Our global real estate portfolio consists of approximately 7.8 million square feet of owned and leased properties. Our domestic portfolio has approximately 5.8 million square feet in 38 states, the District of Columbia, Puerto Rico and the U.S. Virgin Islands. Our International properties contain approximately 2.0 million square feet located throughout the following countries: Australia, Bahrain, Belgium, Canada, China, Hong Kong, India, Indonesia, Kenya, Malaysia, New Zealand, Singapore, South Korea, Spain, Switzerland, Taiwan, Thailand, Turkey, United Arab Emirates, and the United Kingdom.
Unless otherwise indicated, financial information in the MD&A is presented in accordance with accounting principles generally accepted in the United States of America ("GAAP"). See Note 2 to the Consolidated Financial Statements for additional information regarding the Company's significant accounting policies. In some of our financial tables in this MD&A, we present either percentage changes or "N/M" when those changes are so large as to become not meaningful. Changes in percentages are expressed in basis points ("bps").
We use adjusted income (loss) from operations as our principal financial measure of operating performance because management believes it best reflects the underlying results of our business operations and permits analysis of trends in underlying revenue, expenses and profitability. We define adjusted income from operations as shareholders' net income (loss) excluding after-tax realized investment gains and losses, net amortization of other acquired intangible assets and special items. Income or expense amounts are excluded from adjusted income from operations for the following reasons:
•Special items are excluded because management believes they are not representative of the underlying results of operations. See Note 22 to the Consolidated Financial Statements for descriptions of special items.
2016 vs. 2015 - Decrease was due to lower adjusted income from operations, primarily in the Group Disability and Life segment. Increased special item charges in 2016 (primarily higher merger costs and the 2016 risk corridor allowance) also contributed to the decline.
Further discussion of detailed components of revenues and expenses can be found in the "Consolidated Results of Operations" section of this MD&A beginning on page 41. For further analysis and explanation of individual segment results, see the "Segment Reporting" section of this MD&A beginning on page 49.
See Notes 3 and 21 to the Consolidated Financial Statements in this Form 10-K for additional information about the proposed merger. See Item 1A. - Risk Factors in this Form 10-K for risks to our business due to the proposed merger.
(1) Starting in fourth quarter 2016, we did not record amounts due to us under the risk corridor program and recorded an allowance for previously due amounts. See discussion below.
As of September 30, 2016, the Company's risk corridor receivable was $124 million pre-tax. An unfavorable court decision was issued during the fourth quarter rejecting another insurer's statutory, contractual and constitutional claims for payment of risk corridor receivables (Land of Lincoln Mutual Health Insurance Company v. United States). Based on this decision, as well as the large risk corridor program deficit, under applicable accounting rules, the Company determined it was required to establish an allowance for all of the $124 million of receivables associated with the risk corridor program. In addition, the Company was unable to recognize $25 million pre-tax income for incremental fourth quarter risk corridor receivables. This court case is under appeal and notwithstanding the accounting reflected, management continues to believe that the government has a binding obligation to satisfy the risk corridor receivable. We expect full payment of the remaining reinsurance and risk adjustment receivables.
• Revenues. The components of revenue changes are discussed further below:
•Premiums. The increases in both 2016 and 2015, compared with each prior year, reflected premium growth in each of our ongoing reporting segments: Global Health Care, Global Supplemental Benefits and Group Disability and Life. These results were primarily attributable to customer growth in our targeted market segments within Global Health Care, as well as growth in Global Supplemental Benefits and Group Disability and Life. Rate actions in our commercial health care businesses consistent with medical cost trend also contributed to these increases.
•Fees and other revenues. The increases in both 2016 and 2015, compared with each prior year, largely reflected growth from specialty products offered through our Global Health Care segment and an increased customer base for our administrative services only business.
•Net investment income decreased slightly in both 2016 and 2015, compared with each prior year, as lower investment yields in the continued low interest rate environment were partially offset by higher average invested assets. Unfavorable foreign currency effects also contributed to these declines.
•Mail order pharmacy revenues increased in both 2016 and 2015, compared with each prior year, driven by greater volume, primarily for specialty medications (e.g., certain injectables) due to our higher customer base and increased utilization.
• Other operating expenses. The increases in both 2016 and 2015 compared with each prior year were due to business growth, strategic investment across our segments and special items described in Note 22 to the Consolidated Financial Statements. In 2016, the increase also reflected costs associated with our CMS audit response as discussed in the Executive Overview section of this MD&A beginning on page 36.
• Amortization of other acquired intangible assets, net. The increase in 2016 compared with 2015 was driven by the absence of the $23 million bargain purchase gain recorded in 2015 for an acquisition. This factor was partially offset by the expected continuing decline in amortization from our 2012 acquisition of HealthSpring, Inc. The decrease in 2015 compared with 2014 reflects the impact of both the $23 million bargain purchase gain and the decline in HealthSpring amortization.
• Consolidated effective tax rate. The increase in our effective tax rate in 2016 compared with 2015 was largely driven by an increase in certain merger-related transaction costs reported in 2016 that are not tax deductible, partially offset by the tax benefits associated with adopting Accounting Standard Update ("ASU") 2016-09 as discussed in Note 2 to the Consolidated Financial Statements. The increase in the consolidated effective tax rate in 2015 was primarily driven by merger-related transaction costs in 2015 and the non-deductible health insurance industry tax assessed under the Health Care Reform Act. This tax was first assessed in 2014 and increased in 2015. See Note 20 to the Consolidated Financial Statements for additional information about income taxes. We expect our effective tax rate to decline in 2017 as a result of the moratorium on the health insurance industry tax.
• maintaining appropriate levels of cash, cash equivalents and short-term investments; • using cash flows from operating activities; • matching investment durations to those estimated for the related insurance and contractholder liabilities; • selling investments; and • borrowing from affiliates, subject to applicable regulatory limits.
Cash used in investing activities increased in 2016 compared with 2015, due to higher purchases of fixed maturity investments. Net cash used in investing activities decreased in 2015 compared with 2014 due to lower net purchases of fixed maturities.
The weighted average interest rate for outstanding short-term debt (primarily commercial paper) was 0.69% at December 31, 2015. There was no commercial paper outstanding as of December 31, 2016.
• return capital to investors through share repurchase. See Note 3 to the Consolidated Financial Statements for information regarding capital restrictions imposed by our merger agreement with Anthem. The availability of capital resources will be impacted by equity and credit market conditions. Extreme volatility in credit or equity market conditions may reduce our ability to issue debt or equity securities.
At December 31, 2016, there was approximately $2.8 billion in cash and marketable investments available at the parent company level. In 2017, the parent company's combined cash obligations are expected to approximate $660 million for repayment of debt, interest, pension contributions and dividends.
payable to its insurance subsidiaries. Alternatively, to satisfy parent company liquidity requirements we may use short-term borrowings, such as the commercial paper program, the committed revolving credit and letter of credit agreement of up to $1.5 billion subject to the maximum debt leverage covenant in its line of credit agreement. As of December 31, 2016, $1.5 billion of short-term borrowing capacity under the credit agreement was available to us. Within the maximum debt leverage covenant in the line of credit agreement as described in Note 5 to the Consolidated Financial Statements, we have $9.7 billion of borrowing capacity in addition to the $5 billion of debt outstanding. This additional borrowing capacity includes the $1.5 billion available under the credit agreement.
Solvency II. Beginning in 2016, our businesses in the European Union became subject to the directive on insurance regulation, solvency and governance requirements known as Solvency II. This directive imposes economic risk-based solvency and governance requirements and supervisory rules. Our European insurance companies are capitalized at levels consistent with projected Solvency II requirements and in compliance with anticipated governance and technical capability requirements.
•Short-term debt represents current maturities of long-term debt, and current obligations under capital leases.
Fair value of a reporting unit was estimated using models and assumptions that we believe a hypothetical market participant would use to determine a current transaction price. The significant assumptions and estimates used in determining fair value include the discount rate and future cash flows. A range of discount rates was used, corresponding with the reporting unit's weighted average cost of capital, consistent with that used for investment decisions considering the specific and detailed operating plans and strategies within the reporting unit. Projections of future cash flows were consistent with our annual planning process for revenues, claims, operating expenses, taxes, capital levels and long-term growth rates. In addition to these assumptions, we considered market data to evaluate the fair value of each reporting unit.
The discount rate is typically the most significant assumption in measuring the pension liability. We develop the discount rate by applying actual annualized yields at various durations from a discount rate curve constructed from high quality corporate bonds.
If discount rates for the qualified and nonqualified pension plans decreased by 50 basis points, the accrued pension benefit liability would increase by approximately $195 million as of December 31, 2016 resulting in an after-tax decrease to shareholders' equity of approximately $125 million.
A 100 basis point increase in the medical cost trend rate would increase this liability by approximately $30 million, resulting in a decrease in net income of approximately $20 million after-tax, and a 50 basis point decrease in completion factors would increase this liability by approximately $70 million, resulting in a decrease in net income of approximately $45 million after-tax.
