JPFIC, JPLA and our broker/dealers conduct operations in Concord, NH in two buildings on approximately 196 acres owned by JPFIC. A portion of one building is available for commercial leasing.
JPFIC conducts operations in Omaha, NE in three buildings on its 11-acre campus. Portions of two buildings are leased to others. It also conducts some group operations in leased space in Atlanta, GA.
Effective January 1, 2004, the Company adopted SOP 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts.”
Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the consolidated financial condition as of December 31, 2005 compared to December 31, 2004, and changes in financial position and results of operations for the three years ended December 31, 2005, of Jefferson-Pilot Corporation and consolidated subsidiaries (JP or the company which may also be referred to as we or us or our). The discussion should be read in conjunction with the Consolidated Financial Statements and Notes. All dollar amounts are in millions except share and per share amounts. All references to Notes are to Notes to the Consolidated Financial Statements.
Our principal life insurance subsidiaries are Jefferson-Pilot Life Insurance Company (JP Life), Jefferson Pilot Financial Insurance Company (JPFIC) and its wholly owned subsidiary, Jefferson Pilot LifeAmerica Insurance Company (JPLA). Jefferson-Pilot Communications Company (JPCC) and its wholly owned subsidiaries conduct our broadcasting operations. Jefferson Pilot Securities Corporation (with related entities, JPSC) is a registered non-clearing broker/dealer that sells mutual funds, affiliated and non-affiliated variable life and annuity products and other investment products.
policy acquisition costs), and because of acquisitions of in-force blocks of insurance (value of business acquired and goodwill). The assumptions that we use in accounting for these intangible assets are important to our reported results.
For some of the risks which we consider to be most significant to the company, please see the Critical Accounting Policies and Estimates, Investments and Market Risk Exposures sections of this report and Item 1A “Risk Factors.”
Our Individual Products segment sells life insurance on individuals, through which we underwrite the economic risks of mortality and provide vehicles for the accumulation of individual savings. We select and classify mortality risks within a competitive marketplace and a highly regulated industry. Because we earn revenues for accepting mortality risks, the growth in face amount of insurance in force is a key measure for a portion of our revenue growth. We further analyze this segment by its two unique product types: UL-type products and traditional products. UL-type products offered by this segment include universal life (UL) and variable universal life (VUL) products. UL-type product premiums may vary over the life of the policy at the discretion of the policyholder, so we do not recognize them as revenues when received, although UL-type premiums do increase assets and liabilities. We earn spreads between interest earned and credited to policyholders from aggregation and investment of policyholder funds. In managing these spreads, we develop and maintain systems and skills that are necessary to understand and mitigate credit and interest rate risks. We also recognize revenues on UL-type products from mortality, expense and surrender charges earned (policy charges). Trends in policyholder fund balances and segment assets are important measures when analyzing the development of segment earnings.
Our Corporate and Other segment contains the activities of the parent company and passive investment affiliates, surplus of the life insurance subsidiaries not allocated to other segments, financing
expenses on corporate debt, strategic initiatives intended to benefit the entire company, and federal and state income taxes not otherwise allocated to business segments. We include all realized gains and losses on investments in the Corporate and Other segment, and hold all defaulted securities in this segment. Realized investment gains are gains and losses on sales and write downs of investments, and although these are included in revenues and income, we exclude them in assessing the performance of our business segments.
Our segments’ revenues as a percentage of total revenues, excluding realized gains and losses, were as follows:
VUL products. We report both the deferral and amortization of unearned revenue reserves as revenues within universal life and investment product charges.
We consider the following assumptions to be most significant to UL-type products: 1) estimated mortality; 2) estimated interest spreads; and 3) estimated future policy lapses. In addition to these three assumptions, VUL and VA products require an additional critical assumption that affects DAC and VOBA amortization, the rate of growth of the separate account mutual funds that generate additional policy fees we use in the EGP on VUL and VA products. We assume a long-term total net return on separate account assets, including dividends and market value increases, of 8.00% and a five-year reversion period. The reversion period is a period over which a short-term return assumption is used to maintain the model’s overall long-term rate of return. We cap the reversion rate of return at 8.25% for one year and 10% for years two through five. This limitation reduces the cumulative effective long-term rate.
Our traditional individual and group insurance products are long-duration contracts. We amortize DAC and VOBA related to these products in proportion to premium revenue recognized. The DAC and VOBA balances on these products were $304.8 or 10.4% of the gross balances (before adjustments for unrealized gains and losses) at December 31, 2005, and are subject to little volatility.
