Principal properties owned by Standard Insurance Company (“Standard”) and used by StanCorp Financial Group, Inc. or its subsidiaries consist of two office buildings in downtown Portland, Oregon: the Standard Insurance Center, with approximately 460,000 square feet; and the Standard Plaza, with approximately 220,000 square feet. All of our business segments use the facilities described above. We also own two buildings in Hillsboro, Oregon, each with 72,000 square feet of office space. The Hillsboro offices are used by StanCorp Mortgage Investors, LLC and our Employee Benefits claims operations. In addition, Standard leases approximately 160,000 square feet of office space located in downtown Portland, Oregon, for home office and claims operations. We lease 52 offices under commitments of varying terms to support our sales and regional processing offices throughout the United States. Management believes that the capacity and types of facilities are suitable and adequate for operations. See Part II, Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 1-Summary of Significant Accounting Policies-Property and Equipment, Net.”
Net income excluding after-tax net capital losses was $5.25 per diluted share for 2014, compared to $5.34 per diluted share for 2013. The decrease in net income per diluted share was primarily due to lower operating expenses for 2013, which included savings of $20.6 million or $0.30 per diluted share in 2013 due to an amendment of our postretirement medical plan, which did not recur in 2014.
Net income excluding after-tax net capital losses was $5.34 per diluted share for 2013, compared to $3.24 per diluted share for 2012. The increase was primarily due to more favorable claims experience in Employee Benefits, lower operating expenses as a result of expense management actions in 2013, and higher earnings in Asset Management and Individual Disability for 2013. Operating
Employee Benefits reported income before income taxes of $201.8 million for 2014, compared to $216.4 million for 2013. The decrease was primarily due to lower premiums and lower net investment income, partially offset by more favorable claims experience. Employee Benefits premiums decreased 4.4% to $1.84 billion for 2014 from $1.93 billion for 2013. The decrease in premiums for 2014 was primarily due to lower Employee Benefits sales in the first half of 2014 compared to prior periods. Employee Benefits annualized new sales were $215.6 million for 2014, compared to $222.1 million for 2013. The benefit ratio for Employee Benefits was 77.8% for 2014, compared to 78.9% for 2013. The average discount rate used for newly established long term disability insurance claim reserves was 4.00% for 2014, compared to 3.75% for 2013. A 25 basis point increase or decrease in the discount rate currently results in a corresponding increase or decrease in the quarterly pre-tax income of approximately $2 million or approximately $8 million for the full year.
Individual Disability reported income before income taxes of $52.9 million for 2014, compared to $56.0 million for 2013. Individual Disability premiums were $199.1 million for 2014, compared to $190.5 million for 2013. The Individual Disability benefit ratio was 65.3% for 2014, compared to 63.9% for 2013.
As we look to 2015, we expect to face ongoing macro-economic factors: a persistent low interest rate environment, a price sensitive group insurance marketplace, elevated unemployment levels and challenges to wage and employment growth of our customers. Despite these challenges, we will continue to focus on our long-term objectives and address challenges that arise with financial discipline and from a position of financial strength. We manage for long-term profitability by focusing on business diversification, disciplined product pricing, sound underwriting, effective claims management and high-quality customer service.
We intend to preserve the value of our business by continuing to provide excellent service to our customers. We will optimize shareholder value through sustainable profitability by investing in new product and service capabilities and through the strategic use of capital. We believe these actions along with our strong performance in 2014 will continue to benefit the Company and the shareholders in 2015 and beyond.
Total real estate was $37.0 million at December 31, 2014, compared to $65.7 million at December 31, 2013. The $28.7 million decrease in total real estate during 2014 was primarily due to the sale of Real Estate Owned and the impairments on Real Estate Owned.
In 2014, we began the use of interest rate swaps to reduce the risks from changes in interest rates, to manage interest rate exposures arising from asset and liability mismatches, and to protect the value of investments held on the consolidated balance sheets. The interest rate swaps used by us are designed to qualify for hedge accounting.
An interest rate swap designated as part of a hedging relationship must be assessed as being highly effective in offsetting the designated risk of the hedged item. Hedge effectiveness is assessed at inception and periodically throughout the life of the designated hedging relationship, using qualitative and quantitative methods. Qualitative methods include comparison of critical terms of the interest rate swap to the hedged item. Quantitative methods include regression or other statistical analysis of changes in the fair value or cash flows associated with the hedge relationship.
The gain or loss on the termination of an ineffective fair value hedge is reported in the consolidated statements of income as a component of net capital gains or losses. Additionally, when a hedged item is disposed, we will terminate the related derivative instrument and recognize the gain or loss on termination in the consolidated statements of income as a component of net capital gains or losses.
Index-based guarantees embedded in indexed annuities (“index-based interest guarantees”) and Standard & Poor’s (“S&P”) 500 Index call spread options (“S&P 500 Index options”) do not qualify for hedge accounting. We sell indexed annuities, which permit the holder to elect a fixed interest rate return or an indexed return, where interest credited to the contracts is based on the performance of the S&P 500 Index, subject to an upper limit or cap and minimum guarantees. Policyholders may elect to rebalance between interest crediting options at renewal dates annually. At each renewal date, we have the opportunity to re-price the indexed component by changing the cap, subject to minimum guarantees. We estimate the fair value of the index-based interest guarantees for the current period and for all future reset periods until contract maturity. Changes in the fair value of the index-based interest guarantees are recorded in interest credited.
In 2013, Standard became a member of the Federal Home Loan Bank of Seattle (“FHLB of Seattle”) and purchased the required common stock for membership and activity. Our investment in common stock of FHLB of Seattle relates to Standard’s membership and activity in the FHLB of Seattle. The FHLB of Seattle common stock is carried at par value and accounted for under the cost method. We periodically evaluate FHLB of Seattle common stock for OTTI. Our determination of whether this investment is impaired is based on our assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The Federal Home Loan Bank of Des Moines (“FHLB of Des Moines”) and the FHLB of Seattle have announced that they have entered into a definitive agreement to merge the two banks. The merger agreement has been unanimously approved by the boards of directors of both banks and by the Federal Housing Finance Agency (“FHFA”). The potential merger must be approved by the members of both banks through a voting process that is expected to take place in the first half of 2015. We do not expect the merger to have a material effect on our business, financial position, results of operations or cash flows.
Individual disability insurance policy reserves are sensitive to assumptions and considerations regarding:
Claim reserves are established when a claim is incurred or is estimated to have been incurred but not yet reported to us and, as prescribed by GAAP, equal our best estimate of the present value of the liability of future unpaid claims and claim adjustment expenses. Reserves for IBNR claims are determined using our experience and historical incidence rates, claim-reporting patterns and the average cost of claims. The IBNR claim reserves are calculated using a company derived formula based primarily upon premiums, which is validated through an examination of reserve run-out experience. The claim reserves are related to group and individual disability insurance and group life insurance products offered within Employee Benefits and Individual Disability.
Claim reserves are subject to revision based on credible changes in claim experience and expectations of future factors that may influence claim experience. During each quarter, we monitor our emerging claims experience to ensure that the claim reserves remain appropriate. We make adjustments to our assumptions based on emerging trends that are credible and are expected to persist, and expectations of future factors that may influence our claims experience. Assumptions used to calculate claim reserves may vary by the age, gender and occupation class of the claimant, the year the claim was incurred, time elapsed since disablement, and specific contract provisions and limitations.
The following table sets forth total claim reserves by block of business:
Claim reserves for our disability insurance products are sensitive to assumptions and considerations regarding:
VOBA primarily represents the discounted future profits of business assumed through reinsurance agreements. We have established VOBA for a block of individual disability insurance business assumed from Minnesota Life and a block of group disability insurance and group life insurance business assumed from Teachers Insurance and Annuity Association of America (“TIAA”). VOBA is generally amortized in proportion to future premiums for group and individual disability insurance products and group life insurance products. However, the VOBA related to the TIAA transaction associated with an in-force block of group long term disability insurance claims for which no ongoing premium is received is amortized in proportion to expected gross profits. If actual premiums or future profitability are inconsistent with our assumptions, we could be required to make adjustments to VOBA and related amortization. The VOBA associated with the TIAA transaction is amortized in proportion to expected gross profits with an amortization period of up to 20 years. For the VOBA associated with the Minnesota Life block of business assumed, the amortization period is up to 30 years and is amortized in proportion to future premiums. The accumulated amortization of VOBA was $71.0 million and $68.7 million at December 31, 2014 and 2013, respectively.
