The selected financial data should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and accompanying notes included elsewhere herein.
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 our 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").
•Special items are excluded because management believes they are not representative of the underlying results of operations. See Note 22 to our Consolidated Financial Statements for descriptions of special items.
For further information on our business and strategy, please see Item 1, "Business" in this Form 10-K. See Note 1 to our Consolidated Financial Statements for a description of our reporting segments.
(1) See Consolidated Results of Operations beginning on page 38 for reconciliations of operating revenues to total revenues and adjusted income from operations to shareholders' net income on a dollar and per share basis.
2016 versus 2015 - Increase resulted from business growth across all of our ongoing reportable segments.
2017 versus 2016 - Increase due to higher adjusted income from operations across our reporting segments. Debt extinguishment costs and charges resulting from U.S. tax reform, both reported as special items in 2017, partially offset these increases.
2016 versus 2015 - Decrease due to lower adjusted income from operations, primarily in the Group Disability and Life segment. Increased special item charges in 2016 (primarily higher transaction costs and the 2016 risk corridor allowance) also contributed to the decline.
2017 versus 2016 - Increase driven by higher earnings in each of our ongoing reportable segments. These increases were primarily a result of customer growth in Global Health Care and Global Supplemental Benefits and increased specialty contributions in Global Health Care. Improved claim experience in Group Disability and Life also contributed to the increase.
2017 versus 2016 and 2016 versus 2015 - Increases in both 2017 and 2016 reflected growth in targeted markets for our Commercial segment. In 2017, these favorable effects were partially offset by expected disenrollment in the Government segment.
Major U.S. tax reform legislation was signed into law on December 22, 2017. The legislation is highlighted by a reduction in the corporate income tax rate from the current 35% to 21% effective January 1, 2018. As further described on page 39 of this Form 10-K, we expect a significant decline in our effective tax rate beginning in 2018 as a result of the rate reduction. The remaining provisions of the law, most of which take effect on January 1, 2018, are not expected to have a material impact on the Company's results of operations beginning in 2018.
Also as a result of tax reform, the Company recorded a reduction in operating expenses of $56 million ($36 million after-tax) reflecting a decrease in a liability to reimburse a reinsurer for taxes related to a block of business sold through reinsurance. An offsetting tax effect is included in the $144 million charge discussed above, resulting in no after-tax effect for this item.
See Note 20 to our Consolidated Financial Statements for additional information.
Consolidated Results of Operations: 2017 versus 2016 and 2016 versus 2015
•Net investment income increased in 2017 compared with 2016 driven by growth in average invested assets partially offset by lower yields. In 2016, net investment income decreased slightly compared with 2015, as lower investment yields in the protracted low interest rate environment were partially offset by higher average invested assets. Unfavorable foreign currency effects also contributed to the declines in 2016.
• Global Health Care medical costs. The increases in 2017 and 2016 compared with each prior year resulted primarily from customer growth in our commercial health care businesses and medical cost trend. In 2017, the impact of Medicare disenrollment partially offset these effects.
• Other benefit expenses declined slightly in 2017 compared with 2016 as improvements in our disability and life claims experience were largely offset by customer growth in Global Supplemental Benefits. The increase in 2016 compared with 2015 was driven by unfavorable disability and life claim experience due primarily to changes in the disability claims management process in 2016 and elevated life claims during the second quarter of 2016. Business growth in our Group Disability and Life and Global Supplemental Benefits segments also contributed to the 2016 increase.
ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The "Regulation" section of this Form 10-K provides a detailed description of The Patient Protection and Affordable Care Act (the "ACA") provisions and other legislative initiatives that impact our health care business, including regulations issued by CMS and the Departments of the Treasury and Health and Human Services ("HHS"). In October 2017, President Trump issued an executive order that could result in a variety of changes to the individual and group health insurance markets when implemented. At this time, we are unable to determine the effect, if any, of these changes on our business or results of operations. In addition, the President ordered the immediate cessation of cost sharing reduction subsidy payments to insurers. Discussions on the ACA continue in the U.S. Congress. The table presented below provides an update of the impact of these items and other matters affecting our Global Health Care segment as of December 31, 2017.
See Note 2(K) to our Consolidated Financial Statements for a description of and our accounting policy for these programs that commenced in 2014. The risk corridor and reinsurance programs ended as of December 31, 2016.
• maintaining appropriate levels of cash and various types of marketable investments; • collecting dividends from its subsidiaries; • using proceeds from issuance of debt and equity securities; and • borrowing from its subsidiaries, subject to applicable regulatory limits.
(2) As required in adopting ASU 2016-15 in 2016, the Company retrospectively reclassified cash distributions from partnership earnings of $137 million from investing to operating activities in 2015. The comparable amounts reported in operating activities were $161 million in 2017 and $144 million in 2016.
Cash flows from operating activities increased slightly in 2017 compared with 2016 primarily driven by higher net income, partially offset by lower receipts from Medicare Part D and Medicare Advantage programs and a voluntary pension contribution of $150 million in 2017.
Cash used in financing activities increased in 2017 compared with 2016, primarily due to higher share repurchases. The 2017 proceeds from the Company's $1.6 billion debt issuance were largely offset by $1.3 billion paid to extinguish $1.0 billion of debt, as well as repaying maturing debt in the first quarter of 2017.
Cash used in financing activities decreased in 2016 compared with 2015, primarily due to lower share repurchases offset by lower proceeds from employees' exercise of stock options.
Our cash projections may not be realized and the demand for funds could exceed available cash if our ongoing businesses experience unexpected shortfalls in earnings, or we experience material adverse effects from one or more risks or uncertainties described more fully in the Risk Factors section of this Form 10-K. In those cases, we expect to have the flexibility to satisfy liquidity needs through a variety of measures, including intercompany borrowings. The parent company may borrow up to $1.1 billion from its insurance subsidiaries without additional state approval. We have additional liquidity available through short-term commercial paper borrowings and a committed $1.5 billion revolving credit facility. The revolving credit and letter of credit agreement is subject to the maximum debt leverage covenant. As of December 31, 2017, we have $9.3 billion of maximum borrowing capacity in the debt leverage covenant, in addition to the $5.4 billion of debt outstanding. See Note 5 to our Consolidated Financial Statements for additional information regarding the credit facility.