Estimated interest spread increasing (decreasing) 2.5 basis points per year for 10 years from the current assumed spread
Estimated policy lapse rates decreasing (increasing) 50% immediately and then increasing (decreasing) 5.0% per year for 10 years
We regularly monitor our investment portfolio to ensure that investments that may be other-than-temporarily impaired are identified in a timely fashion and properly valued, and that any impairments are charged against earnings in the proper period. Our methodology to identify potential other-than-temporary impairments requires professional judgment and is further described in the Investments section and in Note 4. For further information on the other-than-temporary impairments we recognized, refer to the discussion of our realized losses within the Investments section.
Valuing our investment portfolio involves a variety of assumptions and estimates, particularly for investments that are not actively traded. We rely on external pricing sources for highly liquid publicly traded securities and use an internal pricing matrix for privately placed securities. This matrix relies on our judgment concerning: 1) the discount rate we use in calculating expected future cash flows; 2) credit quality; 3) industry sector performance; and 4) expected maturity. Under certain circumstances, we make adjustments as we apply professional judgment based upon specific detailed information concerning the issuer. Investments valued using independent third party sources comprised 81% of our investment portfolio at December 31, 2005 with the remainder being valued based upon internal analysis using the assumptions described above.
The liability for “Future policy benefits” pertains to our traditional individual and group insurance products and represents 9.8% of total liabilities at December 31, 2005. Changes in this liability are reflected in the “Insurance and annuity benefits” caption in our consolidated statements of income. Assumptions we use in determining future policy benefits include: future investment yields, mortality, morbidity and persistency. We base estimates about future circumstances principally on historical experience and provide for possible adverse deviation. Though not anticipated, significant changes in experience or assumptions may require us to provide for expected future losses on a product by establishing premium deficiency reserves. See Note 7 for further discussion of the assumptions we use in estimating these liabilities.
Goodwill was $312 at December 31, 2005 and 2004 representing 8.0% and 7.9% of stockholders’ equity at these dates. Under Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,” which primarily addresses the accounting for goodwill and intangible assets subsequent to their acquisition, we regularly review the carrying amounts of goodwill for indications of value impairment. This assessment considers financial performance and other relevant factors such as a significant adverse change in the business or legal climate, an adverse action or assessment by a regulator, or unanticipated competition. If considered impaired, the carrying amounts would be written down to a value determined by using a combination of fair value and discounted cash flows. Absent an indication of impairment, we test goodwill for impairment annually in the month of June. We concluded that there have been no impairments in the three years ending December 31, 2005. Also, we have identified no adverse trends or uncertainties that would suggest that an impairment is imminent.
The following tables illustrate our results before and after the cumulative effect of change in accounting principle:
The increase in income before cumulative effect of change in accounting principle for 2004 reflected higher realized gains and earnings growth in the Benefit Partners and Communications segments. The Individual Products and AIP segments declined over the same period. Earnings from business added via the Canada Life transaction favorably impacted the results of Benefit Partners in 2004. Communications achieved market share advances and benefited from increased political advertising revenues in 2004 resulting in earnings growth. The Individual Products and AIP segments were adversely impacted by spread compression due to lower portfolio yields, partially resulting from lower prepayments of investments.
Throughout this Form 10-K, “reportable segment results” is defined as net income before realized investment gains and losses (and cumulative effect of change in accounting principle, if applicable). Reportable segment results is a non-GAAP measure. We believe reportable segment results provides relevant and useful information to investors, as it represents the basis on which we assess the performance of our business segments. We deem reportable segment results to be a meaningful measure for this purpose because, except for losses from other-than-temporary impairments, realized investment gains and losses occur primarily at our sole discretion. Note that reportable segment results as described above may not be comparable to similarly titled measures reported by other companies .
The Individual Products segment markets individual life insurance policies primarily through independent general agents, independent national account marketing firms, and agency building general agents. We also sell products through home service agents, broker/dealers, banks and other strategic alliances.
Sales from our Individual Markets excluding Community Banks and bank-owned life insurance (BOLI) increased in 2005 over 2004 due to product, distribution and service initiatives. Sales in the third quarter of 2005 also included several large cases totaling approximately $15 that we do not view as recurring in nature. Sales from our Individual Markets excluding Community Banks and bank-owned life insurance (BOLI) decreased slightly in 2004 from 2003, due to record sales levels in the first quarter of 2003. In recent years, increased competition among providers of UL-type insurance contracts has resulted in a shortening of the product life cycle. Sales to Community Banks and BOLI business were significantly less in 2005 after essentially remaining unchanged in 2004. Community Bank and BOLI business will vary widely between periods as we respond to sales opportunities for these single premium products only when the market accommodates our required returns.