Our other intangible assets are subject to amortization and consist of certain customer lists from an Asset Management business acquired and an Individual Disability marketing agreement. Customer lists have a combined estimated weighted-average remaining life of approximately 6.5 years. The marketing agreement accompanied the Minnesota Life transaction and provides access to Minnesota Life agents, some of whom now market Standard’s individual disability insurance products. The Minnesota Life marketing agreement will be fully amortized by the end of 2023. The accumulated amortization of other intangible assets was $48.4 million and $42.6 million at December 31, 2014 and 2013, respectively.
We have two non-contributory defined benefit pension plans: the employee pension plan and the agent pension plan. The employee pension plan is generally limited to eligible employees whose date of employment began before 2003 and a participant is entitled to normal retirement benefits at age 65. The agent pension plan is for former field employees and agents. The defined benefit pension plans provide benefits based on years of service and final average pay. The employee pension plan is sponsored by StanCorp and the agent pension plan is sponsored by Standard. Both plans are administered by Standard Retirement Services and are closed for new participants. In addition, eligible executive officers are covered by a non-qualified supplemental retirement plan.
We also have a postretirement benefit plan that includes medical, prescription drug benefits and group term life insurance. Eligible retirees are required to contribute specified amounts for medical and prescription drug benefits that are determined periodically and are based on retirees’ length of service and age at retirement. As of 2006, participation in the postretirement benefit plan was closed to new participants. This plan is sponsored and administered by Standard. An amendment announced in 2012 reduced future benefits to plan participants that did not retire by July 1, 2013.
In 2014, we adopted an updated mortality table which was a significant driver of the increase in the projected benefit obligation at December 31, 2014 compared to December 31, 2013.
We record interest paid on income tax liabilities as interest expense and income tax penalties incurred as an operating expense. Currently, the years 2011 through 2014 are open for audit by the IRS.
Premiums for Insurance Services are the primary driver of consolidated premiums and are affected by sales, persistency, organic growth in Employee Benefits and experienced rated refunds (“ERRs”). Organic growth in Employee Benefits is derived from existing policyholders’ employment and wage growth. ERRs represent cost sharing arrangements with certain group contract holders that provide refunds to the contract holders when claims experience is more favorable than contractual benchmarks, and provide for additional premiums to be paid when claims experience is less favorable than contractual benchmarks. ERRs can fluctuate widely from quarter to quarter depending on the underlying experience of specific contracts.
Administrative fees for Insurance Services are primarily derived from insurance products for which we provide only administrative services and absence management services.
Net investment income is primarily affected by changes in levels of invested assets, portfolio yields, fluctuations in the change in fair value of our S&P 500 Index options related to our equity-indexed annuity product, commercial mortgage loan prepayment fee revenues, bond call premiums on fixed maturity securities and operating losses related to our tax-advantaged investments.
Net capital gains and losses are reported in the Other category and are not likely to occur in a stable pattern. Net capital gains and losses primarily occur as a result of sales of our assets for more or less than carrying value, OTTI of assets in our bond portfolio, provisions to our commercial mortgage loan loss allowance, impairments of real estate and impairments of other invested assets.
The decrease in premiums for 2014 compared to 2013 was primarily due to a decrease in Employee Benefits premiums as a result of lower Employee Benefits sales in the first half of 2014 compared to prior periods. See “Business Segments-Insurance Services.”
The increase in administrative fees for 2014 compared to 2013 was primarily due to the increase in administrative fees from Asset Management as a result of an increase in assets under administration related to higher equity values for retirement plan assets under administration. See “Business Segments-Asset Management.”
Net income for 2013 was $228.5 million, compared to $138.5 million for 2012. The increase in net income was primarily due to more favorable claims experience in Employee Benefits, lower operating expenses as a result of expense management actions, and higher earnings in the Asset Management and Individual Disability segments for 2013. Operating expenses were reduced by $20.6 million for the first half of 2013 due to the amendment of our postretirement medical plan.
The increase in net capital losses for 2013 compared to 2012 was primarily due to an increase in the provision for our commercial mortgage loan losses and capital losses on real estate. These capital losses were partially offset by net capital gains related to the sale of certain fixed maturity securities. See “Business Segments-Other.”
The decrease in benefits to policyholders for 2013 compared to 2012 was primarily due to more favorable claims experience in Employee Benefits. See “Business Segments-Insurance Services.”
The net increase in DAC, VOBA and other intangible assets was primarily due to higher Employee Benefits commissions and bonuses for 2013 compared to 2012.
We collectively view and operate our businesses as Insurance Services and Asset Management. Insurance Services contains two reportable product segments, Employee Benefits and Individual Disability. Insurance Services include our traditional risk acceptance businesses that reflect the application of our specialized expertise in the development, underwriting and administration of insurance products and services. Within Insurance Services, Employee Benefits offers group disability insurance, group life and AD&D insurance, group dental and group vision insurance, and absence management services. Asset Management is a separate reportable segment. Asset Management provides investment and asset management products and services and offers full-service 401(k) plans, 403(b) plans, 457 plans, defined benefit plans, money purchase pension plans, profit sharing plans and non-qualified deferred compensation products and services. Asset Management also offers investment advisory and management services, origination and servicing of fixed-rate commercial mortgage loans, individual fixed and indexed annuity products, group annuity contracts and retirement plan trust products. The Other category includes return on capital not allocated to the product segments, holding company expenses, operations of certain unallocated subsidiaries, interest on debt, unallocated expenses, net capital gains and losses primarily related to the impairment or the disposition of our invested assets and adjustments made in consolidation. We allocate resources and measure performance at the segment level.
The following table sets forth segment revenues measured as a percentage of total revenues, excluding revenues from the Other category:
The following tables set forth our Insurance Services results of operations and key indicators:
The increase in premiums for Individual Disability for 2014 compared to 2013 was primarily due to a high persistency level and new policy sales for 2014.
The benefit ratio for Employee Benefits was 77.8% for 2014, compared to 78.9% for 2013. Contributing to the decrease in the Employee Benefits benefit ratio was a 25 basis point higher average discount rate used for newly established long term disability insurance claim reserves and life waiver reserves for 2014 compared to 2013. A 25 basis point increase or decrease in the discount rate currently results in a corresponding increase or decrease in quarterly pre-tax income of approximately $2 million or approximately $8 million for the full year. The increase in the discount rate was primarily due to the mix and timing of new investments we acquired and the yields on these new investments attributable to the corresponding line of business. See “Critical Accounting Policies and Estimates-Reserves for Future Policy Benefit and Claims” for more information.
The benefit ratio for Individual Disability increased to 65.3% for 2014, compared to 63.9% for 2013. Due to the relatively small size of the Individual Disability business, the benefit ratio generally fluctuates more than Employee Benefits. See “Critical Accounting Policies and Estimates-Reserves for Future Policy Benefits and Claims-Claim Reserves” for more information.
The decrease in premium taxes for Insurance Services for 2014 compared to 2013 was primarily due to the utilization of state premium tax credits for 2014.
Benefits to policyholders related to incurred claims for the Employee Benefits segment for 2013 decreased 3.8% compared to the incurred claims for 2012, which primarily resulted from a 3.5% reduction in long term disability insurance claims incidence for 2013 compared to 2012. The decrease in benefits to policyholders was offset by a 43 basis point lower average discount rate for 2013 compared to 2012 used for newly established long term disability insurance claims reserves. The decrease in the average discount rate was primarily the result of a continued low interest rate environment. Claims experience can fluctuate widely from period to period and tends to be more stable when measured over a longer period of time. See “Critical Accounting Policies and Estimates-Basis of Presentation” for more information.