See Note 8 to the Consolidated Financial Statements for additional information regarding assumptions and methods used to estimate this liability.
Claim resolution rate assumptions involve many factors including claimant demographics, the type of contractual benefit provided and the time since initially becoming disabled. The Company uses its own historical experience to develop its claim resolution rates. A 5 percent decrease in the claim resolution rate would increase long-term disability reserves by approximately $90 million and decrease net income by approximately $60 million after-tax.
Typically, the most significant input in the measurement of fair value is the market interest rate used to discount the estimated future cash flows of the instrument. Such market rates are derived by calculating the appropriate spreads over comparable U.S. Treasury securities, based on the credit quality, industry and structure of the asset. If the interest rates used to calculate fair value increased by 100 basis points, the fair value of the total fixed maturity portfolio of $21 billion would decrease by approximately $1.2 billion, resulting in an after-tax decrease to shareholders' equity of approximately $0.8 billion.
To determine whether a fixed maturity's decline in fair value below its amortized cost is other than temporary, we must evaluate the expected recovery in value and our intent to sell or the likelihood of a required sale of the fixed maturity prior to an expected recovery. To make this determination, we consider a number of general and specific factors including the regulatory, economic and market environments, length of time and severity of the decline, and the financial health and specific near term prospects of the issuer. See Note 11 to the Consolidated Financial Statements for additional discussion of our review of declines in fair value, including information regarding our accounting policies for fixed maturities.
The following section of this MD&A discusses the results of each of our reporting segments. In these segment discussions, we present "operating revenues," defined as total revenues excluding realized investment results and "adjusted income from operations," defined as shareholders' net income (loss) excluding after-tax realized investment results, net amortization of other acquired intangible assets and special items. Ratios presented in this segment discussion exclude the same items as adjusted income from operations. See Note 22 to the Consolidated Financial Statements for additional discussion of these metrics.
See the MD&A Executive Overview beginning on page 36 for summarized financial results of each of our reporting segments.
Adjusted income from operations was essentially flat in 2016 compared with 2015, reflecting earnings growth in our Commercial segment, primarily due to increased contributions from specialty products partially offset by lower margins in our U.S. Individual business. This increase was offset by lower earnings in our Government segment primarily driven by costs related to our CMS audit response.
Operating revenues. The increase in operating revenues in 2016 compared with 2015 was due to growth in our Commercial segment primarily from increased specialty revenues. Growth in Medicare Advantage customer volumes and higher premium rates for most products in our U.S. health care businesses primarily to recover underlying medical cost trend also contributed to the increase. These increases were partially offset by lower customer volumes in our Medicare Part D and U.S. Individual businesses. Operating revenues include amounts related to the Risk Mitigation Programs under the Health Care Reform Act. See the Risk Mitigation section on page 40 for further discussion of the Risk Corridor program.
Medical care ratios. The Commercial medical care ratio increased in 2016 compared with 2015 reflecting a less favorable medical care ratio in our stop loss business as expected, lower premium due to the anticipated reduction of the Health Care Reform Act mandated fees in 2017, and less favorable prior year reserve development. The Commercial medical care ratio decreased slightly in 2015 compared with 2014 primarily due to a lower medical care ratio in our stop loss business.
Operating expense ratio. The operating expense ratio increased slightly in 2016 compared with 2015, reflecting costs related to our CMS audit response. Excluding those costs, the operating expense ratio decreased, reflecting higher revenue and operating efficiencies, partially offset by business initiative investments to enhance our capabilities. The operating expense ratio was flat in 2015 compared with 2014, reflecting business-initiative investments offset by higher revenue and disciplined expense management.
Medical costs payable was higher as of December 31, 2016 compared with 2015, primarily due to medical cost trend across all businesses and customer growth in our Commercial group business. Medical costs payable increased in 2015 compared with 2014, primarily driven by growth in the stop loss book of business and the Government segment. See Note 7 to the Consolidated Financial Statements for additional information.
• has access to the Company's provider network for covered services under their medical plan; or
As described in the Segment Reporting introduction on page 49, the performance of the Global Supplemental Benefits segment is measured using adjusted income from operations. The key factors affecting adjusted income from operations for this segment are:
Adjusted income from operations increased in 2016 compared with 2015 primarily due to business growth, largely in South Korea, and lower acquisition and operating cost ratios. These factors were partially offset by higher income taxes and the unfavorable impact of foreign currency movements, primarily in South Korea. The increase in adjusted income from operations in 2015 compared with 2014 was primarily due to business growth and lower acquisition costs, partially offset by the unfavorable impact of foreign currency movements and higher expense ratios as discussed below.
Operating revenues were higher in 2016 compared with 2015 primarily due to new sales, particularly in South Korea and the U.S., reflecting both customer growth and sales of higher premium products. These higher premiums were partially offset by lower persistency in the U.K. and the unfavorable impact of foreign currency movements, primarily in South Korea and the U.K.
Loss ratios were flat in 2016 compared with 2015 reflecting favorable claims in South Korea, largely offset by higher claims in the U.S. Loss ratios increased in 2015 compared with 2014, primarily due to a business mix shift toward products with higher expected loss ratios in South Korea and the U.S.
Acquisition cost ratios decreased in both 2016 and 2015 compared with each prior year. The decline in each year's ratio largely represents a shift toward higher premium products with lower acquisition costs primarily in South Korea and the U.S.
The expense ratio (excluding acquisition costs) decreased in 2016 compared with 2015 primarily driven by operating efficiencies. The expense ratio (excluding acquisition costs) increased in 2015 compared with 2014 reflecting strategic business investments partially offset by operating efficiencies.
South Korea is the single largest geographic market for our Global Supplemental Benefits segment. South Korea generated 51% of the segment's operating revenues and 85% of the segment's adjusted income from operations in 2016. In 2016, our Global Supplemental Benefits segment operations in South Korea represented 4% of our consolidated operating revenues and 12% of consolidated adjusted income from operations.
As a global company, our business is exposed to risks inherent in foreign operations. While we continue to monitor and evaluate the impacts of the U.K. vote to exit the European Union and the political unrest in Turkey, we do not expect these events to materially impact the results of the Global Supplemental Benefits segment in 2017.
Life: We experienced a period of elevated life claims in the second quarter of 2016, driven by substantially higher new claim incidence and sizes, both of which improved in the second half of 2016.
As described in the Segment Reporting introduction on page 49, the performance of the Other Operations segment is measured using adjusted income from operations. Cigna's corporate-owned life insurance ("COLI") business contributes the majority of earnings in Other Operations. Cigna's Other Operations segment also includes the results from the run-off reinsurance and settlement annuity businesses, as well as the remaining deferred gains recognized from the sale of the individual life insurance and annuity and retirement benefits businesses.
Adjusted income from operations decreased in 2016 compared with 2015, reflecting less favorable mortality experience and lower interest margins in COLI. Adjusted income from operations increased in 2015 compared with 2014, reflecting favorable mortality experience in COLI.
Operating revenues decreased in 2016 compared with 2015 due to lower net investment income driven by lower investment yields. The decrease in operating revenues in 2015 compared with 2014 is largely due to lower net investment income driven by lower investment yields and, to a lesser extent, lower premiums in COLI driven by favorable experience-rating results.
The following table presents our invested asset portfolio, excluding separate account assets, as of December 31, 2016 and 2015. An increase in investable funds has led to an increase across all asset types, except for commercial mortgages, that have continued to decline due to a competitive investment environment and our assessment of relative value versus other fixed income opportunities.
As of December 31, 2016, $18.6 billion, or 89%, of the fixed maturities in our investment portfolio were investment grade (Baa and above, or equivalent), and the remaining $2.4 billion were below investment grade. The majority of the bonds that are below investment grade are rated at the higher end of the non-investment grade spectrum. These quality characteristics have not materially changed from the prior year and are consistent with our investment strategy.
Foreign government. We invest in high quality foreign government obligations with an average quality rating of Aa3 as of December 31, 2016. These investments are concentrated in Asia, primarily South Korea, consistent with the geographic locations of our international business operations. Foreign government obligations also include $221 million of investments in European sovereign debt, none of which are in countries with significant political or economic concerns such as Portugal, Italy, Ireland, Greece, Spain and Turkey.
Corporate. As of December 31, 2016, corporate fixed maturities included the following.
• Private placement investments were $5.3 billion. These investments are generally less marketable than publicly-traded bonds, however yields on these investments tend to be higher than yields on publicly-traded bonds with comparable credit risk. We perform a credit analysis of each issuer, diversify investments by industry and issuer and require financial and other covenants that allow us to monitor issuers for deteriorating financial strength and pursue remedial actions, if warranted.