Approximately 60%, 56% and 58% of life insurance sales were attributable to products with secondary guarantee benefits for 2005, 2004 and 2003. These products were priced considering interest, mortality, withdrawal and termination (lapse) assumptions that are specific to the nature, marketing focus and funding pattern for each product. The lapse assumptions that we use for pricing are based on multi-scenario modeling techniques and are lower than the assumptions we use for non-guaranteed products, particularly when the secondary guarantee option is “in the money”. Since secondary guarantee UL policies are relatively new to the marketplace, credible experience has yet to emerge regarding policy and premium persistency; however, our assumptions represent our best estimate of future experience. See the Capital Resources section for discussion of statutory-basis reserving methodologies for these types of products.
Interest margin on UL-type products increased 1.3% in 2005 on fund balance growth of 4.1%. In 2005 and 2004, interest income of $7.0 and $3.7 was reflected within income taxes for certain tax-favored investments, favorably impacting the effective tax rate rather than interest margin. As discussed further below, the lower investment yield in both 2005 and 2004 was primarily due to the general interest rate environment. We actively manage interest spreads on our fixed UL-type products in
UL-type death benefits increased $14.8 in 2005 due to the growth and aging of our block. UL-type death benefits, net of reinsurance, per thousand dollars of average net face amount at risk (average face amount of insurance in force net of reinsurance and reduced by average policyholder fund balances) were $2.59 in 2005 compared to $2.51 in 2004 and $2.33 in 2003. Business growth and aging of our blocks will continue to contribute to increasing levels of UL-type death benefits. While over the long term death benefits should emerge within actuarial expectations, the level of death benefits will fluctuate from period to period. Other UL-type insurance benefits were $45.2, $22.4 and $7.9 for 2005, 2004 and 2003 with the increase primarily due to the 2004 adoption of a new accounting standard for secondary guarantees and other benefits features and the associated growth in these reserves. The growth in reserves related to secondary guarantees in 2005 compared with 2004 was due to higher sales of policies with these features and an increase in the amount of projected benefits that are attributable to the secondary guarantee benefit feature. The accounting for these benefit features incorporates estimated future gross profits used to calculate amortization of DAC, VOBA and unearned expense charges. A change in estimated future gross profits will impact other insurance benefits and the amortization of DAC, VOBA and unearned expense charges. The effect of updating longer-term assumptions in estimated gross profits for our insurance blocks increased other insurance benefits by $2.0 in 2005 and decreased it by $4.7 in 2004. See the Critical Accounting Policies and Estimates section and Note 6 for further discussion.
In 2005, the traditional block was impacted by the issuance of a supplementary contract that increased premiums and other considerations and benefits by $1.8. This resulted in a significantly smaller decline in premiums and other considerations for the traditional block relative to 2004. Consistent with recent trends and customer preferences for UL-type products, traditional premiums and other considerations declined in 2005, 2004 and 2003. Net investment income from our traditional blocks declined due to a decline in investment yields and the decreasing size of the block.
The growth in average Individual Products assets in 2005, 2004 and 2003 was primarily due to growth in UL policyholder fund balances and market values of separate account assets, partially offset by declines in assets supporting our traditional block of business.
In June 2005, JP Life issued $300 of funding agreements backing medium-term notes. The funding agreements are investment contracts that do not subject us to mortality or morbidity risk. The subsidiary issued the funding agreements to a special purpose entity, Jefferson-Pilot Life Funding Trust I (the Trust) that sold medium-term notes through investment banks to investors seeking high-quality fixed-income investments. As spread products, funding agreements generate profit to the extent that the rate of return on the investments we make with the proceeds exceeds the interest credited and other expenses. We regard funding agreements as a business that can provide additional spread income on an opportunistic basis. Consequently, issuances of funding agreements can vary widely from one reporting period to another. Refer to Note 7 and the Capital Resources section for further discussion.