The state of Illinois continues to experience financial difficulties; however, some of their immediate cash flow constraints were alleviated by a bond offering issued during the fourth quarter of 2017. As a result, we have collected most of the receivables due as of December 31, 2017. The remaining amount due to us from the state of Illinois under our commercial and Medicaid contracts as of December 31, 2017 was immaterial. As of December 31, 2017, all of our contracts with the state of Illinois had been terminated.
Unfunded Pension Plan Liability. As of December 31, 2017, our unfunded pension liability was $688 million, reflecting a decrease of $223 million from December 31, 2016. The decrease in the unfunded liability reflected strong investment asset returns and a contribution of $150 million in 2017, partially offset by the impact of a decrease in discount rates of approximately 45 basis points. No contributions are required in 2018 under the Pension Protection Act of 2006. See Note 15 to our Consolidated Financial Statements for additional information regarding our pension plans.
•Contractholder deposit funds: see Note 2(F) to our Consolidated Financial Statements for our accounting policy for this liability. Expected future cash flows presented above also include estimated future interest crediting on current fund balances based on current investment yields less the estimated cost of insurance charges and mortality and administrative fees for universal life policies.
•Future policy benefits, Global Health Care medical costs payable and unpaid claims and claim expenses: see Notes 2(G), 7 and 8 to our Consolidated Financial Statements for our accounting policies for these liabilities. Expected future cash flows for these liabilities presented in the table above are undiscounted. The expected future cash flows for guaranteed minimum death benefit ("GMDB," reported in future policy benefits) do not consider any of the related reinsurance arrangements.
•Short-term debt represents current maturities of long-term debt and related interest payments, and current obligations under capital leases.
•Other long-term liabilities include estimated payments for guaranteed minimum income benefit ("GMIB") contracts (without considering any related reinsurance arrangements), pension and other postretirement and postemployment benefit obligations, supplemental and deferred compensation plans, interest rate and foreign currency swap contracts, and reinsurance liabilities. These items are presented in accounts payable, accrued expenses and other liabilities in our Consolidated Balance Sheets. Estimated payments of $68 million for deferred compensation, non-qualified and international pension plans and other postretirement and postemployment benefit plans are expected to be paid in less than one year and are included in the table above. We do not expect to make any additional contributions to the qualified domestic pension plans during 2018. We expect to make payments subsequent to 2018 for these obligations; however, subsequent payments have been excluded from the table as their timing is based on plan assumptions that may materially differ from actual activities. See Note 15 to our Consolidated Financial Statements for further information on pension and other postretirement benefit obligations.
See Note 11 to our Consolidated Financial Statements for additional information.
We are contingently liable for various financial and other guarantees provided in the ordinary course of business. See Note 21 to our Consolidated Financial Statements for additional information on guarantees.
• changes in the estimate or different estimates that could have been selected could have a material effect on our consolidated results of operations or financial condition. Management has discussed the development and selection of its critical accounting estimates with the Audit Committee of our Board of Directors and the Audit Committee has reviewed the disclosures presented below.
In addition to the estimates presented in the following table, there are other accounting estimates used in the preparation of our Consolidated Financial Statements, including estimates of liabilities for future policy benefits, as well as estimates with respect to postemployment and postretirement benefits other than pensions, certain compensation accruals, and income taxes.
Management believes the current assumptions used to estimate amounts reflected in our Consolidated Financial Statements are appropriate. However, if actual experience differs from the assumptions used in estimating amounts reflected in our Consolidated Financial Statements, the resulting changes could have a material adverse effect on our consolidated results of operations and, in certain situations, could have a material adverse effect on our liquidity and financial condition. The table below presents the adverse impacts of certain possible changes in assumptions. The effect of assumption changes in the opposite direction would be a positive impact to our consolidated results of operations, liquidity or financial condition, except for the assessments of impairment for goodwill and fixed maturities carried at a fair value below cost. The tax rate used to calculate the after-tax impact of assumption changes is based on the new corporate income tax rate discussed in the "Key Developments" section of this MD&A.
See Note 2 to our Consolidated Financial Statements for further information on significant accounting policies.
At the acquisition date, goodwill represents the excess of the cost of businesses acquired over the fair value of their net assets. We completed our annual evaluations of goodwill for impairment during the third quarter of 2017. These evaluations were performed at the reporting unit level, based on discounted cash flow analyses or market data. The evaluations indicated that no impairment was required.
Future changes in the funding for our Medicare programs by the federal government could materially reduce revenues and profitability in our Government reporting unit and have a significant impact on its fair value.
In our Government operating segment we contract with CMS and various state governmental agencies to provide managed health care services, including Medicare Advantage plans and Medicare-approved prescription drug plans. Estimated future cash flows for this reporting unit's business incorporate the potential effects of Medicare Advantage reimbursement rates for 2018 and beyond as discussed in the "Executive Overview" section of this MD&A. Revenues from the Medicare programs are dependent, in whole or in part, upon annual funding from the federal government through CMS. Funding for these programs is dependent on many factors including general economic conditions, continuing government efforts to contain health care costs and budgetary constraints at the federal level and general political issues and priorities.
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. Based on our historical experience, we believe that a 50 basis point change in the discount rate and a 10% decline in plan assets are reasonably possible outcomes.
If discount rates for the qualified and nonqualified pension plans decreased by 50 basis points, the accrued pension benefit liability would increase by approximately $190 million as of December 31, 2017, resulting in an after-tax decrease to shareholders' equity of approximately $150 million.
If the December 31, 2017 fair values of domestic qualified plan assets decreased by 10%, the accrued pension benefit liability would increase by approximately $425 million as of December 31, 2017, resulting in an after-tax decrease to shareholders' equity of approximately $335 million.
Medical costs payable for the Global Health Care segment includes both reported claims and estimates for losses incurred but not yet reported. The liabilities for medical costs payable as of December 31 were as follows (in millions):
See Note 7 to our Consolidated Financial Statements for additional information regarding assumptions and methods used to estimate this liability.
See Note 8 to our Consolidated Financial Statements for additional information regarding assumptions and methods used to estimate this liability.
The discount rate is the interest rate used to discount the projected future benefit payments to their present value. The discount rate assumption is based on the projected investment yield of the assets supporting the reserves. A 25 basis point decrease in the discount rate would increase long-term disability reserves by approximately $45 million and decrease net income by approximately $35 million after-tax.