The favorable claims experience for 2013 did not result in a significant change in our underlying assumptions or methods used to determine the claim reserves, primarily due to the long-term nature of our group long term disability insurance business and the materiality of other factors, including the potential impact of economic uncertainty. We monitor trends in reserve assumptions and when these trends become credible and are expected to persist, we incorporate these factors into our reserves to ensure the best estimates are established.
Income before income taxes for Asset Management was $77.9 million for 2014, compared to $79.3 million for 2013. The decrease in income before income taxes was primarily due to the change in fair values of the hedging assets and liabilities related to our equity-indexed annuity product, which decreased income before income taxes by $0.5 million for 2014, compared to an increase of $2.6 million for 2013. The decrease was partially offset by an increase in administrative fees for 2014 compared to 2013, which was primarily due to an increase in assets under administration.
The increase in administrative fees for Asset Management for 2014 compared to 2013 was primarily due to an increase in assets under administration. Assets under administration increased 7.4% to $26.53 billion at December 31, 2014, compared to $24.70 billion at December 31, 2013, primarily due to higher equity values and positive cash flows for retirement plan assets under administration.
The increase in net investment income for Asset Management for 2013 compared to 2012 was primarily due to a higher contribution from the change in fair value of our S&P 500 Index options related to our equity-indexed annuity product. The change in fair value of our S&P 500 Index options in 2013 was $14.4 million compared to $7.8 million in 2012. In addition, bond call premiums and commercial mortgage loan prepayment fees added $9.9 million to net investment income for 2013, compared to $8.0 million for 2012. These increases were partially offset by lower portfolio yields for both fixed maturity securities and commercial mortgage loans.
The decrease in benefits to policyholders for Asset Management for 2013 compared to 2012 was primarily due to favorable mortality experience in the individual annuity business.
We report our holding company and corporate activities in the Other category. This category includes return on capital not allocated to the product segments, holding company expenses, operations of certain unallocated subsidiaries, interest on debt, unallocated expenses, net capital gains and losses primarily related to the impairment or the disposition of our invested assets and adjustments made in consolidation.
The increase in net investment income for the Other category for 2014 compared to 2013 was primarily due to a larger amount of invested assets allocated to the Other category.
The increase in operating expenses for the Other category for 2014 compared to 2013 was primarily due to the result of expense management actions taken in the first half of 2013. Operating expenses were reduced by $20.6 million for the first half of 2013 due to the amendment of our postretirement medical plan, which did not recur in 2014.
The decrease in operating expenses for the Other category for 2013 compared to 2012 was primarily due to the result of expense management actions. Operating expenses were reduced by $20.6 million for the first half of 2013 due to the amendment of our postretirement medical plan.
Our interest rate risk analysis reflects the influence of call and prepayment rights present in our fixed maturity securities and commercial mortgage loans. The majority of these investments have contractual provisions that require the borrower to compensate us in part or in full for reinvestment losses if the security or loan is retired before maturity. Callable bonds, excluding bonds with make-whole provisions and bonds with provisions that allow the borrower to prepay near maturity, represented 3.5%, or $275.1 million, of our fixed maturity securities portfolio at December 31, 2014. We also originate commercial mortgage loans containing a make-whole prepayment provision requiring the borrower to pay a prepayment fee. As interest rates decrease, potential prepayment fees increase.
These larger prepayment fees deter borrowers from refinancing during a low interest rate environment. Approximately 96% of the commercial mortgage loan portfolio contains this prepayment provision. In addition, approximately 1% of the commercial mortgage loan portfolio contains fixed percentage prepayment fees that mitigate prepayments but may not fully protect our expected cash flows in the event of prepayment.
Our financial instruments are exposed to financial market volatility and potential disruptions in the market that may result in certain financial instruments becoming less valuable. Financial market volatility includes interest rate risk. We have analyzed the estimated loss in fair value of certain market sensitive financial assets held at December 31, 2014 and 2013, using a hypothetical 10% increase in interest rates and related qualitative information on how we manage interest rate risk. The interest rate sensitivity analysis was based upon our fixed maturity securities net of fair value hedges and commercial mortgage loans held at December 31, 2014 and 2013. Interest rate sensitivity of our financial assets was measured assuming a parallel shift in interest rates. All security yields were increased by 10% of the year-end 10-year U.S. Government Treasury bond yield, or 0.22% and 0.30% for the 2014 and 2013 analyses, respectively. The change in fair value of each security was estimated as the change in the option adjusted value of each security. Option adjusted values were computed using our payment models and provisions for the effects of possible future changes in interest rates. The analyses did not explicitly provide for the possibility of non-parallel shifts in the yield curve, which would involve discount rates for different maturities being increased by different amounts. The actual change in fair value of our financial assets can be significantly different from that estimated by the model. The hypothetical reduction in the fair value of our financial assets that resulted from the model was estimated to be $124 million and $164 million at December 31, 2014 and 2013, respectively.
We maintain prudent diversification across industries, issuers and maturities. Our corporate bond industry diversification targets are based on the Bank of America Merrill Lynch U.S. Corporate Master Index, which we believe reasonably reflects the mix of issuers broadly available in the market. Our fixed maturity securities rated below investment grade are primarily managed by a third party.
We recorded OTTI of $1.2 million and $1.1 million for 2014 and 2013, respectively. See “Critical Accounting Policies and Estimates-Investment Valuations-Fixed Maturity Securities.” We did not have any direct exposure to sub-prime or Alt-A mortgages in our fixed maturity securities portfolio at December 31, 2014.
The estimated average loan to value ratio for the overall portfolio was less than 70% at December 31, 2014. The average loan balance of our commercial mortgage loan portfolio was approximately $0.8 million at December 31, 2014. We have the contractual ability to pursue personal recourse on approximately 74% of our loans and partial personal recourse on a majority of the remaining loans. The weighted-average capitalization rate for the portfolio at December 31, 2014 was approximately 9%. Capitalization rates, which vary by property type and geographic region, are used as part of our annual internal analysis of our commercial mortgage loan portfolio. The rate is used in converting the property’s income to an estimated property value.
At December 31, 2014, our ten largest borrowers represented less than 7% of our total commercial mortgage loan portfolio balance. Our largest borrower concentrations within our commercial mortgage loan portfolio consisted of one borrower that comprised less than 2% of our total commercial mortgage loan portfolio balance. The second largest borrower comprised less than 1% of our total commercial mortgage loan portfolio balance.
In the normal course of business, we commit to fund commercial mortgage loans generally up to 90 days in advance. At December 31, 2014, we had outstanding commitments to fund commercial mortgage loans totaling $134.8 million, with fixed interest rates ranging from 4.00% to 6.00%. These commitments generally have fixed expiration dates. A small percentage of commitments expire due to the borrower’s failure to deliver the requirements of the commitment by the expiration date. In these cases, we will retain the commitment fee and good faith deposit. Alternatively, if we terminate a commitment due to the disapproval of a commitment requirement, the commitment fee and good faith deposit may be refunded to the borrower, less an administrative fee.
Commercial mortgage loan foreclosures may result in the sale of the property to a third party at the time of foreclosure, resulting in fewer properties transferred to Real Estate Owned than the number of loans foreclosed during the period. Commercial mortgage loans may have multiple properties as collateral, resulting in more properties transferred to Real Estate Owned than the number of loans foreclosed during the period. Real Estate Owned is initially recorded at estimated net realizable value, which includes an estimate for disposal costs. These amounts may be adjusted in a subsequent period as additional market information regarding fair value is received, however, these adjustments would not result in a carrying value greater than the initial recorded amount. The book value of real estate acquired during 2014 decreased compared to 2013 primarily due to fewer properties being foreclosed in 2014. See “Critical Accounting Policies and Estimates-Investment Valuations-Commercial Mortgage Loans” for our commercial mortgage loan loss allowance policy.