• Investments in the energy and natural gas sector were $1.7 billion with gross unrealized losses of $18 million. These investments have an average quality rating of Baa2 and are diversified by issuer with no single exposure greater than $40 million. In addition to amounts classified in fixed maturities on our Consolidated Balance Sheets, we operate a joint venture in China in which we have a 50% ownership interest. We account for this joint venture on the equity basis of accounting and report it in other assets, including other intangibles. This entity has an investment portfolio of approximately $3.3 billion that is primarily invested in local Chinese corporate and government fixed maturities and has no investments with a material unrealized loss as of December 31, 2016.
Our commercial mortgage loans are fixed rate loans, diversified by property type, location and borrower. Loans are secured by high quality commercial properties and are generally made at less than 70% of the property's value at origination of the loan. Property value, debt service coverage, quality, building tenancy and stability of cash flows are all important financial underwriting considerations. We hold no direct residential mortgage loans and do not securitize or service mortgage loans. We completed an annual in-depth review of our commercial mortgage loan portfolio during the second quarter of 2016. For further information on the property type, location and credit quality of our commercial mortgage loans, as well as a discussion of the results of the annual portfolio review, see Note 11 to the Consolidated Financial Statements.
The $1.7 billion commercial mortgage loan portfolio consists of approximately 60 loans, including one impaired loan with a carrying value of $21 million, net of a $5 million reserve, that is classified as a problem loan. We have $92 million of loans maturing in the next twelve months. Given the quality and diversity of the underlying real estate, positive debt service coverage and significant borrower investment generally ranging between 30 and 40%, we remain confident that borrowers will continue to perform as expected under their contract terms.
Other long-term investments of $1.5 billion primarily include investments in security partnership and real estate funds as well as direct investments in real estate joint ventures. The funds typically invest in mezzanine debt or equity of privately held companies (securities partnerships) and equity real estate. Given our subordinate position in the capital structure of these underlying entities, we assume a higher level of risk in return for higher expected returns. To mitigate risk, investments are diversified across approximately 120 separate partnerships, and approximately 70 general partners who manage one or more of these partnerships. Also, the funds' underlying investments are diversified by industry sector or property type, and geographic region. No single partnership investment exceeds 4% of our securities and real estate partnership portfolio.
"Problem" bonds and commercial mortgage loans are either delinquent by 60 days or more or have been restructured as to terms, including concessions by us for modification of interest rate, principal payment or maturity date. "Potential problem" bonds and commercial mortgage loans are considered current (no payment is more than 59 days past due), but management believes they have certain characteristics that increase the likelihood that they may become problems. The characteristics management considers include, but are not limited to, the following:
• principal or interest payments past due by more than 30 but fewer than 60 days;
• for commercial mortgages, deterioration of debt service coverage below 1.0 or value declines resulting in estimated loan-to-value ratios increasing to 100% or more. We recognize interest income on problem bonds and commercial mortgage loans only when payment is actually received because of the risk profile of the underlying investment. The amount that would have been reflected in net income if interest on non-accrual investments had been recognized in accordance with their original terms was not significant for 2016 or 2015.
The increase in problem bonds was primarily due to three additional problem bonds in the energy sector. The increase in foreclosed real estate during 2016 reflects the foreclosure of a commercial mortgage loan classified as a problem loan as of December 31, 2015. The decrease in potential problem commercial mortgage loans in 2016 was due to a full payoff of one loan and partial payoff, and subsequent reclassification to good standing, of another loan.
Global financial markets exhibited volatility throughout 2016 resulting from global economic and political uncertainty. The volatility began early in the year led by concerns related to slowing economic global growth, with particular concerns regarding China, potentially destabilizing impacts from cyclically low energy prices, followed in mid-year by concerns regarding the United Kingdom's decision to exit the European Union, and then finished the year with strong market reactions anticipating growth-oriented policy changes in the United States following our recent elections. The near-term impact of these events has not materially impacted our financial condition or liquidity; however, we continue to closely monitor global macroeconomic trends and the potential impact to our investment portfolio. Future realized and unrealized investment results will be driven largely by market conditions that exist when a transaction occurs or at the reporting date. These future conditions are not reasonably predictable; however, we believe that the vast majority of our investments will continue to perform under their contractual terms. Based on our strategy to match the duration of invested assets to the duration of insurance and contractholder liabilities, we expect to hold a significant portion of these assets for the long term. Although future impairment losses resulting from interest rate movements and credit deterioration due to both company-specific and the global economic uncertainties discussed above remain possible, we do not expect these losses to have a material adverse effect on our financial condition or liquidity.
We predominantly rely on three techniques to manage our exposure to market risk:
• Use of derivatives. We use derivative financial instruments to minimize certain market risks. See Note 12 to the Consolidated Financial Statements for additional information about financial instruments, including derivative financial instruments.
• a hypothetical strengthening of the U.S. dollar to foreign currencies, primarily for the net assets of foreign subsidiaries denominated in a foreign currency. Management believes that actual results could differ materially from these examples because:
• changes in the fair values of investments recorded using the equity method of accounting and liabilities for pension and other postretirement and postemployment benefit plans (and related assets) have been excluded, consistent with the disclosure guidance; and
• changes in the fair values of other significant assets and liabilities such as goodwill, deferred policy acquisition costs, taxes, and various accrued liabilities have been excluded; because they are not financial instruments, their primary risks are other than market risk. The effects of hypothetical changes in market rates or prices on the fair values of certain of our financial instruments, subject to the exclusions noted above (particularly insurance liabilities), would have been as follows as of December 31:
The effect of a hypothetical increase in interest rates was determined by estimating the present value of future cash flows using various models, primarily duration modeling. The impact of a hypothetical increase to interest rates at December 31, 2016 was greater than that at December 31, 2015 reflecting increased purchases of fixed maturities, in addition to valuation decreases of our long-term debt resulting from higher market yields during 2016.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, comprehensive income, changes in total equity and cash flows present fairly, in all material respects, the financial position of Cigna Corporation and its subsidiaries at December 31, 2016 and 2015, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2016 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control - Integrated Framework 2013 issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in Management's Annual Report on Internal Control over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
(1) As required in adopting Accounting Standard Update ("ASU") 2016-09, the Company retrospectively reclassified $79 million in 2015 and $53 million in 2014 of cash payments from operating to financing activities. These payments were related to employee tax obligations associated with stock compensation. The comparable amount reported in financing activities in 2016 was $72 million. See Note 2 for further discussion.
Cigna Corporation, together with its subsidiaries (either individually or collectively referred to as "Cigna," the "Company," "we," "our" or "us") is a global health services organization dedicated to a mission of helping individuals improve their health, well-being and sense of security. To execute on our mission, Cigna's strategy is to "Go Deep", "Go Global" and "Go Individual" with a differentiated set of medical, dental, disability, life and accident insurance and related products and services offered by our subsidiaries. The majority of these products are offered through employers and other groups such as governmental and non-governmental organizations, unions and associations. Cigna also offers commercial health and dental insurance, Medicare and Medicaid products and health, life and accident insurance coverages to individuals in the U.S. and selected international markets. In addition to these ongoing operations, Cigna also has certain run-off operations.
The financial results of the Company's businesses are reported in the following segments:
• The Government operating segment offers Medicare Advantage and Medicare Part D plans to seniors and Medicaid plans. Global Supplemental Benefits includes supplemental health, life and accident insurance products offered in selected international markets and in the U.S.
• run-off settlement annuity business. Corporate reflects amounts not allocated to operating segments, such as net interest expense (defined as interest on corporate debt less net investment income on investments not supporting segment operations), interest on uncertain tax positions, certain litigation matters, intersegment eliminations, compensation cost for stock options, expense associated with frozen pension plans and certain costs for corporate projects, including overhead.
The following tables provide information about recently adopted and recently issued accounting guidance applicable to Cigna.
The Company's accounting policies are either described in this Note or are described in the applicable Notes to the Consolidated Financial Statements as indicated in the table below.
Policy loans are carried at unpaid principal balances plus accumulated interest, the total of which approximates fair value. These loans are collateralized by life insurance policy cash values and therefore have minimal exposure to credit loss. Interest rates are reset annually based on an index.
Premiums, accounts and notes receivable and reinsurance recoverables are reported net of allowances for doubtful accounts and unrecoverable reinsurance of $203 million as of December 31, 2016 and $78 million as of December 31, 2015. The Company estimates these allowances for doubtful accounts and unrecoverable reinsurance using management's best estimates of collectability, taking into consideration the age of the outstanding amounts, historical collection patterns and other economic factors. See Note 22 for additional discussion of the allowance established in 2016 for the risk corridor receivable.
Each year, deferred policy acquisition costs are tested for recoverability. For universal life and other individual products, management estimates the present value of future revenues less expected payments. For group health and accident insurance products, management estimates the sum of unearned premiums and anticipated net investment income less future expected claims and related costs. If management's estimates of these sums are less than the deferred costs, the Company reduces deferred policy acquisition costs and records an expense. The Company recorded amortization for policy acquisition costs of $292 million in 2016, $286 million in 2015 and $289 million in 2014 primarily in other operating expenses.