See Note 11 to our Consolidated Financial Statements for additional discussion of our review of declines in fair value, including information regarding our accounting policies for fixed maturities.
If we subsequently determine that the excess of amortized cost over fair value is other-than-temporary for any or all of these fixed maturities, the amount recorded in accumulated other comprehensive income would be reclassified to shareholders' net income as an impairment loss.
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 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 our Consolidated Financial Statements for additional discussion of these metrics.
• operating expense as a percentage of operating revenues (operating expense ratio).
Operating revenues. The increase was primarily due to customer growth in our Commercial risk business, partially offset by lower customer enrollment in our Government segment.
Adjusted income from operations increased, reflecting higher earnings in both our Commercial and Government operating segments. The increase in the Commercial segment reflects customer growth including increased contributions from our specialty products and favorable claim experience in our U.S. Individual business. The Government segment's earnings growth reflects lower operating expenses related to the moratorium on the health insurance industry tax in 2017 and our 2016 CMS audit response, partially offset by lower customer enrollment. Adjusted income from operations included favorable after-tax prior year reserve development of $112 million for 2017; prior year reserve development in 2016 was not material.
Medical care ratios. The Commercial medical care ratio increased, reflecting the 2017 moratorium on the health insurance industry tax, offset by improved performance in our U.S. Individual business and favorable prior year reserve development.
Operating expense ratio. The decrease was primarily due to the moratorium on the health insurance industry tax in 2017 and lower costs related to our 2016 CMS audit response.
Operating revenues. The increase in operating revenues was due to growth in our Commercial segment primarily from increased specialty revenues and growth in Medicare Advantage customer volumes. Higher premium rates for most products (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.
Adjusted income from operations was flat, 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.
Medical care ratios. The Commercial medical care ratio increased, reflecting a less favorable medical care ratio in our stop loss business, lower premium due to the anticipated reduction of the ACA mandated fees in 2017 and less favorable prior year reserve development.
The Government medical care ratio increased slightly, reflecting higher medical costs in our Medicaid business and less favorable prior year development, mostly offset by improvements in the Medicare Part D business.
Operating expense ratio. The operating expense ratio increased slightly, 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.
As described in the Segment Reporting introduction on page 47, 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:
The acquisition cost ratio decreased due to lower spending in certain markets and a shift toward higher premium markets with lower acquisition costs, primarily in South Korea and the United States.
The decrease in the expense ratio (excluding acquisition costs) was primarily driven by strong expense management.
Operating revenues were higher primarily due to new sales, particularly in South Korea and the United States, 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.
Adjusted income from operations increased 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.
As a global company, our business is exposed to risks inherent in foreign operations. We continue to monitor and evaluate the impacts of tensions in the Korean Peninsula.
During the first half of 2016, the Group Disability and Life segment experienced significant unfavorable claims in its disability and life businesses. While claims experience moderated during the second half of 2016 and normalized in 2017, the first half results dampened full year 2016 earnings.
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 have normalized in subsequent periods.
Adjusted income from operations increased in 2017 compared with 2016 reflecting lower disability new claim incidence and a higher resolution rate as modifications to the disability claims management process discussed above continued to mature. In addition, life claims have returned to normal levels after a period of significantly elevated claims and a $17 million after-tax unfavorable reserve review, both in the second quarter of 2016.
Operating revenues. Premiums and fees increased in 2016 compared with 2015 due to new business growth from disability and life sales. Net investment income also increased primarily due to higher average assets partially offset by lower yields.
Adjusted income from operations. Results decreased in 2016 compared with 2015 due primarily to unfavorable disability and life claims experience as well as the absence of favorable reserve reviews and a higher operating expense ratio. Results in 2016 included the unfavorable impact of reserve reviews of $18 million after-tax compared with a favorable impact of $55 million after-tax in 2015.
The loss ratio increased in 2016 compared with 2015 due to lower claim resolutions in disability, higher life claim incidence and sizes in the second quarter of 2016, and the unfavorable impact of reserve reviews as discussed above.
As described in the Segment Reporting introduction on page 47, 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.
Operating revenues decreased in 2017 compared with 2016 primarily due to lower investment income yields across all businesses, partially offset by lower ceded premiums in the COLI business. The decrease in operating revenues in 2016 compared with 2015 was largely due to lower net investment income driven by lower investment yields.
Adjusted income from operations in 2017 decreased compared with 2016, reflecting less favorable mortality experience partially offset by higher interest margins in COLI. Adjusted income from operations decreased in 2016 compared with 2015, reflecting less favorable mortality experience and lower interest margins in COLI.
Corporate reflects amounts not allocated to operating segments, including 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 and related excess tax benefits, expense associated with our frozen pension plans and certain overhead and project costs.
The following table reflects our fixed maturity portfolio by type of issuer as of December 31, 2017 and 2016.
The fixed maturity portfolio increased $2.2 billion during the 12 months ended December 31, 2017, primarily reflecting an increase in investable funds. As of December 31, 2017, $20.5 billion, or 89%, of the fixed maturities in our investment portfolio were investment grade (Baa and above, or equivalent), and the remaining $2.6 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.
State and local government. Our investment in state and local government securities, with an average quality rating of Aa2, was diversified by issuer and geography with no single exposure greater than $35 million as of December 31, 2017. We assess each issuer's credit quality based on a fundamental analysis of underlying financial information and do not rely solely on statistical rating organizations or monoline insurer guarantees.
• Private placement investments were $6 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 $1.8 billion with gross unrealized losses of $9 million. These investments have an average quality rating of Baa2 and are diversified by issuer with no single exposure greater than $65 million.
• Retail sector fixed maturity investments were approximately $460 million with gross unrealized losses of $3 million. These investments had an average quality rating of Baa2 and were diversified across approximately 40 issuers with no exposure exceeding $50 million.
In addition to amounts classified in fixed maturities on our Consolidated Balance Sheets, we operate an insurance 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 had an investment portfolio of approximately $4.9 billion supporting this business that is primarily invested in local Chinese corporate and government fixed maturities. There were no investments with a material unrealized loss as of December 31, 2017.
As of December 31, 2017, approximately $400 million in equity securities were invested in an exchange traded fund ("ETF") as part of a program to invest available cash in high quality and liquid assets. The underlying assets of the ETF are primarily U.S. investment grade corporate bonds and there was a gross unrealized gain of $10 million as of December 31, 2017 due to a decrease in market yields since purchase.