The following table sets forth impaired commercial mortgage loans identified in management’s specific review of probable loan losses and the related allowance:
Under the facility, we are subject to customary covenants that take into consideration the impact of material transactions, changes to the business, compliance with legal requirements and financial performance. Under the two financial covenants, we are required to maintain a total debt to total capitalization ratio that does not exceed 35% and a consolidated net worth that is equal to at least $1.48 billion. The financial covenants exclude the unrealized gains and losses related to fixed maturity securities that are held in accumulated other comprehensive income (loss). At December 31, 2014, we had a total debt to total capitalization ratio of 20.6% and consolidated net worth of $1.95 billion as defined by the financial covenants. The Facility is subject to pricing levels based upon our publicly announced debt ratings and includes an interest rate option at the election of the borrower of a base rate plus the applicable margin or the London Interbank Offered Rate (“LIBOR”) plus the applicable margin, plus facility and utilization fees. At December 31, 2014, we were in compliance with all covenants under the Facility and had no outstanding balance on the Facility. We believe we will continue to meet the financial covenants throughout the life of the Facility.
In 2013, Standard became a member of the FHLB of Seattle. Standard issues collateralized funding agreements to the FHLB of Seattle and invests the cash received from advances to support various spread-based businesses and enhance our asset-liability management. Membership also provides an additional funding source and access to financial services that can be used as an alternative source of liquidity. At December 31, 2014, Standard had $139.0 million outstanding under funding agreements with the FHLB of Seattle. At December 31, 2014, Standard pledged $174.4 million of commercial mortgage loans as collateral to the FHLB of Seattle for our outstanding advances. There were no assets pledged as collateral to the FHLB of Seattle at December 31, 2013. The FHLB of Des Moines and the FHLB of Seattle have announced that they have entered into a definitive agreement to merge the two banks. The merger agreement has been unanimously approved by the boards of directors of both banks and by the FHFA. The potential merger must be approved by the members of both banks through a voting process that is expected to take place in the first half of 2015. We do not expect the merger to have a material effect on our business, financial position, results of operations or cash flows.
State insurance departments require insurance enterprises to maintain minimum levels of capital and surplus. Our target for our statutory insurance subsidiaries is generally to maintain statutory capital and surplus at 300% of the Company Action Level of Risk-Based Capital (“RBC”) required by regulators, which is 600% of the Authorized Control Level RBC required by our states of domicile. The statutory insurance subsidiaries capital and surplus as a percentage of the Company Action Level RBC was approximately 445% at December 31, 2014. At December 31, 2014, capital and surplus, adjusted to exclude asset valuation reserves, for our regulated statutory insurance subsidiaries totaled $1.33 billion.
Capital and surplus growth from our statutory insurance subsidiaries is generally a result of generated income, less a charge for business growth, measured by insurance premium growth, which includes individual annuity sales. The level of capital and surplus in excess of targeted RBC we generate varies inversely in relation to the level of our premium growth. As premium growth increases, capital and surplus is used to fund additional reserve requirements, meet increased regulatory capital requirements based on premium
In the third quarter of 2014, Standard transferred its group life reinsurance from an external party to StanCap Insurance Company, Inc. (“StanCap Insurance Company”), who also reinsures Standard’s AD&D insurance business. The result of this transaction increased the RBC ratio at our statutory insurance subsidiaries by approximately 25%.
(1) The estimated payments expected to be due by period for insurance obligations reflect future estimated cash payments, for pending and future potential claims, to be made to policyholders and others for future policy benefits, policyholders’ account balances, policyholders’ dividends and reinsurance payables. These future estimated net cash payments are based on mortality, morbidity, lapse and other assumptions comparable with our experience, consider future premium receipts on current policies in-force, and assume market growth and interest crediting consistent with assumptions used in amortizing DAC and VOBA. These net cash payments are undiscounted with respect to interest and, as a result, the sum of the net cash payments shown for all years in the table of $7.49 billion exceeds the corresponding liability amount of $5.83 billion included in the Consolidated Financial Statements as of December 31, 2014. We have made significant assumptions to determine the future estimated net cash payments related to the underlying policies and contracts. Due to the significance of the assumptions used, actual net cash payments will differ, possibly materially, from these estimates.
(2) While historical withdrawal patterns indicate withdrawal primarily occurs in periods in excess of one year, policyholder fund obligations in the amount of $4.99 billion have been included in the less than one year column of the table as they may be withdrawn upon request. These net cash payments are undiscounted with respect to interest but reflect an offsetting effect due to reinsurance receivables and, as a result, the sum of the net cash payments shown for all years in the table of $6.14 billion differs from the corresponding liability amount of $6.54 billion included in the Consolidated Financial Statements as of December 31, 2014. Due to the significance of the assumptions used, actual net cash payments will differ, possibly materially, from these estimates.
(3) Separate account liabilities are legally insulated from general account obligations, and it is generally expected these liabilities will be fully funded by separate account assets and their related cash flows. While historical withdrawal patterns indicate withdrawal primarily occurs in periods in excess of one year, separate account liabilities in the amount of $7.18 billion have been included in the less than one year column of the table as they may be withdrawn upon request.
In the normal course of business, we commit to fund commercial mortgage loans generally up to 90 days in advance. At December 31, 2014, we had outstanding commitments to fund commercial mortgage loans totaling $134.8 million, with fixed interest rates ranging from 4.00% to 6.00%. These commitments generally have fixed expiration dates. A small percentage of commitments expire due to the borrower’s failure to deliver the requirements of the commitment by the expiration date. In these cases, we will retain the commitment fee and good faith deposit. Alternatively, if we terminate a commitment due to the disapproval of a commitment requirement, the commitment fee and deposit may be refunded to the borrower, less an administrative fee.
Other long-term obligations reflected in the consolidated balance sheets at December 31, 2014, included $210.6 million in expected benefit payments for supplemental, home office, and field office retirement plans, $13.6 million in expected benefit payments for the postretirement benefit plan, $62.6 million in commitments to fund tax-advantaged investment partnerships, a $12.2 million tax reimbursement liability related to the block of life insurance business sold to Protective Life in 2001, and a $12.6 million liability for our deferred compensation plan.
Insolvency regulations exist in many of the jurisdictions in which our subsidiaries do business. Such regulations may require insurance companies operating within the jurisdiction to participate in guaranty associations. The associations levy assessments against their members for the purpose of paying benefits due to policyholders of impaired or insolvent insurance companies. Association assessments levied against us were $0.7 million, $1.9 million and $0.2 million for 2014, 2013 and 2012, respectively. At December 31, 2014, we maintained a reserve of $0.4 million for future assessments with respect to currently impaired, insolvent or failed insurers.
Commissions, including initial commissions and expense allowance paid for reinsurance assumed, and other policy acquisition expenses are expensed as incurred.
The fluctuations in the difference between the Statutory Results and Adjusted GAAP Results for 2014 compared to 2013 and 2013 compared to 2012 were primarily due to differences in the prescribed accounting treatments between GAAP and Statutory accounting practices for net investment income, reserves for our individual annuity products, net income or loss from the holding company and noninsurance subsidiaries and lower operating expenses as a result of expense management actions. The expense management actions taken in 2013 included an amendment to our postretirement medical plan, which reduced operating expenses by $20.6 million for 2013. The reduced operating expenses were included in the Adjusted GAAP Results but were not included in the Statutory Results.
From time to time StanCorp or its representatives make written or oral statements, including some of the statements contained or incorporated by reference in this Annual Report on Form 10-K and in other reports, filings with the Securities and Exchange Commission, press releases, conferences or otherwise, that are other than purely historical information. These statements, including estimates, projections, expected operating results, statements related to business plans, strategies, objectives and the assumptions upon which those statements are based, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and Section 21E of the Exchange Act. Forward-looking statements also include, without limitation, any statement that includes words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,” “seeks,” “will be,” “will continue,” “will likely result” and similar expressions that are predictive in nature or that depend on or refer to future events or conditions. Our forward-looking statements are not guarantees of future performance and involve uncertainties that are difficult to predict. They involve risks and uncertainties which may cause actual results to differ materially from the forward-looking statements and include, but are not limited to, the following:
The effect of changes in interest rates on reserves, policyholder funds, investment income, bond call premiums and commercial mortgage loan prepayment fees.