Profitability of EIAs is influenced by the management of derivatives to hedge the index performance of the policies. These contracts permit the holder to elect an interest rate return or an equity market component, where interest credited to the contracts is linked to the performance of the S&P 500 Index®. Policyholders may elect to rebalance index options at renewal dates, either annually or biannually. At each renewal date, we have the opportunity to re-price the equity-indexed component by establishing participation rates, subject to minimum guarantees. We purchase options that are highly correlated to the portfolio allocation decisions of our policyholders, such that we are economically hedged with respect to equity returns for the current reset period. The mark-to-market of the options we hold impacts investment income and interest credited in approximately equal and offsetting amounts. This adjustment increased net investment income and interest credited by approximately $18, $20 and $7 in 2005, 2004 and 2003 with no net impact on reportable segment results. Additionally, Statement of Financial Accounting Standard No. 133 “Accounting for Derivative Instruments and Hedging Activities” (SFAS 133) requires that we calculate the fair values of index options we will purchase in the future to hedge policyholder index allocations applicable to future reset periods. These fair values represent an estimate of the cost of the options we will purchase in the future less expected charges to policyholders, discounted back to the date of the balance sheet, using current market indicators of volatility and interest rates. Changes in the fair values of these liabilities result in volatility that is reported in interest credited. Interest credited was decreased by $6.1 in 2005, $2.9 in 2004 and $1.2 in 2003 for these changes. The notional amounts of policyholder fund balances allocated to the index options were $1,742 at December 31, 2005 and $998 at December 31, 2004. Since adoption of SFAS 133, the total cumulative net reduction to interest credited for this fair value adjustment is approximately $9.9.
Excluding the impact of the options market value adjustment described above, net investment income decreased slightly even as average policyholder fund balances in 2005 grew compared to 2004. In 2005, incremental investment income partially offset the lower base investment yields, caused by the general interest rate environment. The effect of this incremental income in the AIP segment increased effective yields by 17, 13 and 24 basis points in 2005, 2004 and 2003.
spreads to achieve targeted returns and require lower levels of capital to support new sales. These factors, combined with the current interest rate environment, will likely result in earnings that lag behind growth in average fund balances for a period of time. However, the effective investment spreads on fixed annuities, excluding the effects of SFAS 133, increased in 2005 after having decreased in 2004 primarily due to lower crediting rates (including the effect of multi-year guaranteed rates (MYG) lapses discussed below) and incremental investment income items mitigating the decline in investment yields. The favorable effect of SFAS 133 further enhanced reported spreads.
Our ability to manage interest crediting rates on fixed annuity products in response to continued low general market interest rates is limited by minimum guaranteed rates provided in policyholder contracts. We have approximately $4.2 billion of average fixed annuity policyholder fund balances with crediting rates that are reset on an annual basis, for which our crediting rates on average were approximately 17 basis points in excess of minimum guaranteed rates at December 31, 2005, including 57% that were already at their minimum guaranteed rates. Approximately $2.7 billion of fixed annuity policyholder fund balances had MYG at December 31, 2005, of which approximately $1.1 billion will reset in 2006 with an additional $1.6 billion resetting in 2007 and thereafter. As multi-year guarantees expire, policyholders have the opportunity to renew their annuities at rates in effect at that time. Our ability to retain these annuities will be subject to then-current competitive conditions. The current average spread to the minimum guarantee on these products is approximately 204 basis points. In 2005, $782 of fixed annuity policyholder fund balances reset, of which approximately $554 lapsed where the holder did not select another product that we offer. These lapses reduced policyholder fund balances and increased DAC amortization but also increased investment spreads for the business retained. Surrenders are affected by factors such as crediting rates on MYG annuities compared to current crediting rates at reset dates and the absence of surrender charges at reset dates.
Fixed annuity surrenders as a percentage of beginning fund balances continued to increase in 2005, reflecting primarily the surrender of annuities with expiring MYGs. The increase in fixed annuity surrenders, other than resetting MYG annuities, favorably impacted surrender charge revenues. The surrender rate in the AIP segment is influenced by many other factors such as: 1) the portion of the business that has low or no remaining surrender charges; 2) competition from annuity products including those which pay up-front interest rate bonuses or higher market rates; and 3) rising interest rates that may make returns available on new annuities or investment products more attractive than our older annuities. In addition to surrender charge protection against early surrender, we have added a market value adjustment (MVA) to many of our new annuity products. The MVA provides some degree of protection from disintermediation in a rising interest rate environment. Fixed annuity fund balances subject to surrender charges of at least 5% or an MVA increased to 53% at year-end 2005 from 47% at year-end 2004, driven by strong sales of EIAs.