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 originate or service securitized mortgage loans.
Commercial real estate capital markets remain very active for well-leased, quality commercial real estate located in strong institutional investment markets. The vast majority of properties securing the mortgages in our mortgage loan portfolio possess these characteristics. As of December 31, 2017, we had $135 million of commercial mortgage loans in the retail sector for various shopping centers in the United States. The loan-to-value ratio for these loans was 49%, and the debt service coverage ratio was 2.15. All of these loans are current.
As of December 31, 2017, the $1.8 billion commercial mortgage loan portfolio consisted of approximately 60 loans that are all in good standing. Given the quality and diversity of the underlying real estate, positive debt service coverage and significant borrower cash 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 included investments in securities limited partnerships and real estate limited partnerships 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 for higher expected returns. To mitigate risk, these investments are diversified across approximately 125 separate partnerships, and approximately 60 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 exceeded 4% of our securities and real estate partnership portfolio.
• 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); and
• changes in the fair values of other significant assets and liabilities such as goodwill, deferred policy acquisition costs, taxes, and various accrued liabilities. Because they are not financial instruments, their primary risks are other than market risk. Excluding these items, our primary market risk exposures from financial instruments are:
•Interest-rate risk on fixed-rate, medium-term instruments. Changes in market interest rates affect the value of instruments that promise a fixed return.
• Use of local currencies for foreign operations. We generally conduct our international business through foreign operating entities that maintain assets and liabilities in local currencies. While this technique does not reduce foreign currency exposure on our net assets, it substantially limits exchange rate risk to those net assets.
• a hypothetical strengthening of the U.S. dollar to foreign currencies, primarily for financial instruments held by foreign subsidiaries denominated in a foreign currency. 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, 2017 was greater than that at December 31, 2016 reflecting increased purchases of fixed maturities partially offset by additional issuances of long-term debt.
• The Government operating segment ("Government segment") offers Medicare Advantage and Medicare Part D plans to seniors. This segment also offers Medicaid plans in selected markets. Global Supplemental Benefits includes supplemental health, life and accident insurance products offered in selected international markets and in the United States.
• deferred gains recognized from the 1998 sale of the individual life insurance and annuity business and the 2004 sale of the retirement benefits business; and
• run-off settlement annuity business. Corporate reflects amounts not allocated to operating segments, including 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 and related excess tax benefits, expense associated with our frozen pension plans and certain overhead and project costs.
Variable interest entities. See Note 13 for a discussion of consolidated variable interest entities.
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 a rolling average of benchmark interest rates.
•Other products are expensed as incurred. Deferred policy acquisition costs also include the value of business acquired for certain acquisitions with material long-duration insurance contracts. The Company recorded amortization of deferred policy acquisition costs of $322 million in 2017, $292 million in 2016 and $286 million in 2015 primarily in other operating expenses.
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 expected to be paid to policyholders, net of future premiums expected 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.
As of December 31, 2017 the redeemable noncontrolling interests on our Consolidated Balance Sheets represent the Turkey joint venture partner's preferred and common stock interests in the entity. Our joint venture partner may, at their election, require the Company to purchase their redeemable noncontrolling interests. We also have the right to require our joint venture partner 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.
Premiums received for the Company's Medicare Advantage Plans and Medicare Part D products from the Centers for Medicare and Medicaid Services ("CMS") and customers are recognized as revenue ratably over the contract period. CMS provides risk-adjusted premium payments for Medicare Advantage Plans and Medicare Part D products based on the demographics and wellness of enrollees. The Company recognizes periodic changes to risk-adjusted premiums as revenue when the amounts are determinable and collection is reasonably assured. Additionally, Medicare Part D premiums include payments from CMS for risk sharing adjustments. The risk sharing adjustments are estimated quarterly based on claim experience by comparing actual incurred drug benefit costs to estimated costs submitted in original contracts. These adjustments may result in more or less revenue from CMS. Final revenue adjustments are determined and settled with CMS in the year following the contract year. Premium revenue also includes an adjustment to reflect the estimated effect of rebates due to CMS under the Medicare Advantage and Medicare Part D minimum medical loss ratio provisions of the ACA.
• The risk adjustment program reallocates funds from insurers with lower risk populations to insurers with higher risk populations based on the relative risk scores of participants in non-grandfathered plans in the individual and small group markets, both on and off the exchanges. We estimate our receivable or payable based on the risk of our members compared to the risk of other members in the same state and market, considering data obtained from industry studies and the United States Department of Health and Human Services ("HHS"). Receivables or payables are recorded 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.
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 fees or a stated dollar amount. The Company defers revenues for estimated payouts associated with these performance guarantees. Approximately 11% of ASO fees reported for the year ended December 31, 2017 were at risk under performance guarantees, with reimbursements estimated to be less than 1% of revenues.
• Contract fees based upon related administrative expenses are recognized in fees and other revenues as they are earned ratably over the contract period. Benefits and expenses for investment-related products consist primarily of income credited to policyholders in accordance with contract provisions.
The following table presents transaction-related costs incurred by the Company for the years ended December 31, 2017, 2016 and 2015. Transaction-related costs primarily consist of fees for legal, advisory and other professional services as well as employee costs. In addition, because the merger with Anthem, Inc. ("Anthem") was not consummated, certain transaction-related costs that were previously not deductible for federal income tax purposes became deductible. The Company recognized an incremental tax benefit for these newly deductible costs in 2017 as presented below.
In the third quarter of 2017, the Company entered into two significant debt transactions: the issuance of new debt and a cash tender offer to retire a portion of outstanding debt. These transactions are described in more detail below.
During the first quarter of 2017, the Company repaid $250 million of long-term notes that had matured.
In April 2015, the Company redeemed two of its outstanding notes early. The Company paid $955 million, including accrued interest and expenses that resulted in a pre-tax loss on early debt extinguishment of $100 million ($65 million after-tax).