Environmental liability exposure resulting from commercial mortgage loan and real estate investments.
Consolidated Statements of Income for the years ended December 31, 2014, 2013 and
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, 2014 and 2013, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2014, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2014, based on the criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2015 expressed an unqualified opinion on the Company’s internal control over financial reporting.
(2) Net of tax benefits of $1.1 million, $3.1 million and $2.2 million for 2014, 2013 and 2012, respectively.
(4) Net of tax expense of $0.9 million, tax benefit of $3.2 million and tax expense of $3.4 million for 2014, 2013 and 2012, respectively.
StanCorp, headquartered in Portland, Oregon, is a holding company and conducts business through wholly-owned operating subsidiaries throughout the United States. Through its subsidiaries, StanCorp has the authority to underwrite insurance products in all 50 states. The Company collectively views and operates its businesses as Insurance Services and Asset Management. Insurance Services contains two reportable product segments, Employee Benefits and Individual Disability. Asset Management is a separate reportable segment. See “Note 5-Segments.”
The consolidated financial statements include StanCorp and its subsidiaries. Intercompany balances and transactions have been eliminated on a consolidated basis.
The Company will continue to evaluate its holdings; however, the Company currently expects the fair values of its investments to recover either prior to their maturity dates or upon maturity. Should the credit quality of the Company’s fixed maturity securities significantly decline, there could be a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
Total real estate was $37.0 million at December 31, 2014, compared to $65.7 million at December 31, 2013. Accumulated depreciation for real estate totaled $12.0 million and $13.4 million at December 31, 2014 and 2013, respectively.
Changes in the fair value of an interest rate swap designated as a fair value hedge, including amounts measured as ineffective, and changes in the fair value of the hedged item, are recognized in the consolidated statements of income as a component of net capital gains and losses each period. The gain or loss on the termination of a fair value hedge is recognized in the consolidated statements of income as a component of net capital gains and losses during the period in which the termination occurs. When interest rate swaps are used in hedge accounting relationships, periodic settlements are recorded in net investment income.
The gain or loss on the termination of an ineffective fair value hedge is reported in the consolidated statements of income as a component of net capital gains or losses. Additionally, when a hedged item is disposed, the Company will terminate the related derivative instrument and recognize the gain or loss on termination in the Company’s consolidated statements of income as a component of net capital gains or losses.
The Company defers certain acquisition costs that vary with and are directly related to the origination of new business and placing that business in-force. Certain costs related to obtaining new business and acquiring business through reinsurance agreements have been deferred and are amortized to accomplish matching against related future premiums or gross profits as appropriate. The Company normally defers certain acquisition-related commissions and incentive payments, certain costs of policy issuance and underwriting, and certain printing costs. Assumptions used in developing DAC and amortization amounts each period include the amount of business in-force, expected future persistency, withdrawals, interest rates and profitability. These assumptions are modified to reflect actual experience when appropriate. Additional amortization of DAC is charged to current earnings to the extent it is determined that future premiums or gross profits are not adequate to cover the remaining amounts deferred. Changes in actual persistency are reflected in the calculated DAC balance. Costs that are not directly associated with the acquisition of new business are not deferred as DAC and are charged to expense as incurred. Generally, annual commissions are considered expenses and are not deferred.
The Company’s other intangible assets are subject to amortization and consist of certain customer lists from Asset Management business acquired and an individual disability marketing agreement. Customer lists have a combined estimated weighted-average remaining life of approximately 6.5 years. The marketing agreement accompanied the Minnesota Life transaction and provides access to Minnesota Life agents, some of whom now market Standard’s individual disability insurance products. The Minnesota Life marketing agreement will be fully amortized by the end of 2023.
Property and equipment are stated at cost less accumulated depreciation. The Company depreciates property and equipment using the straight-line method over the estimated useful lives with a half-year convention. The estimated useful lives are generally 40 years for properties, range from three to ten years for equipment and range from three to five years for capitalized software. Leasehold improvements are depreciated over the lesser of the estimated useful life of the asset or the life of the lease. Depreciation expense for 2014, 2013 and 2012 was $17.8 million, $19.9 million and $24.1 million, respectively. The Company reviews property and equipment for impairment when circumstances or events indicate the carrying amount of the asset may not be recoverable and recognizes a charge to earnings if an asset is impaired.
The amount of premiums that the Company will receive in the future.
The rate of return on assets the Company purchases with premiums received.
Persistency, which is the measurement of the percentage of premiums remaining in-force from year to year.
Year of issue for policy reserves or incurred date for claim reserves.
Other policyholder funds are liabilities for investment-type contracts and are based on the policy account balances including accumulated interest. Other policyholder funds also include amounts related to advanced premiums of $188.3 million and $186.1 million at December 31, 2014 and 2013, respectively, and premiums on deposit and experience rated liabilities totaling $187.0 million and $193.5 million at December 31, 2014 and 2013, respectively.
Premiums from group life and group and individual disability contracts are recognized as revenue when due. Investment-type contract 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 unearned and included in other policyholder funds on the consolidated balance sheets. Experience rated refunds (“ERRs”) are computed in accordance with the terms of the contracts with certain group policyholders and are accounted for as an adjustment to premiums.
The Company records interest paid on income tax liabilities as interest expense and income tax penalties incurred as an operating expense.
In January 2014, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2014-01, Accounting for Investments in Qualified Affordable Housing Projects. This ASU permits entities to account for qualified affordable housing projects under the proportional amortization method (“PAM”) of accounting. Under PAM, the cost of the investments is amortized in each period in proportion to the tax credits and benefits of tax losses received in that period to total benefits to be received over the life of the investments and allows the amortization of the investments and the tax benefits to be recognized in income taxes on the consolidated statements of income.
ASU No. 2014-01 is effective for annual reporting periods and interim reporting periods within those annual reporting periods beginning after December 15, 2014. Early adoption is permitted. The Company is adopting this ASU effective January 1, 2015, which it expects will decrease the beginning balance of 2015 retained earnings between $15 million and $20 million. Based on the investments held at December 31, 2014, the Company estimates the adoption of the ASU will result in a decrease in net income
ASU No. 2014-09 is effective for annual reporting periods and interim reporting periods within those annual reporting periods beginning after December 15, 2016. Early adoption is not permitted. The Company’s revenue is primarily from insurance contracts and financial instruments; therefore, the Company does not expect this ASU to have a material effect on its results of operations.
In January 2015, the FASB issued ASU No. 2015-01, Income Statement-Extraordinary and Unusual Items. The main objective of ASU No. 2015-01 is to eliminate from GAAP the concept of extraordinary items, however, the requirement to disclose unusual and infrequent items still exists. Under this guidance, an entity will no longer segregate extraordinary items from the results of ordinary operations; separately present an extraordinary item on its income statement, net of tax, after income from continuing operations; and disclose income taxes and earnings-per-share data applicable to an extraordinary item. The ASU affects the reporting and disclosure requirements for an event that is unusual in nature or that occurs infrequently.
ASU No. 2015-01 is effective for annual reporting periods and interim reporting periods within those annual reporting periods beginning after December 15, 2015. Early adoption is permitted if guidance is applied as of the beginning of the annual reporting period of adoption. The Company does not expect this ASU to have a material effect on its results of operations or disclosures.
The Company has two active share-based compensation plans: the 2002 Stock Incentive Plan (“2002 Plan”) and the 1999 Employee Share Purchase Plan (“ESPP”). The 2002 Plan authorizes the Board of Directors to grant incentive or non-statutory stock options and stock awards to eligible employees and certain specified parties. The Company’s ESPP allows eligible employees to purchase StanCorp common stock at a discount. Of the 7,000,000 shares of common stock authorized for the 2002 Plan, 2,694,980 shares or options for shares remain available for grant at December 31, 2014. Of the 3,500,000 shares authorized for the ESPP, 1,378,369 shares remain available for issuance at December 31, 2014.