Policy benefits decreased 5.3% in 2005 primarily as a result of a decline in crediting rates, partially offset by growth in average fund balances and the increase in market value adjustment of index options. Beginning with the first quarter of 2004 when a new accounting standard was adopted, net deferral and amortization of bonus interest is presented in policy benefits. Previously, it had been included as a component of DAC and was included in insurance expenses. Accordingly, in 2004, policy benefits increased 2.3% as growth in average fund balances and the market value adjustment of options were partially offset by the net deferral and amortization of bonus interest and crediting rate reductions.
AIP expenses (including the net deferral and amortization of DAC and VOBA) were as follows:
Commissions and capitalized expenses decreased compared to 2004, due to the decline in fixed annuity premium sales. Higher investment product sales contributed to the increase in acquisition-related expenses. In 2005, general administrative acquisition expenses increased compared to 2004 due to costs incurred in the development and rollout of new products and transaction costs related to the issuance of the funding agreements during the second quarter of 2005. In 2005, general and administrative maintenance expense increased $2.0 compared to 2004 due to accruals for litigation costs. Amortization of DAC and VOBA increased compared to 2004, due to a $7.5 increase in unlockings, primarily from higher lapsation assumptions for MYG annuities, and a $2.9 increase in true-ups, primarily the effect of higher incremental investment income and the favorable change in the fair value of EIA option liabilities. Additionally, broker/dealer expenses increased at a slightly higher rate than revenues, primarily due to a $1.3 accrual for litigation costs in 2005. In 2004, commissions, acquisition-related general and administrative expenses and DAC capitalization all increased with the strong sales increase over 2003. DAC amortization increased partly due to true-ups of $3.2, reflecting actual lapse experience of MYG annuities and the impact of the favorable change in the fair value of EIA option liabilities. Insurance companies’ net expenses also increased in 2004 as a result of the reclassification of the net deferral of bonus interest to policy benefits as discussed above. Broker/dealer revenues and expenses increased commensurately due to the improved condition of equity markets and higher sales volumes.
Reportable segment results for Benefit Partners increased in 2005 reflecting primarily strong earnings emergence from favorable claim experience and reserve development on the acquired Canada Life business, partially offset by elevated DAC amortization. The 2004 increase in reportable segment results is primarily due to the acquisition of substantially all of the U.S.-based group life, disability and dental business of Canada Life in March and to organic growth from sales during 2004.
Premiums and other considerations increased 6.2% in 2005, as growth in our core businesses of life and disability offset significant declines in the Canada Life block caused by shock lapsation of groups at their renewal dates, discussed further below. Annualized sales increased 28.6% in 2005 due to strong growth in the number of our field representatives and their maturation in our system, and from good sales execution.
Total expense growth in 2005 reflects the overall growth in the business and accelerated amortization primarily due to DAC persistency adjustments. The Canada Life block represented $6.9 of the accelerated amortization. Although we had anticipated that a certain amount of “shock lapse” would occur on the Canada Life business as it is renewed with the Company, the actual lapsation during 2005 was higher than forecasted. Additionally, the increase in the expense ratio for 2005 relative to the 2004 period was driven by a higher average commission rate during 2005 and higher unit expenses for taxes, licenses and fees due to unfavorable municipal tax true-ups without the benefit of favorable state tax adjustments experienced in 2004. The expense growth in 2004 reflects expenses from Canada Life integration activities and overall growth in the business. The 2004 increase in the total unit expense ratios relative to the 2003 period is driven by the impact of these integration expenses as well as the decline in DAC capitalization and growth in DAC amortization expense on a unit expense basis as the overall block continues to grow. In the first quarter 2004, we also changed our presentation of commissions, which are paid and expensed on a monthly basis. Previously, we reflected such commissions as capitalized and fully amortized each month. We no longer flow these commissions through DAC. This change has no impact on total expenses or reportable segment results.
Cost of sales includes direct and variable costs, consisting primarily of sales commissions, rights fees and sports production costs. Operating expenses represent other costs to operate the broadcast properties, including salaries, marketing, research, purchased programming and station overhead costs. Total expenses, excluding interest expense, increased 0.5% in 2005 and increased 6.6% in 2004. As a percent of communication revenues, these expenses were 60.8%, 61.9% and 64.6% for 2005, 2004 and 2003. The 2005 and 2004 improvements reflect growing revenues and continued expense discipline, partially offset in 2004 by increased sales commissions and bonuses.
Total assets for the Corporate and Other segment decreased primarily due to increases in long-term interest rates, which resulted in a decrease in unrealized gains on fixed interest investments.