In December 2017, the Company entered into an updated revolving credit and letter of credit agreement. This agreement extends through December 2022 and is diversified among 15 banks. Under this agreement, the Company can borrow up to $1.5 billion for general corporate purposes, of which up to $500 million can be used for letters of credit. The credit agreement includes options to increase the commitment amount to $2 billion and to extend the term past December 2022, subject to consent by the lenders. The agreement contains customary covenants and restrictions, including a financial covenant that the Company may not permit its leverage ratio - total consolidated debt to total consolidated capitalization (each as defined in the credit agreement) - to be greater than 50%. The Company was in compliance with its debt covenants as of December 31, 2017.
As of December 31, 2017, the Company had $9.3 billion of borrowing capacity within the maximum debt leverage covenant in the credit agreement, in addition to $5.4 billion of debt outstanding. The Company had $11 million of letters of credit outstanding as of December 31, 2017.
The Company has authorized a total of 25 million shares of $1 par value preferred stock. No shares of preferred stock were outstanding at December 31, 2017, 2016 or 2015.
This liability predominately consists of incurred but not reported amounts and reported claims in process including expected development on reported claims. The liability is primarily calculated using "completion factors" developed by comparing the claim incurral date to the date claims were paid. Completion factors are impacted by several key items including changes in: 1) electronic (auto-adjudication) versus manual claim processing, 2) provider claims submission rates, 3) membership and 4) the mix of products. The Company uses historical completion factors combined with an analysis of current trends and operational factors to develop current estimates of completion factors. The Company estimates the liability for claims incurred in each month by applying the current estimates of completion factors to the current paid claims data. This approach implicitly assumes that historical completion rates will be a useful indicator for the current period.
For each reporting period, the Company compares key assumptions used to establish the medical costs payable to actual experience. When actual experience differs from these assumptions, medical costs payable are adjusted through current period shareholders' net income. Additionally, the Company evaluates expected future developments and emerging trends that may impact key assumptions. The process used to determine this liability requires the Company to make critical accounting estimates that involve considerable judgment, reflecting the
variability inherent in forecasting future claim payments. These estimates are highly sensitive to changes in the Company's key assumptions, specifically completion factors and medical cost trends.
Activity in medical costs payable for the years ended December 31 was as follows:
Reinsurance and other amounts recoverable reflect amounts due from reinsurers and policyholders to cover incurred but not reported and pending claims for certain business where the Company administers the plan benefits but the right of offset does not exist. See Note 9 for additional information on reinsurance.
The total of incurred but not reported liabilities plus expected development on reported claims, including reported claims in process, was $2.6 billion at December 31, 2017 and $2.4 billion at December 31, 2016. The remaining balance in both periods reflects amounts due for physician incentives and other medical care expenses and services payable.
(1) Percentage of current year incurred costs as reported for 2016.
(3) Other amounts in 2017 primarily related to an increase in the 2016 reinsurance reimbursement rate from CMS under the ACA. Other amounts in 2016 primarily related to increased medical costs in the Government segment resulting from sharing additional risk adjustment revenue with providers.
Incurred costs related to prior years in the table above, although adjusted through shareholders' net income, do not directly correspond to an increase or decrease to shareholders' net income. The primary reason for this difference is that decreases to prior year incurred costs pertaining to the portion of the liability established for moderately adverse conditions are not considered as impacting shareholders' net income if they are offset by increases in the current year provision for moderately adverse conditions.
The net impact of prior year development on shareholders' net income was a $112 million increase for the year ended December 31, 2017. The net impact of prior year development on shareholders' net income was insignificant in 2016. Favorable prior year development implies primarily lower than expected utilization of medical services and vice versa while amounts close to zero imply utilization of medical services that are consistent with expectations.
The following table depicts the incurred and paid claims development as of December 31, 2017 (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, 2016 is presented as supplementary information and is unaudited.
There is no single or common claim frequency metric used in the health care industry. The Company believes a relevant metric for the Global Health Care segment is the number of customers for whom an insured medical claim was paid. Customers for whom no insured medical claim was paid are excluded from the calculation. Claims that did not result in a liability are not included in the frequency metric.
Accounting policy. Liabilities for unpaid claims and claim expenses are established by book of business within the Company's Group Disability and Life, Global Supplemental Benefits and Other Operations segments. The Group Disability and Life segment's liability for unpaid claims and claim expenses consists of the following primary products: long-term and short-term disability, life insurance, and accident coverages. Unpaid claims and claim expenses consist of (1) case or claims reserves for reported claims that are unpaid as of the balance sheet date; (2) incurred but not reported reserves for claims when the insured event has occurred but has not been reported to the Company; and (3) loss adjustment expense reserves for the expected costs of settling these claims. The Company consistently estimates incurred but not yet reported losses using actuarial principles and assumptions based on historical and projected claim incidence patterns, claim size and the expected payment period. The Company recognizes the actuarial best estimate of the ultimate liability within a level of confidence, consistent with actuarial standards of practice that the liabilities be adequate under moderately adverse conditions. When estimates of these liabilities change, the Company immediately records the adjustment in benefits and expenses.
The majority of the Company's liability for disability claims consists of the present value of estimated future benefit payments, including expected development, for each reported claim that is currently receiving benefit payments, or pending a decision on eligibility for benefits, 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.
The Company discounts certain liabilities, predominantly long-term disability, because benefits payments are made over extended periods. Discount rate assumptions for these liabilities are based on projected investment returns for the supporting asset portfolios. Details of the Company's unpaid claim discounted liability balances as of December 31 were as follows:
Interest is accreted and recognized in other benefit expenses in the Consolidated Statement of Income.
Reinsurance in the previous table reflects amounts due from reinsurers related to unpaid claims liabilities. The Company's insurance subsidiaries enter into agreements with other companies primarily to limit losses from large exposures and to permit recovery of a portion of incurred losses. See Note 9 for additional information on reinsurance.
The majority of the liability for unpaid claims and claim expenses is related to disability claims with long-tailed payouts. Interest earned on assets backing these liabilities is an integral part of pricing and reserving. Therefore, interest accreted on prior year balances is shown as a separate component of prior year incurred claims. This interest is calculated by applying the average discount rate used in determining the liability balance to the average liability balance over the period. The remaining prior year incurred claims amount primarily reflects updates to the Company's liability estimates and variances between actual experience during the period relative to the assumptions and expectations reflected in determining the liability. Assumptions reflect the Company's expectations over the life of the book of business and will vary from actual experience in any period, both favorably and unfavorably, with variation in resolution rates being the most significant driver for the long-term disability business. Prior year incurred claims reported in 2016 included the impact of changes made to our disability claims management process and a period of elevated life claims.