Other assets, including other intangibles consist primarily of GMIB assets, accrued net investment income, other intangible assets and various other insurance-related assets. See Note 17 for the Company's accounting policy for other intangibles. Additionally, these other assets include the carrying value of our equity-method investments in joint ventures in China and other foreign jurisdictions.
Obligations for annuities represent specified periodic benefits to be paid to an individual or groups of individuals over their remaining lives. Obligations for life insurance policies and GMDB contracts represent benefits to be paid to policyholders, net of future premiums to be received. Management estimates these obligations based on assumptions as to premiums, interest rates, mortality or morbidity, future claim adjudication expenses and surrenders, allowing for adverse deviation as appropriate. Mortality, morbidity and surrender assumptions are based on the Company's own experience and published actuarial tables. Interest rate assumptions are based on management's judgment considering the Company's experience and future expectations, and range from 0.1% to 9%. Obligations for the run-off settlement annuity business include adjustments for realized and unrealized investment returns consistent with GAAP when a premium deficiency exists.
Products and services are offered in Turkey and India through joint venture entities for which the Company is the principal equity holder or primary beneficiary. Accordingly, these entities are consolidated. The redeemable noncontrolling interests on our Consolidated Balance Sheets represent our joint venture partners' preferred and common stock interests in these entities. Our joint venture partners may, at their election, require the Company to purchase their redeemable noncontrolling interests. We also have the right to require our joint venture partners to sell their redeemable noncontrolling interests to us. The redeemable noncontrolling interests were recorded at fair value as of the dates of purchase. When the estimated redemption value for a redeemable noncontrolling interest exceeds its carrying value, an adjustment to increase the redeemable noncontrolling interest is recorded with an offsetting reduction to additional paid-in capital. When an adjustment is made to the carrying value of the redeemable noncontrolling interest, the calculation of shareholders' net income per share will be adjusted if the redemption value exceeds the greater of the carrying value or fair value.
•A three-year (2014-2016) reinsurance program is designed to provide reimbursement to insurers for high cost individual business sold on or off the public exchanges. The reinsurance entity established by the U.S. Department of Health and Human Services ("HHS") is funded by a per-customer reinsurance fee assessed on all insurers, Health Maintenance Organizations ("HMOs") and self-insured group health plans, excluding certain products such as Medicare Advantage and Medicare Part D. Only non-grandfathered individual plans are eligible for recoveries if claims exceed a specified threshold, up to a reinsurance cap.
•A three-year (2014-2016) risk corridor program is designed to limit insurer gains and losses by comparing allowable medical costs to a target amount as defined by HHS. This program applies to individual and small group qualified health plans, operating on and off the exchanges. Variances from the target amount exceeding certain thresholds may result in amounts due to or due from HHS. Reinsurance contributions associated with non-grandfathered individual plans are reported as reductions in premium revenues, and estimated reinsurance recoveries are established with offsetting reductions in Global Health Care medical costs. Reinsurance fee contributions for other insured business are reported in other operating expenses. Final recoverable amounts are determined and settled with HHS in the year following the policy year. For the risk adjustment and risk corridor programs, the Company records receivables or payables as adjustments to premium revenue based on our year-to-date experience when the amounts are reasonably estimable and collection is reasonably assured. Final revenue adjustments are determined by HHS in the year following the policy year. For additional discussion on our revenue recognition considerations for the risk corridor program in 2016, see Note 22.
Premiums for individual life, accident and supplemental health insurance and annuity products, excluding universal life and investment-related products, are recognized as revenue when due. Benefits and expenses are matched with premiums.
• Charges for mortality, administration and policy surrender are recognized in premiums as earned. Administrative fees are considered earned when services are provided. Benefits and expenses for universal life products consist of benefit claims in excess of policyholder account balances and income earned by policyholders. Expenses are recognized when claims are incurred, and income is credited to policyholders in accordance with contract provisions.
L. Fees, Related Expenses and Mail Order Pharmacy Revenues and Costs
Contract fees for administrative services only ("ASO") programs and pharmacy programs and services are recognized in fees and other revenues as services are provided, net of estimated pharmaceutical manufacturer rebates payable to ASO clients using our network of retail pharmacies and estimated refunds under performance guarantees. Expenses associated with these programs and services are recognized in other operating expenses as incurred, net of estimated pharmaceutical rebates from manufacturers for prescriptions filled through our network of retail pharmacies.
In some cases, the Company provides performance guarantees associated with meeting certain service standards, clinical outcomes or financial metrics. If these service standards, clinical outcomes or financial metrics are not met, the Company may be financially at risk up to a stated percentage of the contracted fee or a stated dollar amount. The Company defers revenues for estimated payouts associated with these performance guarantees. Approximately 10% of ASO fees reported for the year ended December 31, 2016 were at risk under performance guarantees, with reimbursements estimated to be less than 1% of revenues.
• Investment income on assets supporting investment-related products is recognized in net investment income as earned.
Mail order pharmacy revenues and the cost of prescriptions are recognized as each prescription is shipped. Mail order pharmacy revenues are presented net of estimated pharmaceutical manufacturer rebates payable to ASO clients using our mail order business. Mail order pharmacy costs include the cost of prescriptions sold and other costs to operate this business including supplies, shipping and handling, net of estimated pharmaceutical rebates from manufacturers for prescriptions filled through our mail order business.
On July 23, 2015, the Company entered into a merger agreement with Anthem, Inc. ("Anthem") and Anthem Merger Sub Corp. ("Merger Sub"), a direct wholly-owned subsidiary of Anthem.
The Company incurred pre-tax costs of $166 million ($147 million after-tax) for the year ended December 31, 2016, and $66 million ($57 million after-tax) for the year ended December 31, 2015 directly related to the proposed merger. These costs consisted primarily of fees for financial advisory, legal and other professional services. If the merger is consummated, most of the merger-related costs are not deductible for federal income tax purposes. If the merger is not consummated, most of these costs would become deductible for federal income tax purposes, resulting in a tax benefit of approximately $50 million.
The Company completed certain acquisitions during the three years ended December 31, 2016 that were not material to the Company's results of operations, liquidity or financial condition. In accordance with GAAP, the purchase price for each acquisition was allocated to the tangible and intangible net assets acquired based on management's estimates of their fair values.
• The Company redeemed its 8.50% Notes due 2019, including accrued interest from November 1, 2014 through the settlement date of April 13, 2015. The redemption price equaled the present value of the remaining principal and interest payments on the Notes being redeemed, discounted at a rate equal to the 10-year Treasury Rate plus a fixed spread of 50 basis points. The Company paid $329 million including accrued interest and expenses, resulting in a pre-tax loss on early debt extinguishment of $79 million ($51 million after-tax) that was recognized in the second quarter of 2015. Maturities of long-term debt and capital leases are as follows:
(1) Percentage of current year incurred costs as reported for 2015.
(3) In 2015, the other balance primarily relates to an increase in the 2014 reinsurance reimbursement rate from CMS under the Health Care Reform Act.
The table below depicts the incurred and paid claims development as of December 31, 2016 (net of reinsurance), claims frequency metrics and incurred but not reported liabilities for Cigna's Global Health Care medical costs payable. The information about incurred and paid claims development for the year ended December 31, 2015 is presented as supplementary information and is unaudited.
The Company's liability for disability claims reported but not yet paid is the present value of estimated future benefit payments over the expected disability period. The Company projects the expected disability period by using historical resolution rates combined with an analysis of current trends and operational factors to develop current estimates of resolution rates. Using the Company's experience, expected claim resolution rates may vary based upon the anticipated disability period, the covered benefit period, the cause of disability, the benefit design and the claimant's age, gender and income level. The gross monthly benefit is reduced (offset) by disability income received under other benefit programs, most commonly Social Security Disability Income, workers' compensation, statutory disability or other group benefit plans. For certain offsets not yet finalized, the Company estimates the probability and amount of future offset awards and lapses based on the Company's experience.
Liability balance details. The liability for unpaid claims and claim expenses by segment as of December 31 is as follows:
Interest is accreted and recognized in other benefit expenses in the Consolidated Statements of Income.
Long-Term Disability Development Tables. The table below presents information about incurred and paid claims development as of December 31, 2016 (net of reinsurance) cumulative claim frequency and total incurred but not reported liabilities for the Company's long-term disability book of business. The information about incurred and paid claims development for the years ended December 31, 2012 through 2015, is presented as supplementary information and is unaudited. As permitted under the standard in the initial year of adoption, the Company
presented development table information for five years because obtaining information beyond this period was impracticable as historical data was not maintained in such detail at this level.