The fair value of each option award was estimated using the Black-Scholes option pricing model as of the grant date using the assumptions noted in the following table. The Black-Scholes option pricing model uses the expected term as an input with the calculated option value varying directly with the length of time until exercise. The Company bases its estimate of the expected term on an analysis of the historical exercise experience of similar options granted to similar employee or director groups. The expected term given below represents the weighted-average expected term of options granted. Expected stock price volatility is based on the volatility of StanCorp’s common stock price per share over the prior period equal in duration to the expected term. The dividend rate is the rate expected to be paid over the expected term, generally estimated to be equal to the rate for the year prior to the grant. The risk-free rate is the interest rate on a U.S. Treasury bond of a maturity closest to the expected term of the option granted.
The weighted-average grant date fair value of options granted was $23.29, $16.15 and $13.73 for 2014, 2013 and 2012, respectively.
The total intrinsic value of the options exercised was $5.9 million, $14.4 million and $3.2 million for 2014, 2013 and 2012, respectively. The amount that the Company received from the exercise of stock options was $10.9 million, $50.2 million and $7.6 million for 2014, 2013 and 2012, respectively. The related tax benefit derived from the tax deduction received by the Company for the difference between the market price of StanCorp common stock and the exercise price when the options were exercised was $3.6 million for both 2014 and 2013 and $1.1 million for 2012.
The compensation cost of stock options is recognized over the vesting period, which is also the period over which the grantee must provide services to the Company. At December 31, 2014, the total cost related to unvested option awards that had not yet been recognized in the financial statements was $5.5 million. This cost will be recognized over a weighted-average period of 2.4 years.
The Company currently grants three types of stock awards: restricted stock unit awards (“RSUs”), performance-based stock awards (“Performance Shares”) and non-employee director stock awards (“Director Stock Grants”). Under the 2002 Plan, the Company had 1,059,828 shares available for issuance as stock award grants at December 31, 2014.
The Company granted 48,294 and 59,823 RSUs for 2014 and 2013, respectively. The fair value of the RSUs is determined based on the closing market price of StanCorp common stock on the grant date.
The compensation cost of RSUs is recognized over the vesting period, which is the period over which the grantee must provide services to the Company. At December 31, 2014, the total compensation cost related to unvested RSUs that had not yet been recognized in the financial statements was $2.8 million. This cost will be recognized over a weighted-average remaining period of 1.7 years.
The Company granted 77,634 and 129,172 Performance Shares for 2014 and 2013, respectively.
The fair value of the Performance Shares is based on the closing market price of StanCorp common stock on the grant date.
The compensation cost of Performance Shares is based on an estimate of the number of shares that will be earned and cost is recognized over the vesting period. The cost the Company will ultimately recognize as a result of these stock awards is dependent on the Company’s financial performance. Assuming that the maximum performance is achieved for each performance goal, $7.7 million in additional compensation cost would be recognized through 2016. Assuming that the target performance is achieved, this cost would be recognized over a weighted-average period of 1.4 years. The target payout is 50% of the maximum performance shares. Assuming that the target performance is achieved for each performance goal, $2.1 million in additional compensation cost would be recognized through 2016.
Each non-employee director receives annual stock grants with fair value equal to $100,000 based on the closing market price of StanCorp common stock on the day of the annual shareholder meeting. The stock grants generally vest after one year. Prior to May 7, 2012, the non-employee directors received compensation of $50,000 in stock options and $50,000 in stock grants.
The Company issued 17,294, 20,099 and 9,489 shares of StanCorp common stock for 2014, 2013 and 2012, respectively, related to the vesting of the annual Director stock grant for 2013, 2012 and 2011. The weighted-average fair value per share for the shares issued was $45.74, $44.12 and $36.40 for the same periods, respectively.
The Company has two non-contributory defined benefit pension plans: the employee pension plan and the agent pension plan. The employee pension plan is generally limited to eligible employees of the Company whose date of employment began before 2003 and a participant is entitled to a normal retirement benefit at age 65. The agent pension plan is for former field employees and agents. The defined benefit pension plans provide benefits based on years of service and final average pay. The employee pension plan is sponsored by StanCorp and the agent pension plan is sponsored by Standard. Both plans are administered by Standard Retirement Services and are closed to new participants.
The following table sets forth the amounts recognized in accumulated other comprehensive (income) loss:
Pension plan assets are recorded at fair value and are disclosed below using a three-level hierarchy. See “Note 9-Fair Value” for additional fair value information. The fair values of pooled separate accounts are valued daily based upon quoted market prices in an active market and are classified as Level 1 assets. Pooled separate accounts are recorded at fair value on a recurring basis. The fair value of the stable asset fund is included in the financial statements at the Deposit Administration Contract value and is classified as a Level 2 asset. The contract value approximates fair value, as the contract crediting rate resets annually, and the contracts are fully benefit-responsive. Contract value represents contributions made under the contracts, plus earnings, less withdrawals and administrative expenses. The Stable asset fund is primarily invested in investment grade securities and commercial mortgage loans.
There were no transfers into or from Level 1, 2 or 3 for 2014 and 2013.
As a result of inputs used during the current period to estimate the fair value of the stable asset fund, Plan management has categorized the stable asset fund as having Level 2 inputs at December 31, 2014. The valuation methods may produce fair value calculations that may not be indicative of net realizable values or reflective of future fair values. See “Note 9-Fair Value” for further disclosure on valuation methods. Furthermore, although the Plan believes its valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date.
Standard sponsors and administers a postretirement benefit plan that includes medical, prescription drug benefits and group term life insurance. Eligible retirees are required to contribute specified amounts for medical and prescription drug benefits that are
The following table sets forth the amounts recognized in accumulated other comprehensive loss (income):
For the postretirement benefit plan, the expected long-term rate of return on assets was developed by considering the historical returns and the future expectations for returns, as well as the target asset allocation. Assumptions for rate of compensation increase were not applicable in determining benefit obligations or net periodic costs for 2014, 2013 or 2012 due to the curtailment of the group term life insurance benefit as of December 31, 2011.
Postretirement benefit plan assets are recorded at fair value and are disclosed below using a three-level hierarchy. See “Note 9-Fair Value” for additional fair value information. As there was not an active market for the Company’s municipal and corporate bond holdings at December 31, 2014, the municipal and corporate bonds were valued using Level 2 measurements.
The following tables set forth the estimated fair values of assets measured and recorded at fair value on a recurring basis:
Eligible executive officers are covered by a non-qualified supplemental retirement plan (“non-qualified plan”). Under the non-qualified plan, a participant is entitled to a normal retirement benefit once the participant reaches age 65. A participant can also
receive a normal, unreduced retirement benefit once the sum of his or her age plus years of service is at least 90. The Company recognizes the unfunded status of the non-qualified plan in other liabilities on the consolidated balance sheets. The unfunded status was $42.8 million and $31.1 million at December 31, 2014 and 2013, respectively. Expenses were $3.9 million, $3.1 million and $1.9 million for 2014, 2013 and 2012, respectively. The net loss and prior service cost, net of tax, excluded from the net periodic benefit cost and reported as a component of accumulated other comprehensive income were $11.7 million, $5.7 million and $4.7 million at December 31, 2014, 2013 and 2012, respectively.
As of December 31, 2014, the Company is subject to examination by the IRS for the years 2011 through 2014.
The Company did not have any material unrecognized tax benefits at December 31, 2014 and 2013. The Company records interest paid on income tax liabilities as interest expense and income tax penalties incurred as an operating expense. See “Note 1-Summary of Significant Accounting Policies-Income Taxes.”