The other short-duration insurance books of business, net of reinsurance, primarily include liabilities for life, accident and short-term disability insurance products. Liabilities for these products are typically complete within one year. Claim development on these liabilities is largely driven by completion factors and loss ratio assumptions. In 2016, development on these liabilities was driven by a period of elevated life claims.
The Company's insurance subsidiaries enter into agreements with other insurance companies to assume and cede reinsurance. Reinsurance is ceded primarily to limit losses from large exposures and to permit recovery of a portion of direct or assumed losses. Reinsurance is also used in acquisition and disposition transactions when the underwriting company is not being acquired. Reinsurance does not relieve the originating insurer of liability. Therefore, reinsured liabilities must continue to be reported along with the related reinsurance recoverables. The Company regularly evaluates the financial condition of its reinsurers and monitors concentrations of its credit risk.
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. The Company reviews its reinsurance arrangements and establishes reserves against the recoverables if recovery is not considered probable.
GMDB is accounted for as reinsurance and GMIB assets and liabilities are reported as derivatives at fair value as discussed below. GMIB assets are reported in other assets, including intangibles, and GMIB liabilities are reported in accounts payable, accrued expenses and other liabilities.
Because the product is premium deficient, the Company records an increase to the net retained reserve if it is inadequate based on the model.
As of December 31, 2017 and 2016, there were three reinsurers for GMIB as follows:
Assumptions used in fair value measurement. GMIB assets and liabilities are established using capital market assumptions (including market returns, interest rates and market volatilities of the underlying equity and bond mutual fund investments) and assumptions related to future annuitant behavior (including mortality, lapse, and annuity election rates). As assumptions related to future annuitant behavior are largely unobservable, the Company classifies GMIB assets and liabilities in Level 3 in the fair value hierarchy presented in Note 10.
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 (2018 through 2022); and
• all underlying mutual fund investment values remained at the December 31, 2017 value of $822 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 $573 million, which is lower than the recorded liability for GMIB calculated using fair value assumptions.
Nearly all of these instruments are valued using recent trades or pricing models. Less than 1% of the fair value of investments classified in Level 2 represents foreign bonds that are valued using a single unadjusted market-observable input derived by averaging multiple broker-dealer quotes, consistent with local market practice.
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, 2017 or 2016. Level 2 also includes exchange-traded interest rate swap contracts.
• Realized investment gains (losses) and net investment income for amounts related to fixed maturities and equity securities and realized investment gains (losses) for the impact of changes in non-performance risk related to GMIB assets and liabilities, similar to hedge ineffectiveness; and
Accounting policy. Separate account assets and liabilities are contractholder funds maintained in accounts with specific investment objectives. The assets of these accounts are legally segregated and are not subject to claims that arise out of any of the Company's other businesses. These separate account assets are carried at fair value with equal amounts recorded for related separate account liabilities. The investment income and fair value gains and losses of these accounts generally accrue directly to the contractholders and, together with their deposits and withdrawals, are excluded from the Company's Consolidated Statements of Income and Cash Flows. Fees and charges earned for mortality risks, asset management or administrative services are reported in either premiums or fees and other revenues. Investments that are measured using the practical expedient of Net Asset Value ("NAV") are excluded from the fair value hierarchy.
• actively-traded institutional and retail mutual fund investments. 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, 2017 and 2016.
Fair values of off-balance sheet financial instruments were not material as of December 31, 2017 and 2016.
Accounting policy. Fixed maturities (including bonds, mortgage and other asset-backed securities and preferred stocks redeemable by the investor) and most equity securities are classified as available for sale and are carried at fair value with changes in fair value recorded in accumulated other comprehensive income (loss) within shareholders' equity. Net unrealized appreciation on investments supporting the Company's run-off settlement annuity business is reported in future policy benefit liabilities rather than accumulated other comprehensive income (loss).
The Company records impairment losses in net income for fixed maturities with fair value below amortized cost that meet either of the following conditions:
• If the Company intends to sell or determines that it is more likely than not to be required to sell these fixed maturities before their fair values recover, an impairment loss is recognized for the excess of the amortized cost over fair value.
• 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.
As of December 31, 2017, the Company had commitments to extend credit under commercial mortgage loan agreements of $21 million.
The following table summarizes 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, 2017 and 2016:
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 2017 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 for each loan.
As of December 31, 2017 and 2016, impaired commercial mortgage loans and valuation reserves associated with impaired loans were not material. For the years ended December 31, 2017 and 2016, the average recorded investment in impaired loans and interest income on impaired loans were not material.
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, 2017 and 2016 is expected to be held longer than one year and includes real estate acquired through the foreclosure of commercial mortgage loans.
Other long-term investments and related commitments are diversified by issuer, property type and geographic regions. The following table provides unfunded commitment and fair value information on these investments. The Company expects to disburse approximately 31% of the committed amounts in 2018.
Short-term investments and cash equivalents included the following types of issuers:
As of December 31, 2017 and 2016, the Company did not have a concentration of investments in a single issuer or borrower exceeding 10% of shareholders' equity.
(1) Net investment income for these investments is excluded from the Company's revenues.
Real estate investments and securities partnerships with a carrying value of $191 million at December 31, 2017 and $220 million at December 31, 2016 were non-income producing during the preceding twelve months.
Accounting policy. Realized investment gains and losses are based on specifically identified assets and result from sales, investment asset write-downs, changes in the fair values of certain derivatives and changes in valuation reserves on commercial mortgage loans.
The following table presents sales information for available-for-sale fixed maturities and equity securities for the years ended December 31. Gross gains on sales and gross losses on sales exclude amounts required to adjust future policy benefits for the run-off settlement annuity business.
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 further discussed in Note 9. Derivatives in the Company's
Accounting policy. The Company applies hedge accounting when derivatives are designated, qualified and highly effective as hedges. Effectiveness is formally assessed and documented at inception and each period throughout the life of a hedge using various quantitative methods appropriate for each hedge, including regression analysis and dollar offset. Under hedge accounting, the changes in fair value of the derivative and the hedged risk are generally recognized together and offset each other when reported in shareholders' net income. Changes in the fair value of a derivative instrument may not always equal changes in the fair value of the hedged item. This is referred to as "hedge ineffectiveness" and is generally recorded in realized investment gains and losses. In the event of an early hedge termination, the changes in fair value of derivatives that qualified for hedge accounting are reported in shareholders' net income, generally as a part of realized investment gains and losses. Derivative cash flows are generally reported in operating activities.