The claims frequency metric used for the Company's long-term disability line of business represents the number of unique claim events for which benefits have been approved and payments made. Claim events are identified using a unique claimant identifier and incurral date. Thus, if an individual has multiple claims for different disabling events (and therefore different incurral dates), each will be determined to be a unique claim event. However, if an individual receives multiple benefits under more than one policy (for example for supplemental disability benefits such as pension contribution benefits or survivor benefits), the Company treats this as a single claim occurrence because they related to the same claim event. Claims frequency metrics for the most recent year are expected to be low, reflecting the long-term disability product features including waiting and elimination periods that result in delayed eligibility for contract benefits.
The following reconciles the long-term disability net incurred and paid claims development table to the liability for unpaid claims and claim expenses in the Company's Consolidated Balance Sheets as of December 31, 2016.
The Company bears the risk of loss if its reinsurers and retrocessionaires do not meet or are unable to meet their reinsurance obligations to the Company. Over 90% of the Company's reinsurance recoverables were from companies rated A or higher by Standard & Poors at December 31, 2016. The Company reviews its reinsurance arrangements and establishes reserves against the recoverables if recovery is not considered probable. As of December 31, 2016 and December 31, 2015, the Company's recoverables were net of a reserve of $3 million.
In 2013, the Company entered into an agreement with Berkshire to effectively exit the GMDB and GMIB business via a reinsurance transaction for a payment of $2.2 billion. Berkshire reinsured 100% of the Company's future claim payments in this business, net of retrocessional arrangements existing at that time. The reinsurance agreement is subject to an overall limit with approximately $3.5 billion remaining at December 31, 2016.
The majority of the GMDB exposure arises under annuities written by ceding companies that guarantee the benefit received at death will be no less than the highest historical account value of the related mutual fund investments on a contractholder's anniversary date. Under this type of death benefit, the Company's exposure arises when the highest anniversary account value exceeds the fair value of the related mutual fund investments at the time of a contractholder's death.
As of December 31, 2016, there were three reinsurers for GMIB as follows:
Assumptions used in fair value measurement. The Company estimates the fair value of the assets and liabilities for GMIB contracts by calculating the results for many scenarios run through a model utilizing various assumptions. The only assumption expected to impact future shareholders' net income is non-performance risk. The non-performance risk adjustment reflects a market participant's view of nonpayment risk by adding an additional spread to the discount rate in the calculation of both (a) the GMIB liabilities to be paid by the Company, and (b) the GMIB assets to be paid by the reinsurers, after considering collateral.
• all annuitants elected to receive their benefit on the next available date (2017 through 2021); and
• all underlying mutual fund investment values remained at the December 31, 2016 value of $810 million with no future returns. The Company has reinsurance coverage in place that covers the exposures on these contracts. Using these hypothetical assumptions, GMIB exposure is $703 million, which is lower than the recorded liability for GMIB calculated using fair value assumptions.
(1) Fixed maturities included $524 million of net appreciation required to adjust future policy benefits for the run-off settlement annuity business including $14 million of appreciation for securities classified in Level 3. See Note 11A for additional information.
Other derivatives classified in Level 2 represent over-the-counter instruments such as interest rate and foreign currency swap contracts. Fair values for these instruments are determined using market observable inputs including forward currency and interest rate curves and widely published market observable indices. Credit risk related to the counterparty and the Company is considered when estimating the fair values of these derivatives. However, the Company is largely protected by collateral arrangements with counterparties and determined that no adjustment for credit risk was required as of December 31, 2016 or 2015. Level 2 also includes exchange-traded interest rate swap contracts. Credit risk related to the clearinghouse counterparty and the Company is considered minimal when estimating the fair values of these derivatives because of upfront margin deposits and daily settlement requirements. The nature and use of these other derivatives are described in Note 12.
Fair values of mortgage and other asset-backed securities, corporate and government fixed maturities are primarily determined using pricing models that incorporate the specific characteristics of each asset and related assumptions including the investment type and structure, credit quality, industry and maturity date in comparison to current market indices, spreads and liquidity of assets with similar characteristics. For mortgage and other-backed securities, inputs and assumptions for pricing may also include collateral attributes and prepayment speeds. Recent trades in the subject security or similar securities are assessed when available, and the Company may also review published research in its evaluation, as well as the issuer's financial statements.
The following tables summarize the fair value and significant unobservable inputs used in pricing the following securities that were developed directly by the Company as of December 31, 2016 and 2015. The range and weighted average basis point amounts ("bps") for fixed maturity spreads (adjustment to discount rates) and price-to-earnings multiples for equity investments reflect the Company's best estimates of the unobservable adjustments a market participant would make to calculate these fair values.
Mortgage and other asset-backed securities. The significant unobservable inputs used to value the following mortgage and other asset-backed securities are liquidity and weighting of credit spreads. When there is limited trading activity for the security, an adjustment for liquidity is made as of the measurement date that considers current market conditions, issuer circumstances and complexity of the security structure. An adjustment to weight credit spreads is needed to value a more complex bond structure with multiple underlying collateral and no standard market valuation technique. The weighting of credit spreads is primarily based on the underlying collateral's characteristics and their proportional cash flows supporting the bond obligations. The resulting wide range of unobservable adjustments in the table below is due to the varying liquidity and quality of the underlying collateral, ranging from high credit quality to below investment grade.
• actively-traded institutional and retail mutual fund investments and separate accounts priced using the daily net asset value that is the exit price. Separate account assets classified in Level 3 primarily support Cigna's pension plans, and include certain newly issued, privately-placed, complex, or illiquid securities that are priced using methods discussed above, as well as commercial mortgage loans that are valued according to the methodologies discussed below. The following tables summarize the changes in separate account assets reported in Level 3 for the years ended December 31, 2016 and 2015.
(1) The attributes noted are effective as of December 31, 2016 and 2015.
B. Assets and Liabilities Measured at Fair Value under Certain Conditions
Some financial assets and liabilities are not carried at fair value each reporting period, but may be measured using fair value only under certain conditions, such as investments in real estate, partnership entities and commercial mortgage loans when they become impaired. Impaired values for these asset types classified as Level 3 representing less than 1% of total investments, were written down to their fair values, resulting in realized investment losses of $4 million after-tax in 2016 and $16 million after-tax in 2015.
Commercial mortgage loans. The Company estimates the fair value of commercial mortgage loans generally by discounting the contractual cash flows at estimated market interest rates that reflect the Company's assessment of the credit quality of the loans. Market interest rates are derived by calculating the appropriate spread over comparable U.S. Treasury rates based on the property type, quality rating and average life of the loan. The quality ratings reflect the relative risk of the loan considering debt service coverage, the loan-to-value ratio and other factors. Fair values of impaired mortgage loans are based on the estimated fair value of the underlying collateral generally determined using an internal discounted cash flow model. The fair value measurements were classified in Level 3 because the cash flow models incorporate significant unobservable inputs.
Contractholder deposit funds, excluding universal life products. Generally, these funds do not have stated maturities. Approximately 70% of these balances can be withdrawn by the customer at any time without prior notice or penalty. The fair value for these contracts is the amount estimated to be payable to the customer as of the reporting date, which is generally the carrying value. Most of the remaining contractholder deposit funds are reinsured by the buyers of the individual life and annuity and retirement benefits businesses. The fair value for these contracts is determined using the fair value of these buyers' assets supporting these reinsured contracts. The Company had reinsurance recoverables equal to the carrying value of these reinsured contracts. These instruments were classified in Level 3 because certain inputs are unobservable (supported by little or no market activity) and significant to their resulting fair value measurement.
Fair values of off-balance sheet financial instruments were not material as of December 31, 2016 and 2015.
• If the net present value of projected future cash flows of a fixed maturity (based on qualitative and quantitative factors, including the probability of default, and the estimated timing and amount of recovery) is below the amortized cost basis, that difference is recognized as an impairment loss. For mortgage and asset-backed securities, estimated future cash flows are also based on assumptions about the collateral attributes including prepayment speeds, default rates and changes in value. The amortized cost and fair value by contractual maturity periods for fixed maturities were as follows at December 31, 2016:
Equity securities include an investment of approximately $400 million in an exchange traded fund ("ETF") with a gross unrealized loss of $5 million at December 31, 2016. The underlying assets of the ETF are primarily U.S. investment grade corporate bonds and the gross unrealized loss is due to an increase in market yields since purchase. There were no other available for sale equity securities with a significant unrealized loss reflected in accumulated other comprehensive income at December 31, 2016.
As of December 31, 2016, the Company had commitments to extend credit under commercial mortgage loan agreements of $69 million.
Quality ratings are based on our evaluation of a number of key inputs related to the loan, including real estate market-related factors such as rental rates and vacancies, and property-specific inputs such as growth rate assumptions and lease rollover statistics. However, the two most significant contributors to the credit quality rating are the debt service coverage and loan-to-value ratios. The debt service coverage ratio measures the amount of property cash flow available to meet annual interest and principal payments on debt, with a ratio below 1.0 indicating that there is not enough cash flow to cover the required loan payments. The loan-to-value ratio, commonly expressed as a percentage, compares the amount of the loan to the fair value of the underlying property collateralizing the loan.
