loan is considered impaired when it is probable that the Company will be unable to collect all amounts due, including principal and interest. Loan impairment is measured using discounted cash flows except when the current fair value, reduced by costs to sell, is determinable. Loans that are deemed uncollectible are written off against the allowance, and recoveries, if any, are credited to the allowance. There were no commercial mortgage loans foreclosed and transferred to real estate in 2002. Commercial mortgage loans foreclosed and transferred to real estate were $1.2 million for 2001. There were no commercial mortgage loans delinquent or in the process of foreclosure at the end of 2002, 2001 and 2000.
Liability for unpaid claims, claims adjustment expenses and other policyholder funds include liabilities for insurance offered on products such as group long term and short term disability, individual disability, group dental, and group accidental death and dismemberment. The liability for unpaid claims and claim adjustment expenses are included in future policy benefits and claims in the consolidated balance sheets. The change in the liabilities for unpaid claims and claim adjustment expenses was as follows for the years ended December 31:
Approximately $200 million of the debt offering proceeds were used to fund the acquisition by Standard of the group disability and group life insurance business of TIAA which closed on October 1, 2002 (see “-Note 16. Acquisition and Disposition of Blocks of Business”), which included a ceding commission of $75 million and $125 million for maintenance of our risk-based capital target levels. The remaining proceeds were used to pay our annual dividend to shareholders, to fund a modest level of share repurchases and for general corporate purposes.
The provision for income taxes was as follows for the years ended December 31:
Prior to 2002, pension benefit plans’ assets were invested in Standard’s general account invested assets. Effective January 2, 2002, the Company initiated an investment strategy to invest approximately 50% of one of the pension plan’s assets in equity investments with the remaining assets invested in general account invested assets. The postretirement benefit plan’s assets are invested primarily in long-term municipal bonds.
Substantially all full-time employees are covered by deferred compensation plans under which a portion of the employee contribution is matched. Contributions by Standard to the plans for 2002, 2001, and 2000 were $2.8 million, $2.5 million and $2.2 million, respectively.
During 2002, options were granted to purchase 315,050 shares of common stock at prices ranging from $46.81 to $57.10 per share. These options were granted to members of StanCorp’s board of directors and employee groups consisting of officer and non-officer employees. Members of StanCorp’s board of directors received grants of options totaling 44,000 shares of common stock. Officers and other employees received grants of options totaling 271,050 shares of common stock. The employee options are subject to a four year annual step-vesting schedule beginning one year after the date of grant. Directors’ options are subject to a one-year vesting period.
The weighted-average grant date fair value of option awards in 2002, 2001, and 2000 was $21.14, $20.95, and $12.37, respectively.
The Company grants to certain key management employees restricted stock in which full ownership is not vested until the attainment of certain financial benchmarks (“performance” shares), or the completion of a specified period of employment with the Company (“retention” shares). Performance shares were first issued in 2000 and will be released, subject to the attainment of financial goals, through 2004. The Company’s experience with these shares through 2002 has been as follows:
Retention shares were granted during 2002 in the amount of 12,000 shares. These shares will vest based on the recipients’ continued employment with the Company through the year 2005. The fair value of these shares at grant date was $53.08 (for 4,000 shares) and $56.25 (for 8,000 shares).
The Company’s Employee Share Purchase Plan allows eligible employees to purchase common stock at 85% of the lesser of the fair market value of the stock on either the commencement date of each six month offering period or the end-of-the-period purchase date. Under the terms of the plan, each eligible employee may elect to have up to 10% of the employee’s gross total cash compensation for the period withheld to purchase common stock. No employee may purchase common stock having a maximum fair market value in excess of $25,000 in any calendar year.
The primary purpose of ceding reinsurance is to limit losses from large exposures. The maximum retention limit per individual for group life and accidental death and dismemberment policies combined is $500,000. For group disability policies, the maximum monthly retention limit is $10,000 gross monthly benefit per individual. Except for certain policies acquired with the Minnesota Life block of business, the maximum retention for individual disability policies is generally $3,500 monthly benefit per individual. Certain policies acquired with the Minnesota Life block of business have maximum retention limits of $6,000 monthly benefit per individual. The retention limits for the Minnesota Life block of business were established by a reinsurance agreement entered into effective July 1, 2002.
receivable from Standard. The market value of assets required to be maintained in the trust at December 31, 2002 was $169.5 million.
Recoveries recognized under reinsurance agreements were $42.4 million, $34.9 million and $10.7 million for 2002, 2001, and 2000, respectively. Amounts recoverable from reinsurers were $873.9 million and $867.5 million at December 31, 2002 and 2001, respectively. Of these amounts, $809.3 million and $813.3 million were from the reinsurance transaction with Protective Life Insurance Company (“Protective Life”) effective January 1, 2001 (see “-Note 16, Acquisition and Disposition of Blocks of Business”).
Deferred acquisition costs and related amortization include VOBA. Other operating expenses include operating expenses, commissions and bonuses, and the net increase in deferred acquisition costs.