Purpose. To convert a portion of the interest rate exposure on the Company's long-term debt from fixed to variable rates. This more closely aligns the Company's interest expense with the interest income received on its cash equivalent and short-term investment balances. The variable rates are benchmarked to LIBOR.
Purpose. To hedge the foreign exchange related changes in fair values of a U.S. dollar-denominated fixed maturity bond portfolio to reflect the local currency for one of the Company's foreign subsidiaries.
As of and for the years ended December 31, 2017 and 2016, the effects of these derivative instruments on the Consolidated Financial Statements were not material, including the amounts of gains or losses reclassified from accumulated other comprehensive income into shareholders' net income. No material amounts were excluded from the assessment of hedge effectiveness and no significant gains or losses were recognized due to hedge ineffectiveness.
• 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, 2017 and 2016, the Company determined it was not a primary beneficiary in any material variable interest entities. The Company's involvement in variable interest entities where it is not the primary beneficiary is described below.
Other asset-backed and corporate securities. In the normal course of its investing activities, the Company also makes passive investments in certain asset-backed and corporate securities that are issued by variable interest entities whose sponsors or issuers are unaffiliated with the Company. The Company receives fixed-rate cash flows from these investments and the maximum potential exposure to loss is limited to the carrying amount of $0.6 billion as of December 31, 2017 that is reported in fixed maturities. The Company's combined ownership interests are insignificant relative to the total principal amounts issued by these entities.
The Company is also involved in real estate joint ventures, independent physician associations ("IPAs") and a joint venture in India that are variable interest entities. The carrying values and maximum exposures associated with these arrangements are immaterial.
AOCI includes the Company's share from entities accounted for using the equity method. AOCI excludes amounts required to adjust future policy benefits for the run-off settlement annuity business and a portion of deferred acquisition costs associated with the corporate-owned life insurance business. Changes in the components of accumulated other comprehensive income (loss) were as follows:
For balance sheet purposes, we measure plan assets at fair value. When the actual return differs from the expected return, those differences are reflected in the net unrealized actuarial gain (loss) discussed above. However, to measure pension benefit costs, we use a "market-related" asset valuation that differs from the actual fair value for domestic pension plan assets invested in non-fixed income investments. The "market-related" value recognizes the difference between actual and expected long-term returns in the portfolio over five years, a method that reduces the short-term impact of market fluctuations on pension costs. At December 31, 2017, the market-related asset value was approximately $4.1 billion compared with a fair value of approximately $4.3 billion.
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. For 2018, we do not expect to make any 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.
We expect to recognize pre-tax losses of $69 million in 2018 from amortization of the net actuarial loss in our pension plans and pre-tax gains of $3 million in 2018 from amortization of prior service cost in the other postretirement benefit plans. These estimates are based on a weighted average amortization period for the frozen and inactive plans that is based on the average expected remaining life of plan participants of approximately 26 years.
The Company used the Society of Actuaries mortality table RP2014 and the updated improvement scales published in 2016 and 2017 to value its benefit obligations because the Company's mortality experience closely matched these tables based on internal studies. The updated improvement scales published in 2016 and 2017 both indicated that mortality improvement is expected to be lower than was originally projected when the study was first published in 2014, resulting in decreases to the benefit obligations in both years.
The Company may elect to increase its matching contributions if the Company's annual performance meets certain targets. The Company's annual expense for these plans was as follows:
Shares of common stock available for award at December 31 were as follows:
Compensation cost for stock options recorded in operating expenses was as follows for the years ended December 31:
Compensation expense of $39 million related to unvested stock options at December 31, 2017 will be recognized over the next two years (weighted average period).
Accounting policy. Fair value of restricted stock awards is equal to the market price of Cigna's common stock on the date of grant. This fair value is reduced by awards that are expected to forfeit. At the grant date, the Company estimates forfeitures based on experience and adjusts
the expense to reflect actual forfeitures over the vesting period. This fair value, net of forfeitures, is recognized in other operating expenses over the vesting period on a straight line basis.
Compensation cost for restricted stock awards was as follows for the years ended December 31:
The fair value of vested restricted stock at the vesting date for the years ended December 31 was as follows:
The Company awards SPSs to executives and certain other key employees generally with a performance period of three years. Half of these shares are subject to a market condition (total shareholder return relative to industry peer companies) and half are subject to a performance condition (cumulative adjusted net income). These targets are set by the Committee. At the end of the performance period, holders of SPSs are awarded shares of Cigna common stock ranging anywhere from 0 to 200% of the original grant of SPSs.
At the end of 2017, approximately 1,500 employees held 778,000 SPSs and $38 million of related compensation expense is expected to be recognized over the next two years. For "performance condition" SPSs, the amount of expense may vary based on actual performance in 2018 and 2019.
In 2017, the Company granted most employees a one-time stock award of five shares that immediately vested. In connection with this program, approximately 205,000 shares were issued at a price of $162.96, resulting in a pre-tax cost of $33 million.
During the vesting period, the Company records tax benefits in shareholders' net income based on the amount of expense being recognized. When stock options are exercised, or when restricted stock and SPSs vest, the difference between tax benefits based on the expense and the actual tax benefit realized are also recorded in net income beginning in 2016 in accordance with ASU 2016-09. Prior to 2016, such excess tax benefits were recorded as an adjustment to additional paid-in capital. The table below provides information about the cost and tax benefits related to all of our share-based compensation arrangements discussed above.
Goodwill activity. Goodwill activity during 2017 and 2016 was as follows:
Description of operating leases. The Company's operating leases are primarily for office space and certain computer and other equipment. Some of these leases include renewal options and other incentives that are amortized over the life of the lease. Leases active in 2017 had terms ranging from one month to 18 years.
As of December 31, 2017, future net minimum rental payments under non-cancelable operating leases were approximately $580 million, payable as follows:
The Company's HMO and life, accident and health insurance subsidiaries are also subject to minimum statutory surplus requirements and may be required to maintain investments on deposit with state departments of insurance or other regulatory bodies. Additionally, these subsidiaries may be subject to regulatory restrictions on the amount of annual dividends or other distributions (such as loans or cash advances) that insurance companies may extend to the parent company without prior approval. As of December 31, 2017, these amounts, including restricted GAAP net assets of the Company's subsidiaries, were as follows:
Income taxes for the Company's foreign operations are provided using the respective foreign jurisdictions' tax rate.