The following tables summarize the credit risk profile of the Company's commercial mortgage loan portfolio based on loan-to-value and debt service coverage ratios, as of December 31, 2016 and 2015:
The Company's annual in-depth review of its commercial mortgage loan investments is the primary mechanism for identifying emerging risks in the portfolio. The most recent review was completed by the Company's investment professionals in the second quarter of 2016 and included an analysis of each underlying property's most recent annual financial statements, rent rolls, operating plans, budgets, a physical inspection of the property and other pertinent factors. Based on historical results, current leases, lease expirations and rental conditions in each market, the Company estimates the current year and future stabilized property income and fair value and categorizes the investments as loans in good standing, potential problem loans or problem loans. The results of the 2016 review showed improvement from the prior review in each of the key metrics and confirmed the overall strength of the portfolio. Based on property values and cash flows estimated as part of this review, and considering updates for loans where material changes were subsequently identified, the portfolio's average loan-to-value ratio improved to 57% at December 31, 2016 from 58% at December 31, 2015. The portfolio's average debt service coverage ratio improved to 1.95 at December 31, 2016 from 1.78 at December 31, 2015. These improvements are primarily attributable to improvements in property operations and the relative stability of these metrics is primarily due to low portfolio turnover.
Potential problem mortgage loans are considered current (no payment is more than 59 days past due), but they exhibit certain characteristics that increase the likelihood of future default. The characteristics management considers include, but are not limited to, the deterioration of debt service coverage below 1.0, estimated loan-to-value ratios increasing to 100% or more, downgrade in quality rating and requests from the borrower for restructuring. In addition, loans are considered potential problems if principal or interest payments are past due by more than 30 but less than 60 days. Problem mortgage loans are either in default by 60 days or more or have been restructured as to terms that could include concessions on interest rate, principal payment or maturity date. The Company monitors each problem and potential problem mortgage loan on an ongoing basis, and updates the loan categorization and quality rating when warranted.
Problem and potential problem mortgage loans, net of valuation reserves, totaled $21 million at December 31, 2016 and $139 million at December 31, 2015.
The carrying value of the Company's impaired commercial mortgage loans and related valuation reserves were as follows:
Changes in valuation reserves for commercial mortgage loans were not material for the years ended December 31, 2016 and 2015.
Accounting policy. Other long-term investments include investments in unconsolidated entities. These entities include certain limited partnerships and limited liability companies holding real estate, securities or loans. These investments are carried at cost plus the Company's ownership percentage of reported income or loss in cases where the Company has significant influence; otherwise the investment is carried at cost. Income from certain entities is reported on a one quarter lag depending on when their financial information is received. Other long-term investments are considered impaired, and written down to their fair value, when cash flows indicate that the carrying value may not be recoverable. Fair value is generally determined based on a discounted cash flow analysis.
Other long-term investments also include investment real estate carried at depreciated cost less any impairment write downs to fair value when cash flows indicate that the carrying value may not be recoverable. Depreciation is generally recorded using the straight-line method based on the estimated useful life of each asset. Investment real estate as of December 31, 2016 and 2015 is expected to be held longer than one year and includes real estate acquired through the foreclosure of commercial mortgage loans.
As of December 31, 2016, the Company had commitments to contribute:
• $810 million to entities that hold securities diversified by issuer and maturity date. The Company expects to disburse approximately 26% of the committed amounts in 2017.
Accounting policy. When interest and principal payments on investments are current, the Company recognizes interest income when it is earned. The Company recognizes interest income on a cash basis when interest payments are delinquent based on contractual terms or when certain terms (interest rate or maturity date) of the investment have been restructured.
Real estate investments and securities partnerships with a carrying value of $220 million at December 31, 2016 and $277 million at December 31, 2015 were non-income producing during the preceding twelve months.
(1) These write-downs pertain to other-than-temporary declines in fair values due to increases in market yields (widening of credit spreads), particularly within the energy sector, for certain below investment grade fixed maturities with an increased probability of sales activity prior to recovery of amortized cost basis.
(2) Other asset write-downs include other-than-temporary declines in the fair values of equity securities, increases in valuation reserves on commercial mortgage loans, and asset write-downs related to security partnerships and real estate investments.
Realized investment gains in other investments, including derivatives, represent primarily gains on sale of real estate properties held in joint ventures.
The Company uses derivative financial instruments to manage the characteristics of investment assets (such as duration, yield, currency and liquidity) to meet the varying demands of the related insurance and contractholder liabilities (such as paying claims, investment returns and withdrawals) and to hedge interest rate risk of its long-term debt. The Company has written and purchased GMIB reinsurance contracts in its run-off reinsurance business that are accounted for as freestanding derivatives and discussed in Note 9. Derivatives in the Company's separate accounts are excluded from the following discussion because associated gains and losses generally accrue directly to separate account policyholders.
The following tables provide information on the Company's specific applications of derivative financial instruments during the years ended December 31.
Accounting. Using fair value hedge accounting, the fair values of the swap contracts are reported in other assets, including other intangibles, or accounts payable, accrued expenses, and other liabilities. The critical terms of these swaps match those of the long-term debt being hedged. As a result, the carrying value of the hedged debt is adjusted to reflect changes in its fair value driven by LIBOR. The effects of those adjustments on other operating expenses are offset by the effects of corresponding changes in the swaps' fair value. The net impact from the hedge reported in other operating expenses reflects interest expense on the hedged debt at the variable interest rate.
Purpose. To hedge the foreign exchange related changes in fair values of the Company's fixed maturity bonds.
Accounting. As these arrangements were not designated as accounting hedges, fair values are reported in short-term investments or accounts payable, accrued expenses, and other liabilities, and changes in fair values are reported in other realized investment gains and losses.
Collateral and termination features. The Company routinely monitors exposure to credit risk associated with derivatives and diversifies the portfolio among approved dealers of high credit quality to minimize this risk. As of December 31, 2016, the Company had $18 million in cash on deposit representing the upfront margin required for the Company's centrally-cleared derivative instruments. Certain of the Company's over-the-counter derivative instruments contain provisions requiring either the Company or the counterparty to post collateral or demand immediate payment depending on the amount of the net liability position and predefined financial strength or credit rating thresholds. Collateral posting requirements vary by counterparty. The net asset or liability positions of these derivatives were not material as of December 31, 2016 or 2015.
When the Company becomes involved with a variable interest entity, as well as when there is a change in the Company's involvement with an entity, the Company evaluates the following to determine if it is the primary beneficiary and must consolidate the entity:
• the risks and rewards created by and shared through the entity; and
• the Company's ability to direct its activities, receive its benefits and absorb its losses relative to the other parties involved with the entity including its sponsors, equity holders, guarantors, creditors and servicers. As of December 31, 2016 and 2015, the Company determined it was not a primary beneficiary in any material variable interest entities.
The Company is also involved in real estate joint ventures with carrying values of $0.2 billion where all decisions significantly affecting the entities' economic performance are subject to unanimous approval by the equity holders. As a result, the Company determined that the power
To provide certain services to its Medicare Advantage customers, the Company contracts with independent physician associations ("IPAs") that are variable interest entities. Physicians provide health care services to Medicare Advantage customers and the Company provides medical management and administrative services to the IPAs. The Company's maximum exposure to loss related to the IPA arrangements is limited to their liability for incurred but not reported medical costs for the Company's Medicare Advantage customers. These liabilities are not material and are generally secured by deposits maintained by the IPAs.
• it has neither the right to receive benefits nor the obligation to absorb losses that could be significant to these variable interest entities. The Company has not provided, and does not intend to provide, financial support to these entities that it is not contractually required to provide. The Company performs ongoing qualitative analyses of its involvement with these variable interest entities to determine if consolidation is required.
Pension plans. The Company's principal qualified defined benefit pension plans, the Cigna Pension Plan and the Cigna Pension Plan for Certain Former Employees, cover approximately 21,700 retirees, 15,700 vested former employees and 14,800 active employees. Current retirees, certain vested former employees and longer-service active employees are entitled to an annuity benefit based on pay and length of service. Most pension-eligible active employees and certain vested former employees are entitled to a cash balance defined benefit. The Cigna Supplemental Pension Plan, a non-qualified and unfunded plan, covers only certain employees. We froze future benefit accruals for all of these domestic pension plans in 2009. Additionally the Company has foreign pension and other postretirement benefit plans that are immaterial to our results of operations, liquidity and financial position.