Standard and The Standard Life Insurance Company of New York prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by their states of domicile. Prescribed statutory accounting practices include state laws, regulations, and general administrative rules, as well as accounting practices set forth in publications of the National Association of Insurance Commissioners (“NAIC”).
Statutory accounting practices differ in some respects from GAAP. The principal statutory practices which differ from GAAP are: a) bonds and commercial mortgage loans are reported principally at amortized cost; b) asset valuation and interest maintenance reserves are provided as prescribed by the NAIC; c) certain assets designated as non-admitted, principally deferred tax assets, furniture, equipment, and unsecured receivables, are not recognized as assets, resulting in a charge to statutory surplus; d) premiums are recognized as income when due, annuity considerations with life contingencies are recognized as income when received; e) reserves for life and disability policies and contracts are based on statutory requirements; f) commissions and other policy acquisition expenses are expensed as incurred; and (g) federal income tax expense includes current income taxes defined as current year estimates of federal income taxes and tax contingencies for current and all prior years; and amounts incurred or received during the year relating to prior periods, to the extent not previously provided. Deferred tax assets and liabilities are included in the regulatory financial statements and represent the expected future tax consequences of differences between the tax and the financial statement basis of assets and liabilities resulting in a change in statutory surplus.
Standard and The Standard Life Insurance Company of New York are subject to statutory restrictions that limit the maximum amount of dividends that they could declare and pay to StanCorp without prior approval of the states in which the subsidiaries are domiciled. The amount available for payment of dividends by Standard in 2003 without approval of the Oregon Department is $80.8 million payable after February 25, 2003. In February 2003, Standard’s board of directors approved and paid a dividend of $65 million to StanCorp. There was no amount available for payment of dividends by The Standard Life Insurance Company of New York in 2003.
State insurance departments require insurance enterprises to adhere to minimum Risk-Based Capital (“RBC”) requirements promulgated by the NAIC. At December 31, 2002 and 2001 the insurance subsidiaries’ RBC levels were significantly in excess of that which would require corrective action by the insurance subsidiaries or regulatory agencies. The amount of statutory capital and surplus necessary to satisfy the regulatory action requirements was $141.0 million and $108.1 million at December 31, 2002 and 2001, respectively.
Effective October 1, 2002, Standard acquired the group disability and group life insurance business, through a reinsurance transaction, of TIAA. This block of business includes approximately 1,800 group insurance contracts, representing 650,000 insured individuals, and contributed $40.9 million in premiums during the fourth quarter of 2002. Standard paid a ceding commission of approximately $75 million and received approximately $705 million in assets and corresponding statutory liabilities. If Standard were to become unable to meets its obligations, TIAA would retain the reinsured liabilities. In accordance with the agreement with TIAA, Standard established a trust for the benefit of TIAA with the market value of assets in the trust equal to TIAA’s reinsurance receivable from Standard. The market value of assets required to be maintained in the trust at December 31, 2002 was $753.0 million. Approximately $60 million in VOBA was recorded upon closing of the acquisition.
Effective October 1, 2000, Standard acquired a substantial block of individual disability insurance business, through a reinsurance transaction, from Minnesota Life. Standard paid a ceding commission of approximately $55
million and received approximately $500 million in assets and corresponding statutory liabilities. If Standard were to become unable to meet its obligations, Minnesota Life would retain the reinsured liabilities. Therefore, in accordance with the agreement with Minnesota Life, Standard established a trust for the benefit of Minnesota Life with the market value of assets in the trust equal to Minnesota Life’s reinsurance receivable from Standard. The market value of assets required to be maintained in the trust at December 31, 2002 was $555.6 million. Accompanying the transaction was an agreement that provides access to Minnesota Life agents, some of whom now market Standard’s individual disability insurance products.
The Company leases certain buildings and equipment under non-cancelable operating leases that expire in various years through 2010, with renewal options for periods ranging from one to five years. Future minimum payments under the leases are: 2003, $10.0 million; 2004, $9.0 million; 2005, $7.2 million; 2006, $5.8 million; 2007, $5.2 million and thereafter, $7.8 million. Total rent expense was $13.9 million, $12.0 million and $9.5 million for the years ended December 31, 2002, 2001, and 2000, respectively. At December 31, 2002, minimum future rental receivables on non-cancelable leases with initial terms of one year or more were: 2003, $12.2 million; 2004, $11.1 million; 2005, $9.9 million; 2006, $8.3 million; 2007, $7.7 million and thereafter, $22.1 million.
From time to time, the Board of Directors has authorized share repurchase programs. Share repurchases are to be effected in the open market or in negotiated transactions in compliance with the safe harbor provisions of Rule 10b-18 under regulations of the Securities Exchange Act of 1934. Execution of the share repurchase program is based upon management’s assessment of market conditions for its common stock and other potential growth opportunities. During 2002, the Company repurchased 853,000 shares of its common stock at a total cost of $45.5 million, for a weighted-average price per share of $53.34 At December 31, 2002, approximately 400,000 shares were remaining under the currently authorized share repurchase program which expires December 31, 2003.