The Company's foreign operations continue to retain a significant portion of their earnings overseas. These undistributed earnings are deployed outside of the United States in support of the liquidity and capital needs of our foreign operations as well as to support growth initiatives overseas. The Company does not intend to repatriate these earnings.
The consolidated effective tax rate was 38.1% in both 2017 and 2016. The additional tax expense associated with the recently enacted U.S. tax reform legislation was offset by the favorable effects of the one-year moratorium on the non-deductible health insurance industry tax and recognizing an incremental tax benefit associated with transaction-related costs that is included in "Other" in the above table.
Included in the consolidated net deferred tax asset of $33 million is approximately $175 million of deferred tax liabilities attributable to foreign jurisdictions, most notably South 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.
A reconciliation of unrecognized tax benefits for the years ended December 31 was as follows:
The Internal Revenue Service has completed review of the Company's consolidated income tax returns through 2012. The statute of limitations for 2013 has expired, but the Company has filed an amended return for which the pending refund is subject to review. The Company conducts business in a number of state and foreign jurisdictions, and may be engaged in multiple audit proceedings at any given time. Generally, no further state or foreign audit activity is expected for tax years prior to 2011.
that the Company will be required to make payment under the guarantees; there were no additional liabilities required for these guarantees as of December 31, 2017. Separate account assets supporting these guarantees are classified in Levels 1 and 2 of the GAAP fair value hierarchy (see Note 10).
The Company had indemnification obligations to a lender of approximately $90 million as of December 31, 2017, related to a borrowing by a certain real estate joint venture that the Company records as an investment. This borrowing (a nonrecourse obligation of the Company) is secured by the joint venture's real estate property with a fair value in excess of the loan amount and matures in 2021. The Company's indemnification obligation would require payment to the lender for any actual damages resulting from certain acts such as unauthorized ownership transfers, misappropriation of rental payments by others or environmental damages. Based on initial and ongoing reviews of property management and operations, the Company does not expect that payments will be required under this indemnification obligation. Any payment that might be required could be recovered through a refinancing or sale of the assets. The Company also has recourse to the partner for their proportionate share of amounts paid. There were no liabilities required for this indemnification obligation as of December 31, 2017.
The Company operates in a regulatory environment that may require its participation 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.
On March 1, 2017, the Commonwealth Court of Pennsylvania entered an order of liquidation of Penn Treaty Network America Insurance Company, together with its subsidiary American Network Insurance Company (collectively "Penn Treaty", a long-term care insurance carrier), triggering guaranty fund coverage and accrual of a liability. For the year ended December 31, 2017, the Company recorded in operating expenses approximately $130 million pre-tax (approximately $85 million after-tax), representing its estimate of the total assessments, net of premium tax offsets for insurance contracts currently written. Some of the assessments were recorded on a discounted basis, using a weighted average discount rate of 3.5%. As of December 31, 2017, the recorded liability was approximately $55 million and total future cash outflows as of December 31, 2017 are expected to approximate $65 million. This assessment is expected to be updated in future periods for changes in the estimate of the insolvency. In addition, a portion of this assessment is expected to be offset in the future by premium tax credits that will be recognized in the period received.
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. Except for the specific matters noted below, 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. Disputed tax matters arising from audits by the Internal Revenue Service ("IRS") or other state and foreign jurisdictions, 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.
condition or liquidity for any particular period. The Company had pre-tax reserves as of December 31, 2017 of $195 million ($155 million after-tax) for the matters discussed below under "Litigation Matters." Litigation related to the Company's claim processing practices for a commercial client, for which the Company held a reserve of $40 million pre-tax ($25 million after-tax) at September 30, 2016, was settled for that amount during the fourth quarter of 2016.
Amara cash balance pension plan litigation. In December 2001, Janice Amara filed a class action lawsuit in the U.S. District Court for the District of Connecticut against Cigna Corporation and the Cigna Pension Plan (the "Plan") on behalf of herself and other similarly situated Plan participants affected by the 1998 conversion to a cash balance formula. The plaintiffs allege various violations of the Employee Retirement Income Security Act of 1974 ("ERISA"), including that the Plan's cash balance formula discriminates against older employees; that the conversion resulted in a wear-away period (when the pre-conversion accrued benefit exceeded the post-conversion benefit); and that the Plan communications contained inaccurate or inadequate disclosures about these conditions.
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. From that time through the present, both parties have disputed various aspects of the Court's interpretation and the Court has attempted to clarify. On July 14, 2017, the Court issued a ruling clarifying certain aspects of the January 2016 order. The Plaintiffs filed a motion for reconsideration of the July 14, 2017 ruling that was denied by the Court on November 7, 2017. The Company's reserve for this litigation is adequate at December 31, 2017, based on calculations consistent with the Company's interpretation of the latest guidance from the Court. Due to the continuing inability of the parties to agree on the details of calculating the pension benefits, the final timing of the resolution of this matter remains uncertain. Once these issues are resolved, the Plan will be amended to comply with the District Court's orders and the benefits will begin to be paid.
Disability claims regulatory matter. During the second quarter of 2013, the Company finalized an agreement with the Departments of Insurance for Maine, Massachusetts, Pennsylvania, Connecticut and California (together, the "monitoring states") related to the Company's long-term disability claims handling practices. The agreement requires primarily: (1) enhanced procedures related to documentation and disposition and (2) a two-year monitoring period followed by a re-examination that began in the second quarter of 2016. Management believes the Company has addressed the requirements of the agreement. If the monitoring states find material non-compliance with the agreement upon re-examination, the Company may be subject to additional costs and penalties or requests to change its business practices that could negatively impact future earnings for this business.
Litigation with Anthem. In February 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 in February 2017, the Company filed suit against Anthem in the Delaware Court of Chancery (the "Chancery Court") seeking 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, including the lost premium value to the Company's shareholders caused by Anthem's willful breaches of the merger agreement.
(2) 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. The Company's foreign revenues are generated by its foreign operating entities. In the periods shown, no foreign country contributed more than 5% of consolidated revenues from external customers.