These are both the highest ratings that the agencies issue and were reaffirmed in 2005. A significant drop in these ratings could cause us to pay higher rates on commercial paper borrowings or lose access to the commercial paper market. Concurrent with the proposed Lincoln merger announcement discussed earlier, our ratings were placed under review with negative implications, reflecting the rating agencies’ assessments of the merged entity that will exist following the closing of the transaction.
Our insurance subsidiaries have sold collateralized mortgage obligations and agency debentures under repurchase agreements involving various counterparties, accounted for as financing arrangements, with maturities less than six months. We may use proceeds to purchase securities with longer durations as an asset/liability management strategy. At December 31, 2005 and 2004, repurchase agreements, including accrued interest, were $452 and $468. The securities involved had a fair value and amortized cost of $469 and $457 at December 31, 2005 versus $489 and $459 at December 31, 2004. The maximum principal amounts outstanding were $598 and $528 during 2005 and 2004.
In June 2005, a subsidiary issued $300 of funding agreements that are reported as a component of policy liabilities within our consolidated balance sheets. The funding agreements were issued to a trust and back medium-term notes sold to investors by the trust. Our insurance subsidiary’s general account assets back these funding agreements. Concurrent with the issuance of the funding agreements, the subsidiary executed an interest rate swap that converts the variable rate of the funding agreements issued to a fixed rate of 4.28%. This program represents a cost effective alternative for earning spread income to replace some portion of the lapses in our MYG annuity liabilities. Refer to Note 7 of our financial statements and the AIP segment results section for further discussion.
In January 2004, we issued $300 of 4.75% 10-year term notes and $300 of floating rate EXtendible Liquidity Securities® (EXLs) that currently have a maturity of December 2006, as of December 31, 2005, subject to periodic extension through 2011. Each quarter, the holders must make an election to extend the maturity of the EXLs for 13 months, otherwise they become due and payable on the next maturity date to which they had previously been extended. The EXLs bear interest at
In 2005 we repurchased 3,175,500 of our common shares at an average cost of $49.12 per share compared to 5,368,200 shares at an average cost of $51.05 in 2004. At year-end 2005, we had authorization from our board to repurchase 0.9 million additional shares, but no repurchases are presently contemplated.
Our insurance subsidiaries have statutory surplus and risk based capital levels well above current regulatory required levels. As mentioned earlier, approximately half of our life sales consist of products containing no-lapse guarantees (secondary guarantees). Regulators recently approved statutory reserving practices under Actuarial Guideline 38 (referred to as “AXXX” or the “Guideline”) that will require us, and other companies, to record higher AXXX reserves on new sales during a 21-month period beginning July 1, 2005, followed by a long-term change to reserving methods for these products. Under these reserving practices, we established approximately $77 of additional statutory reserves ($45 after-tax reduction in surplus) over the second half of 2005. Absent changes to product pricing or product design, we estimate that new sales during 2006 will require $180 of additional statutory reserves ($110 after-tax reduction in surplus) in addition to the December 31, 2005 amount. As a result of the new requirements, we are in the process of re-pricing our principal secondary-guarantee products. We expect that other insurers may also increase pricing or may limit the availability of guaranteed no-lapse features and other benefits included in future designs of life insurance products. In December 2004, we formed an insurance subsidiary chartered in Bermuda for the purpose of providing intracompany reinsurance. In conjunction with the establishment of this subsidiary, we obtained a $500 letter of credit facility, which will provide credit enhancement for our subsidiary’s reinsurance obligations. JP is a guarantor under the letter of credit facility. At December 31, 2005, we had not reinsured any reserves subject to AXXX. We and other insurers may seek other capital market solutions to mitigate the impact on statutory capital. We cannot estimate the cost of potential alternative solutions.
Proper liquidity management is crucial to preserve stable, reliable, and cost-effective sources of cash to meet future benefit payments under our various insurance and deposit contracts, pay operating expenses (including interest and income taxes), provide funds for debt service and dividends, pay costs related to acquiring new business, and maintain reserve requirements. In this process, we focus on our assets and liabilities, the manner in which they combine, and the impact of changes in both short-term and long-term interest rates, market liquidity and other factors. We believe we have the ability to generate adequate cash flows for operations on a short-term basis and a long-term basis. Additionally, the Company has access to unused borrowing capacity including unused short-term lines of credit.