Goodwill is related to Asset Management and totaled $36.0 million at both December 31, 2014 and 2013. Goodwill is not amortized and is tested at least annually for impairment. If indicators of impairment appear throughout the year, or in the event of material changes in circumstances, the test will be more frequent. The Company performs a step-one test and compares the carrying value of the tested assets with the fair value of the assets. Fair value is measured using a combination of the income approach and the market approach. The income approach consists of utilizing the discounted cash flow method that incorporates the Company’s estimates of future revenues and costs, discounted using a market participant weighted-average cost of capital. The estimates the Company uses in the income approach are consistent with the plans and estimates that the Company uses to manage its operations. The market approach utilizes multiples of profit measures in order to estimate the fair value of the assets. As the income approach more closely aligns with how the Company internally evaluates and manages its business, the Company weights the income approach more heavily than the market approach in determining the fair value of the assets. However, the Company performs testing to ensure that both models are providing reasonably consistent results. Additionally, the Company performs sensitivity analysis on the key input factors in these models to determine whether any input factor or combination of factors moving moderately in either direction would change the results of these tests. Through the performance of these tests, the Company determined the fair value of goodwill substantially exceeded the carrying value, and concluded that it was not impaired as of December 31, 2014.
The market approach uses prices or other relevant information generated by market transactions involving identical or comparable assets or liabilities.
The income approach uses the present value of cash flows or earnings.
The pricing service provides quoted market prices when available. Quoted prices are not always available due to bond market inactivity. The pricing service obtains a broker quote when sufficient information, such as security structure or other market information, is not available to produce a valuation. Valuations and quotes obtained from third-party commercial pricing services are non-binding and do not represent quotes on which one may execute the disposition of the assets.
The Company performs control procedures over the external valuations at least quarterly through a combination of procedures that include an evaluation of methodologies used by the pricing service, analytical reviews and performance analysis of the prices against statistics, trends and secondary pricing sources, back testing of sales activity and maintenance of a list of fixed maturity securities with characteristics that could indicate potential impairment. As necessary, the Company compares prices received from the pricing service to prices independently estimated by the Company utilizing discounted cash flow models or through performing independent valuations of inputs and assumptions similar to those used by the pricing service in order to ensure prices represent a reasonable estimate of fair value. Although the Company does identify differences from time to time as a result of these validation procedures, the Company did not make any significant adjustments as of December 31, 2014 or December 31, 2013.
The Company calculates the fair value for its S&P 500 Index options using the Black-Scholes option pricing model and parameters derived from market sources. The Company’s valuations maximize the use of observable inputs, which include direct price quotes from the Chicago Board Options Exchange (“CBOE”) and values for on-the-run treasury securities and London Interbank Offered Rate (“LIBOR”) as reported by Bloomberg. Unobservable inputs are estimated from the best sources available to the Company and include estimates of future gross dividends to be paid on the stocks underlying the S&P 500 Index, estimates of bid ask spreads, and estimates of implied volatilities on options. Valuation parameters are calibrated to replicate the actual end-of-day market quotes for options trading on the CBOE. The Company performs additional validation procedures such as the daily observation of market activity and conditions and the tracking and analyzing of actual quotes provided by banking counterparties each time the Company purchases options from them. Additionally, in order to help validate the values derived through the procedures noted above, the Company obtains indicators of value from representative investment banks.
The Company uses the discounted cash flow valuation model to determine the fair value of the interest rate swaps. The inputs used in the model are observable in the market. The interest rate swaps qualify as Level 2 under the fair value hierarchy since their valuation is based on a model for which all significant assumptions are observable in the market.
The following table sets forth quantitative information regarding significant unobservable inputs used in Level 3 valuations of assets and liabilities measured and recorded at fair value:
(b) Represents various actuarial assumptions which include combined lapse, mortality and withdrawal decrement rates which generally have a range of inputs from 5%-36% for both December 31, 2014 and December 31, 2013.
(c) Capitalization rates are used as an internal analysis in converting the underlying property income to an estimated property value.
Changes in the fair value of fixed maturity securities that are not designated as part of a hedging relationship are recorded to other comprehensive income. Changes in the fair value of the S&P 500 Index options are recorded to net investment income. Changes in the fair value of the index-based interest guarantees are recorded to interest credited and are sensitive to a number of variables and assumptions. As a result of the Company’s annual update of the key assumptions used to value index-based interest guarantees, a process known as “unlocking”, interest credited decreased $4.0 million and $4.1 million for 2014 and 2013, respectively.
Commercial mortgage loans measured on a nonrecurring basis with a carrying amount of $74.2 million were written down to their fair value of $56.0 million, less selling costs, at December 31, 2014. The specific commercial mortgage loan loss allowance related to these commercial mortgage loans was $23.8 million at December 31, 2014. The Real Estate Owned measured on a nonrecurring basis as of December 31, 2014, and still held at December 31, 2014 had net capital losses totaling $1.2 million for 2014. Real Estate Owned measured on a nonrecurring basis represents newly acquired properties or properties whose value has been adjusted based on pending sale or other market information.
The following table sets forth the assets measured at fair value on a nonrecurring basis as of December 31, 2013 that the Company continued to hold:
Commercial mortgage loans measured on a nonrecurring basis with a carrying amount of $87.7 million were written down to their fair value of $68.7 million, less selling costs, at December 31, 2013. The specific commercial mortgage loan loss allowance related to these commercial mortgage loans was $25.9 million at December 31, 2013. The Real Estate Owned measured on a nonrecurring basis as of December 31, 2013, and still held at December 31, 2013 had capital losses totaling $7.2 million for 2013. See “Note 10-Investments-Commercial Mortgage Loans” for further disclosures regarding the commercial mortgage loan loss allowance.
Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations. Callable bonds, excluding bonds with make-whole provisions and bonds with provisions that allow the borrower to prepay near maturity, represented 3.5%, or $275.1 million, of the Company’s fixed maturity securities portfolio at December 31, 2014. At December 31, 2014, the Company did not have any direct exposure to sub-prime or Alt-A mortgages in its fixed maturity securities portfolio.
The unrealized losses on the fixed maturity securities set forth above were partly due to increases in market interest rates subsequent to their purchase by the Company and have also been affected by overall economic factors. The Company expects the fair value of these fixed maturity securities to recover as the fixed maturity securities approach their maturity dates or sooner if market yields for such fixed maturity securities decline. The Company does not believe that any of the fixed maturity securities are impaired due to credit quality or due to any company or industry specific event. Based on management’s evaluation of the securities and the Company’s intent to hold the securities, and as it is unlikely that the Company will be required to sell the securities, none of the unrealized losses summarized in this table are considered other-than-temporary. See “Note 1-Summary of Significant Accounting Policies-Investment Valuations-Fixed Maturity Securities” for a discussion regarding OTTI for fixed maturity securities.
The Company underwrites mortgage loans on commercial property throughout the United States. In addition to real estate collateral, the Company requires either partial or full recourse on most loans. At December 31, 2014, the Company did not have any direct exposure to sub-prime or Alt-A mortgages in its commercial mortgage loan portfolio.
An impaired commercial mortgage loan is a loan where the Company does not expect to receive contractual principal and interest in accordance with the terms of the original loan agreement. A specific allowance for losses is recorded when a loan is considered to be impaired and it is probable that all amounts due will not be collected based on the terms of the original note. The Company also holds specific loan loss allowances on certain performing commercial mortgage loans that it continues to monitor and evaluate. Impaired commercial mortgage loans without specific allowances for losses are those for which the Company has determined that it remains probable that all amounts due will be collected although the timing or nature may be outside the original contractual terms. In addition, for impaired commercial mortgage loans, the Company evaluates the cost to dispose of the underlying collateral, any significant out of pocket expenses the loan may incur and other quantitative information management has concerning the loan. Negotiated reductions of principal are generally written off against the allowance, and recoveries, if any, are credited to the allowance.
The amount of interest income recognized on impaired commercial mortgage loans was $5.3 million, $4.2 million and $4.1 million for 2014, 2013 and 2012, respectively. The cash received by the Company in payment of interest on impaired commercial mortgage loans was $4.8 million, $3.8 million and $4.0 million for 2014, 2013 and 2012, respectively. See “Note 1-Summary of Significant Accounting Policies-Investment Valuations-Commercial Mortgage Loans” for policies regarding interest income for delinquent commercial mortgage loans.