Other postretirement benefit plans. The Company's postretirement benefit medical plan covers approximately 19,400 retirees and 19,900 active employees. Post-1988 retirees contribute to the cost of this coverage, whereas pre-1989 retirees do not. For post-1988 retirees, the Company's cost is capped at 200% of the per capita cost in 2000. Pharmacy coverage for Medicare-eligible retirees is delivered using an Employer Group Waiver Plan. Under that plan, the Company receives subsidies from CMS. The postretirement medical plan is unfunded and future benefit accruals were frozen in 2013. The Company also offers certain postretirement life insurance benefits through various plans. Retirees do not contribute to the cost of life insurance benefits.
B. Funded Status and Amounts Included in Accumulated Other Comprehensive Income
We fund our qualified pension plans at least at the minimum amount required by the Employee Retirement Income Security Act of 1974 and the Pension Protection Act of 2006. In February 2017, we made a voluntary contribution of $150 million. For the remainder of 2017, we do not expect to make any additional contributions to the qualified pension plans because none are required. Future years' contributions will ultimately be based on a wide range of factors including but not limited to asset returns, discount rates and funding targets. Non-qualified pension and other postretirement benefit plans are generally funded on a pay-as-you-go basis as there are no plan assets for these plans.
The Company sets discount rates by applying actual annualized yields for high quality bonds at various durations to the expected cash flows of the pension and other postretirement benefits liabilities. The discount rate curve is constructed using an array of bonds in various industries
The estimated rate of future increases in the per capita cost of postretirement health care benefits is 6.50% in 2017, decreasing by 0.25% per year to 4.75% in 2024 and beyond. The impact of a 1% increase or decrease in the estimated rate would be immaterial to postretirement cost and benefit obligation.
(1) A pooled separate account has several participating benefit plans and each owns a share of the total pool of investments.
The Company's current target investment allocation percentages (50% fixed income, 25% public equity securities, and 25% in other investments, including private equity (securities partnerships), real estate and hedge funds) are developed by management as guidelines, although the fair values of each asset category are expected to vary as a result of changes in market conditions. The Company would expect to further reduce the allocation to equity securities and other investments and increase the allocation to fixed income investments as funding levels improve.
See Note 10 for further details regarding how fair value is determined, including the level within the fair value hierarchy and the procedures we use to validate fair value measurements. The Company classifies substantially all pension assets fixed maturities in Level 2. These assets are valued using recent trades of similar securities or are fund investments priced using their daily net asset value that is the exit price. Within pension assets, a substantial portion of domestic equity securities are classified as Level 1, while international equity funds are predominantly classified in Level 2 using daily net asset value.
Accounting policy. The Company awards options to purchase Cigna common stock at the market price of the stock on the grant date. Options vest over periods ranging from one to five years and expire no later than 10 years from grant date. Fair value is estimated using the Black-Scholes option-pricing model by applying the assumptions presented below. That fair value is reduced by options expected to be forfeited during the vesting period. The Company estimates forfeitures at the grant date based on our experience and adjust the expense to reflect actual forfeitures over the vesting period. The fair value of options, net of forfeitures, is recognized in operating expenses on a straight line basis over the vesting period.
Compensation expense of $37 million related to unvested stock options at December 31, 2016 will be recognized over the next two years (weighted average period).
The Company awards restricted stock to the Company's employees or directors with vesting periods ranging from two to five years. These awards are generally in one of two forms: restricted stock grants or restricted stock units. Restricted stock grants are the most widely used form and are used for substantially all U.S.-based employees receiving such awards. Recipients of restricted stock grants accumulate dividends and can vote during the vesting period, but forfeit their awards and accumulated dividends if their employment terminates before the vesting date. Awards of restricted stock units are generally limited to overseas employees. A restricted stock unit represents a right to receive a common share of stock when the unit vests. Recipients of restricted stock units are entitled to accumulate hypothetical dividends, but cannot vote during the vesting period. They forfeit their units and accumulated dividends if their employment terminates before the vesting date.
The table below shows the status of, and changes in, restricted stock grants and units during the last three years.
Accounting policy. Compensation expense for strategic performance shares is recorded over the performance period. For strategic performance shares with payment dependent on a market condition, fair value is determined at the grant date using a Monte Carlo simulation model and not subsequently adjusted regardless of the final outcome. For strategic performance shares with payment dependent on
The Company evaluates goodwill for impairment at least annually during the third quarter at the reporting unit level and writes it down through shareholders' net income if impaired. Fair value of a reporting unit is generally estimated based on either market data or a discounted cash flow analysis using assumptions that the Company believes a hypothetical market participant would use to determine a current transaction price. The significant assumptions and estimates used in determining fair value include the discount rate and future cash flows. A range of discount rates is used that corresponds with the reporting unit's weighted average cost of capital, consistent with that used for investment decisions considering the specific and detailed operating plans and strategies within the reporting unit. Projections of future cash flows for the reporting unit are consistent with our annual planning process for revenues, claims, operating expenses, taxes, capital levels and long-term growth rates.
(1) Current capital lease agreements are for equipment and generally have a term of 48 months with the equipment expected to be returned to the lessor at termination.
(1) Other property and equipment includes amortization on assets recorded under capital leases of $20 million in 2016, $22 million in 2015 and $20 million in 2014.
As of December 31, 2016, future net minimum rental payments under non-cancelable operating leases were approximately $650 million, payable as follows:
State insurance departments and foreign jurisdictions that regulate certain of the Company's subsidiaries prescribe accounting practices (differing in some respects from GAAP) to determine statutory net income and surplus. The Company's life insurance and HMO subsidiaries are regulated by such statutory requirements. The statutory net income of the Company's life insurance and HMO subsidiaries for the years ended, and their statutory surplus as of December 31, were as follows:
The consolidated effective tax rates of 38.1% in 2016 and 37.6% in 2015 have increased from historical levels due to the health insurance industry tax that took effect in 2014 and that is not deductible for federal income tax purposes. Undistributed foreign earnings also may affect the effective tax rates. The Company has accumulated undistributed foreign earnings of $2.5 billion as of December 31, 2016. If the Company
Deferred income tax assets and liabilities as of December 31 were as follows:
Included in the consolidated net deferred tax asset of $304 million is approximately $140 million of deferred tax liabilities attributable to foreign jurisdictions, most notably Korea and Taiwan.
Management believes that future results will be sufficient to realize the Company's deferred tax assets. With the exception of certain net operating loss related tax benefits, the Company's deferred tax benefits may be carried forward indefinitely. Net operating loss benefits are primarily attributable to foreign jurisdictions. The Company establishes a valuation allowance when it determines that realization of a deferred tax asset does not meet the more likely than not standard. Valuation allowances have been established against certain federal, foreign and state deferred tax assets, generally when there is a requirement to assess them on a separate entity basis. The increased valuation allowance in 2016 is primarily attributable to net operating losses of certain foreign operations.
In 2016, the Internal Revenue Service ("IRS") completed its examination of the Company's 2011 and 2012 tax years, resulting in an immaterial effect on shareholders' net income.
Separate account assets are contractholder funds maintained in accounts with specific investment objectives. The Company records separate account liabilities equal to separate account assets. In certain cases, the Company guarantees a minimum level of benefits for retirement and insurance contracts written in separate accounts. The Company establishes an additional liability if management believes that the Company will be required to make a payment under these guarantees.
The Company guarantees that separate account assets will be sufficient to pay certain life insurance or retiree benefits. The sponsoring employers are primarily responsible for ensuring that assets are sufficient to pay these benefits and are required to maintain assets that exceed a certain percentage of benefit obligations. This percentage varies depending on the asset class within a sponsoring employer's portfolio (for example, a bond fund would require a lower percentage than a riskier equity fund) and thus will vary as the composition of the portfolio changes. If employers do not maintain the required levels of separate account assets, the Company or an affiliate of the buyer of the retirement benefits business (Prudential Retirement Insurance and Annuity Company) has the right to redirect the management of the related assets to provide for benefit payments. As of December 31, 2016, employers maintained assets that exceeded the benefit obligations. Benefit obligations under these arrangements were $490 million as of December 31, 2016 and approximately 13% of these are reinsured by an affiliate of the buyer of the retirement benefits business. The remaining guarantees are provided by the Company with minimal reinsurance from third parties. There were no additional liabilities required for these guarantees as of December 31, 2016. Separate account assets supporting these guarantees are classified in Levels 1 and 2 of the GAAP fair value hierarchy. See Note 10 for further information about the fair value hierarchy.
The Company operates in a regulatory environment that may require the Company to participate in assessments under state insurance guaranty association laws. The Company's exposure to assessments for certain obligations of insolvent insurance companies to policyholders and claimants is based on its share of business written in the relevant jurisdictions. For the year ended December 31, 2016 and 2015, charges related to guaranty fund assessments were immaterial to the Company's results of operations.