Net cash provided by financing activities was $566, $810 and $888 in 2005, 2004 and 2003, including cash inflows from policyholder contract deposits net of withdrawals of $556, $1,022 and $1,081. The fluctuations in net policyholder contract deposits reflect lower sales of EIAs and higher surrenders of annuities in 2005 compared to 2004. Net borrowings increased in 2004 over 2003 largely due to borrowings to support the Canada Life acquisition.
In order to meet the parent company’s dividend payments, debt servicing obligations and other expenses, we rely on dividends from our insurance subsidiaries. Cash dividends received from our insurance and non-insurance subsidiaries by the parent company were $308, $289 and $273 in 2005, 2004 and 2003. Our life insurance subsidiaries are subject to laws in their states of domicile that limit the amount of dividends that can be paid without the prior approval of the respective state’s insurance regulator. The limits are based in part on the prior year’s statutory income and capital, which are negatively impacted by bond losses and write-downs and by increases in reserves. Approval of these dividends will depend upon the circumstances at the time, but we have not experienced problems with state approvals in the past.
Cash and cash equivalents were $150, $87 and $72 at December 31, 2005, 2004 and 2003. The parent company and non-regulated subsidiaries held equity and fixed income securities of $611, $678 and $753 at these dates, the decline reflecting the effect of equity markets and some equity sales. We consider the majority of these securities to be a source of liquidity to support our strategies.
Total debt and equity securities available-for-sale at December 31, 2005 and 2004 were $20,826 and $20,375. Related gross unrealized gains and losses at December 31, 2005 were $1,039 and $(233) compared to gross unrealized gains and losses at December 31, 2004 of $1,415 and $(57).
Purchase obligations consist of JPCC commitments for purchases of syndicated television programming and commitments on other contracts and future sports programming rights. We have estimated the amount of the future obligations that will be required under the present terms of these arrangements to be $326 as of December 31, 2005, payable through the year 2011. We have commitments to sell a portion of the sports programming rights to other entities and advertising contracts with customers for the airing of commercials totaling $229 over the same period. These commitments are not reflected as an asset or liability in our balance sheets because the programs are not currently available for use. We expect advertising revenues that are sold on an annual basis to fund the purchase commitments. In the second quarter of 2005, JPCC executed an agreement that gives JP Sports and its broadcasting partner 50/50 television syndication rights to Atlantic Coast Conference football and basketball games through the 2010 seasons . Through 2005, JPCC held the football rights individually.
We have no material off balance sheet arrangements of a financing nature. We routinely enter into commitments to extend credit in the form of mortgage loans and to purchase certain debt instruments in private placement transactions for our investment portfolio. The fair value of such outstanding commitments as of December 31, 2005 approximates $29. These commitments will be funded through cash flows from operations and investment maturities during 2005 and are not included in contractual obligations listed above.
Our strategy for managing the investment portfolio of our insurance subsidiaries is to consistently meet pricing assumptions while appropriately managing credit risk. We invest for the long term, and most of our investments are held until they mature. Our investment portfolio includes primarily fixed income securities and commercial mortgage loans. The nature and quality of investments that our insurance subsidiaries hold must comply with state regulatory requirements. We have
established a formal investment policy, which describes our overall quality and diversification objectives and limits.
Approximately 91% of our securities portfolio has been designated as available-for-sale (AFS) and is carried on the balance sheet at fair value. We determine fair values of our securities, including securities not actively traded, using the methodology described in the Critical Accounting Policies and Estimates section above. Changes in fair values of AFS securities (net of related deferred policy acquisition cost, value of business acquired, and income taxes) are reflected in other comprehensive income. The remainder of our securities portfolio has been designated as held-to-maturity (HTM). As prescribed by GAAP, HTM securities are carried at amortized cost, and accordingly there is a difference between fair value and carrying value for HTM securities.
The majority of our unrealized gains and losses can be attributed to changes in interest rates and market changes in credit spreads. These unrealized gains and losses do not necessarily represent future gains or losses that will be realized. Changing conditions related to specific bonds, overall market interest rates, credit spreads or equity securities markets as well as general portfolio management decisions are likely to impact values we ultimately realize. Gross unrealized gains and losses at December 31, 2004 were $1,569 and $(66).
We monitor those securities that are rated below-investment-grade as to individual exposures and in comparison to the entire portfolio, as an additional credit risk management strategy.
The following table shows the ten largest below-investment-grade debt security exposures by individual issuer at December 31, 2005. Investment grade bonds of issuers listed below are not included in these values. The gross unrealized gain or loss shown below is calculated as the difference between the amortized cost of the securities and their fair values.
industry sector or geographic area applicable to the specific issuer; and
our ability and intent to retain the investment for a sufficient time to recover its value.