The following tables set forth the aging of commercial mortgage loans by property type:
In 2014, the Company began the use of interest rate swaps to reduce risks from changes in interest rates, to manage interest rate exposures arising from asset and liability mismatches, and to protect the value of investments held on the consolidated balance sheets. The interest rate swaps used by the Company are designed to qualify for hedge accounting. Therefore, recognized changes in the fair value of the interest rate swaps and the changes in fair value of the hedged items attributable to the hedged risk, are offset in net capital gains and losses. Valuations for interest rate swaps are sensitive to changes in the interest rate environment.
Interest income, interest expense and fees related to interest rate swaps are recorded as a component of net investment income.
Option premiums paid for the Company’s index option contracts were $9.3 million and $9.4 million for 2014 and 2013, respectively. The Company received $20.1 million and $19.3 million for options exercised in 2014 and 2013, respectively.
The following table sets forth the gross amounts of derivative instruments recorded on the consolidated balance sheets and the collateral pledged related to the derivative instruments:
The following table sets forth the amount of gains or losses recognized in the consolidated statements of income from the change in fair value of the Company’s derivative assets and liabilities:
The ineffective portion of derivatives accounted for using hedge accounting was not material to the results of operations of the Company for 2014 and 2013 and 2012.
The Company is exposed to the credit worthiness of the institutions from which it purchases its S&P 500 Index options and these institutions’ continued abilities to perform according to the terms of the contracts. The current values for the credit exposure have been affected by fluctuations in the S&P 500 Index. The Company’s maximum credit exposure would require an increase of 4.5% in the value of the S&P 500 Index. The maximum credit risk is calculated using the cap strike price of the Company’s S&P 500 Index options less the floor price, multiplied by the notional amount of the S&P 500 Index options.
The following table sets forth the estimated net amortization of VOBA and other intangible assets for each of the next five years:
The changes in amounts incurred related to prior years are not the result of a significant change in an underlying assumption or method used to determine the estimate. Instead the Company expects these amounts to change over time as a result of the growth in the size of the Company’s in-force insurance business and the actual claims experience with respect to that business during the time periods captured for claims with an incurred date in years prior to the year of valuation. Interest is also a key component in the year to year development of the reserves and therefore the positive changes in amounts incurred related to prior years should not be taken as an indicator of the adequacy or inadequacy of the reserves held. In each of the years captured, there was a decrease in incurred amounts associated with prior years after the effect of interest is taken into account, indicating that claim experience was favorable compared to the assumptions used to establish the associated reserves. Significant changes to assumptions regarding unpaid claims and claims adjustment expenses for prior periods in the group long term disability insurance reserves were not made in 2014, 2013 and 2012 primarily due to the long-term nature of this product and the materiality of other factors including the potential impact of the economic uncertainty in 2014, 2013 and 2012. The Company carefully monitors trends in reserve assumptions and when these trends become credible and are expected to persist, the Company incorporates these factors into its reserves to ensure best estimates are established.
Standard maintains a strategic marketing alliance with Ameritas Life Insurance Corp. (“Ameritas”) that offers Standard’s policyholders flexible dental coverage options and access to Ameritas’ nationwide preferred provider organization panel of dentists. As part of this alliance, Standard and Ameritas entered into a reinsurance agreement. In 2014, the agreement provided for 26.1% of the net dental premiums written by Standard and the risk associated with this premium to be ceded to Ameritas.
The Terrorism Risk Insurance Act of 2002 (“TRIA”), which has been extended through 2020, provides for federal government assistance to property and casualty insurers in the event of material losses due to terrorist acts on behalf of a foreign person or foreign interest. Due to the concentration of risk present in group life insurance and the fact that group life insurance is not covered under TRIA, an occurrence of a significant catastrophe or a change in the on-going nature and availability of reinsurance and catastrophe reinsurance could have a material adverse effect on the Company.
Effective October 1, 2000, Standard assumed, through a reinsurance agreement, the individual disability insurance business of 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 is determined quarterly. The market value of assets required to be maintained in the trust at December 31, 2014, was $562.3 million. Accompanying the transaction was a national marketing agreement that provides access to Minnesota Life agents, some of whom now market Standard’s individual disability insurance products. The national marketing agreement is renewed annually.
(1) See “Note 1-Summary of Significant Accounting Policies-DAC, VOBA and Other Intangible Assets” And “Note 12-DAC, VOBA and Other Intangible Assets.”
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 the Statements of Statutory Accounting Principles set forth in publications of the National Association of Insurance Commissioners (“NAIC”). Standard and the Standard Life Insurance Company of New York did not use any prescribed or permitted statutory accounting practices that are different than the statutory accounting practices promulgated by the NAIC for the years ended 2014, 2013 or 2012.
Statutory accounting practices differ in some respects from GAAP. The principal statutory accounting practices that differ from GAAP are:
Standard and The Standard Life Insurance Company of New York are subject to statutory restrictions that limit the maximum amount of dividends and distributions that they could declare and pay to StanCorp without prior approval of the states in which the subsidiaries are domiciled. Standard’s ability to pay dividends to StanCorp is affected by factors deemed relevant by Standard’s Board of Directors and by Oregon law, which limits Standard’s dividend payments and other distributions to the earned surplus arising from its business. If the proposed dividend or other distribution exceeds certain statutory limitations, Standard must receive prior approval of the Director of the Oregon Department of Consumer and Business Services-Insurance Division (“Oregon Insurance Division”). The current statutory dividend limitations are the greater of (a) 10% of Standard’s combined capital and surplus as of December 31 of the preceding year, or (b) the net gain from operations after dividends to policyholders and federal income taxes and before realized capital gains or losses for the 12-month period ended on the preceding December 31. In each case, the limitation must be determined under statutory accounting practices. Oregon law gives the Oregon Insurance Division broad discretion to approve or decline requests for dividends and other distributions in excess of these limits. As of December 31, 2014, Standard’s net gain from operations after dividends to policyholders and federal income taxes and before capital gains or losses for the 12-month period then ended was $208.5 million and capital and surplus was $1.15 billion. Based upon Standard’s results for 2014, the amount of ordinary dividends and other distributions available in 2015, without additional approval from the Oregon Insurance Division is $208.5 million. As of December 31, 2013, Standard’s net gain from operations after dividends to policyholders and federal income taxes and before capital gains or losses for the 12-month period then ended was $195.1 million and capital and surplus was $1.29 billion. Based upon Standard’s results for 2013, the amount of ordinary dividends and other distributions available in 2014, without additional approval from the Oregon Insurance Division was $195.1 million.
Under the agreement, the Company is subject to two financial covenants, which are based on the Company’s ratio of total debt to total capitalization and consolidated net worth. The Company is also subject to covenants that limit subsidiary indebtedness. The Facility is subject to pricing levels based upon the Company’s publicly announced debt ratings and includes an interest rate option at the election of the borrower of a base rate plus the applicable margin or LIBOR plus the applicable margin, plus facility and utilization fees. At December 31, 2014, the Company was in compliance with all financial covenants under the Facility and had no outstanding balance on the Facility.
At December 31, 2014, the Company had $62.6 million of commitments to fund tax-advantaged investment partnerships. The commitments are recorded as other liabilities on the Company’s consolidated balance sheets with a corresponding recognition to other invested assets.
In the normal course of business, the Company commits to fund commercial mortgage loans generally up to 90 days in advance. At December 31, 2014, the Company had outstanding commitments to fund commercial mortgage loans totaling $134.8 million, with fixed interest rates ranging from 4.00% to 6.00%. These commitments generally have fixed expiration dates. A small percentage of commitments expire due to the borrower’s failure to deliver the requirements of the commitment by the expiration date. In these cases, the Company will retain the commitment fee and good faith deposit. Alternatively, if the Company terminates a commitment due to the disapproval of a commitment requirement, the commitment fee and good faith deposit may be refunded to the borrower, less an administrative fee.