The Company is routinely involved in numerous claims, lawsuits, regulatory audits, investigations and other legal matters arising, for the most part, in the ordinary course of managing a global health services business. These actions may include benefit disputes, breach of contract claims, tort claims, provider disputes, disputes regarding reinsurance arrangements, employment and employment discrimination-related suits, employee benefit claims, wage and hour claims, privacy, claims arising from consumer protection laws, intellectual property claims and real estate-related disputes. There are currently, and may be in the future, attempts to bring class action lawsuits against the industry. The Company also is regularly engaged in IRS audits and may be subject to examinations by various state and foreign taxing authorities. Disputed income tax matters arising from these examinations, including those resulting in litigation, are accounted for under GAAP guidance for uncertain tax positions. Further information on income tax matters can be found in Note 20.
In addition, there is heightened review by federal and state regulators of the health care, disability and life insurance industry business and related reporting practices. Cigna is frequently the subject of regulatory market conduct reviews and other examinations of its business and reporting practices, audits and investigations by state insurance and health and welfare departments, state attorneys general, CMS and the Office of Inspector General ("OIG"). With respect to Cigna's Medicare Advantage business, CMS and OIG perform audits to determine a health plan's compliance with federal regulations and contractual obligations, including compliance with proper coding practices (sometimes referred to as Risk Adjustment Data Validation audits or RADV audits), that may result in retrospective adjustments to payments made to health plans. Regulatory actions can result in assessments, civil or criminal fines or penalties or other sanctions, including loss of licensing or exclusion from participating in government programs.
As a global company, Cigna is also subject to the laws, regulations and rules of the foreign jurisdictions in which it conducts business. Foreign laws and rules, and regulatory audit and investigation practices, may differ from or be more stringent than, similar requirements in the U.S.
The outcome of litigation and other legal or regulatory matters is always uncertain, and unfavorable outcomes that are not justified by the evidence or existing law can occur. The Company believes that it has valid defenses to the matters pending against it and is defending itself vigorously. Except as otherwise noted, the Company believes that the legal actions, regulatory matters, proceedings and investigations currently pending against it should not have a material adverse effect on the Company's results of operations, financial condition or liquidity based upon our current knowledge and taking into consideration current accruals. Litigation related to the Company's claim processing practices for a commercial client, for which the Company held a reserve at September 30, 2016, was settled during the fourth quarter of 2016. The Company had pre-tax reserves as of December 31, 2016 of $190 million ($125 million after-tax) for the matters discussed below under "Litigation Matters." Due to numerous uncertain factors presented in these cases, it is not possible to estimate an aggregate range of loss (if any) for these matters at this time. In light of the uncertainties involved in these matters, there is no assurance that their ultimate resolution will not exceed the amounts currently accrued by the Company. An adverse outcome in one or more of these matters could be material to the Company's results of operations, financial condition or liquidity for any particular period.
In 2008, the District Court (1) affirmed the Company's right to convert to a cash balance plan prospectively beginning in 1998; (2) found for plaintiffs on the disclosure claim only; and (3) required the Company to pay pre-1998 benefits under the pre-conversion traditional annuity formula and post-1997 benefits under the post-conversion cash balance formula. The Second Circuit upheld this decision. From 2008 through the present, this case has undergone a series of court proceedings that resulted in the original District Court order being largely upheld. In 2015, the Company submitted to the District Court its proposed method for calculating the additional pension benefits due to class members and plaintiffs responded in August 2015.
In January 2016, the District Court ordered the method of calculating the additional pension benefits due to class members. The court order left several aspects of the calculation of additional plan benefits open to interpretation. During 2016, the Company submitted its interpretation of the Court Order and the plaintiffs filed various objections. On January 10, 2017, the District Court issued an additional ruling regarding certain aspects of the calculation of additional plan benefits. The Company's reserve for this litigation remains reasonable at December 31, 2016 based on calculations consistent with the Company's interpretation of the updated guidance from the Court. However, certain aspects of the ruling will need further clarification from the Court before final plan benefits can be determined. As a result, the timing of the resolution of this matter remains uncertain. Once resolved, the Plan will be amended to comply with the final interpretation of the District Court's order and the benefits will begin to be paid.
CMS actions. In January 2016, CMS issued a Notice of Imposition of Immediate Intermediate Sanctions (the "Notice") to the Company. The Notice required us to suspend certain enrollment and marketing activities for Medicare Advantage-Prescription Drug and Medicare Part D Plans. The sanctions do not impact the right of current enrollees to remain covered by our Medicare Advantage-Prescription Drug or Medicare Part D Plans. The Company continues to devote significant resources to our remediation efforts. For the year ended December 31, 2016, costs related to our CMS audit response were approximately $100 million after-tax.
CMS imposed sanctions based on its findings of deficiencies with the Company's operations of its Parts C and D appeals and grievances, Part D formulary and benefit administration and compliance program. While these matters were not resolved in time to participate in the 2017 Medicare Advantage and Part D annual enrollment period, we continue to work with CMS to address the audit findings and have the sanctions lifted as quickly as possible. We expect to have these sanctions lifted in time to participate in the 2018 annual enrollment period. The impact of disenrollment was not material to 2016 consolidated revenues and earnings. In 2017, Medicare enrollment and consolidated revenues will be materially impacted due to our inability to participate in 2017 annual enrollment. However, management does not anticipate that 2017 shareholders' net income will be materially affected because we expect to offset the margin impact of the revenue loss with several factors including significantly lower costs to remediate the sanctions and other operational efficiencies.
On October 12, 2016, CMS announced Medicare Star Quality Ratings ("Star Ratings") for 2017. While Star Ratings are based on a number of plan performance measures that are evaluated each year, the projected Star Ratings for our plans included certain reductions that are primarily attributable to our CMS audit discussed above. Under these revised Star Ratings, approximately 20% of our Medicare Advantage customers are expected to be in a 4 Stars or greater plan. The Company does not believe that these Star Ratings reflect the quality offerings Cigna-HealthSpring provides to beneficiaries.
Antitrust Litigation. On July 21, 2016, the U.S. Department of Justice ("DOJ") and certain state attorneys general filed a civil antitrust lawsuit in the U.S. District Court for the District of Columbia (the "District Court") seeking to block the merger and, on January 4, 2017, the parties concluded the District Court trial. On February 8, 2017, the District Court issued an order enjoining the proposed merger. Anthem filed a notice of appeal of the District Court's order with the U.S. Court of Appeals for the District of Columbia Circuit (the "Appeals Court") and requested an expedited appeal. On February 17, 2017, the Appeals Court granted Anthem's motion for an expedited appeal and set oral arguments for March 24, 2017. That same day, the Company filed its notice of appeal of the District Court's order with the Appeals Court.
Litigation with Anthem. On February 14, 2017, the Company delivered a notice to Anthem terminating the merger agreement, and notifying Anthem that it must pay the Company the $1.85 billion reverse termination fee pursuant to the terms of the merger agreement. Also on February 14, 2017, the Company filed suit against Anthem in the Delaware Court of Chancery (the "Chancery Court"). The complaint sought declaratory judgments that the Company's termination of the merger agreement was valid and that Anthem was not permitted to extend the termination date. The complaint also sought payment of the reverse termination fee and additional damages in an amount exceeding $13 billion, which includes the lost premium value to the Company's shareholders caused by Anthem's willful breaches of the merger agreement.
We believe in the merits of our claims and dispute Anthem's claims, and we intend to vigorously defend ourselves and pursue our claims. The outcomes of lawsuits are inherently unpredictable, and we may be unsuccessful in the ongoing litigation or any future claims or litigation.
• Special items, if any, are excluded because management believes they are not representative of the underlying results of operations. This is generally because the nature and size of these matters are not indicative of our ongoing business operations. Additional details about these items that provide further context as to why they are not considered indicative of ongoing business operations may be found in the footnotes referenced in the table below. The table below presents the special items recorded by the Company for the years ended December 31, 2016 and 2015. There were no special items recorded for the year ended 2014.
(1) Includes a $23 million bargain purchase gain for a 2015 acquisition.
Foreign and U.S. revenues from external customers for the three years ended December 31 are shown below. In the periods shown, no foreign country contributed more than 5% of consolidated revenues from external customers.
(1) Shareholders' net income includes after-tax charges related to the Company's proposed merger with Anthem as follows: $29 million in the third quarter of 2015, $28 million in the fourth quarter of 2015, $36 million in the first quarter of 2016, $26 million in the second quarter of 2016, $46 million in the third quarter of 2016 and $39 million in the fourth quarter of 2016. See Note 3 to the Consolidated Financial Statements for additional details.(2) Shareholders' net income includes an after-tax charge of $25 million for charges related to litigation matters in the third quarter of 2016. See Note 21 to the Consolidated Financial Statements for a description of litigation matters.(3) Shareholders' net income includes an after-tax charge of $65 million for the early extinguishment of debt in the second quarter of 2015. See Note 5 to the Consolidated Financial Statements for additional details.(4) Shareholders' net income includes an after-tax charge of $80 million for an allowance for the risk corridor receivable balance in the fourth quarter of 2016. See Note 22 to the Consolidated Financial Statements for additional details.