When this intensive review determines that the decline is other-than-temporary, the security is written down to fair value through a charge to realized investment gains and losses. We adjust the amortized cost for both AFS and HTM securities that have experienced other-than-temporary impairments to reflect fair value at the time of the impairment. We consider factors that lead to an other-than-temporary impairment of a particular security in order to determine whether these conditions have impacted other similar securities.
The following table shows the credit quality of our debt securities with unrealized losses at December 31, 2005:
One individual creditor, General Motors Corp, has an unrealized loss of $10.8 at December 31, 2005. No other individual creditor has an unrealized loss of $10 or greater at December 31, 2005.
The following table shows the length of time that individual debt securities have been in a continuous unrealized loss position.
Information about unrealized gains and losses is subject to rapidly changing conditions. Securities with unrealized gains and losses will fluctuate, as will those securities that we have identified
as potentially distressed. We consider all of the factors discussed earlier when we determine if an unrealized loss is other-than-temporary, including our ability and intent to hold the security until the value recovers. However, we may subsequently identify securities for which a change in facts and circumstances regarding the specific investments has occurred. At such time, we will write down the security to fair value to recognize any unrealized losses. In 2005, we recognized $18.6 of impairments for securities that we no longer had the intent and ability to hold until forecasted recovery.
In 2005, we had other-than-temporary impairments on securities of $36.1 as compared to $60 for 2004. No individual securities experienced a write-down amount greater than $10 in 2005.
Our investment strategy with respect to our mortgage-backed securities (MBS) portfolio focuses on actively traded issues with less volatile cash flows. The majority of the MBS holdings are sequential and planned amortization class tranches of federal agency issuers. The MBS portfolio has been constructed with underlying mortgage collateral characteristics and structure in order to mitigate cash flow volatility over a range of interest rates.
Our MBS portfolio is primarily a discount portfolio; therefore, prepayments accelerate the accretion of discount into income. We experienced MBS prepayments totaling $536 or 21.86% and $1,034 or 39.3% of the average carrying value of the MBS portfolio in 2005 and 2004. The excess accretion of discount insignificantly impacted investment income in both 2005 and 2004, while it increased investment income $49.8 in 2003. These prepayments are reinvested at yields that are lower
We employ various methodologies to manage our exposure to interest rate risks. Our asset/liability management process focuses primarily on the management of interest rate risk of our insurance operations. We monitor the duration of insurance liabilities compared to the duration of assets backing the insurance lines, measuring the optionality of cash flows. Our goal in this analysis is to prudently balance profitability and risk for each insurance product category, and for us as a whole. At both December 31, 2005 and 2004, 89% of policy liabilities related to interest-sensitive portfolios.
We have derived the estimated incremental loss amounts below by modeling estimated cash flows of our market risk sensitive instruments and insurance portfolios. Incremental income or loss is net of taxes at 35%. The model also assumes that all floating rate debt, including reverse repurchase agreements, is replaced with similar instruments. Estimated cash flows produced in the model assume reinvestments representative of our current investment strategy, and calls/prepayments include scheduled maturities as well as those expected to occur when borrowers can benefit financially based on the difference between prepayment penalties and new money rates under each scenario. Assumed lapse rates within insurance portfolios consider the relationships expected between crediting rates and market interest rates, as well as the level of surrender charges inherent in individual contracts. The illustrated incremental income or loss also includes the expected impact of true-up adjustments to amortization of DAC, VOBA, and unearned revenue reserves but excludes the potential impact of unlocking adjustments. The model is based on our existing business in force as of December 31, 2005 and does not consider new sales of life and annuity products or the potential impact of interest rate fluctuations on sales.
These estimated impacts are incremental to potential earnings impacts from trends and/or environmental factors already in existence, such as a reduction in the level of prepayments on mortgage-backed securities or the increased lapsation in our annuity business. The model assumes that changes in our crediting rates will occur correspondingly with increases or declines in investment yields, subject to the impact of minimum rate guarantees. As discussed previously, as of year end our crediting rates on blocks of business that are on an annual reset basis were approximately 27 basis points and 17 basis points on average in excess of minimum guaranteed rates for Individual Products and AIP, with many policies already at minimum.
We are exposed to equity price risk on our equity securities (other than trading). We hold common stock with a fair value of $618; approximately $376 is in a single issuer, Bank of America Corporation (BankAmerica). We believe that a hypothetical 10% decline in the equity market is possible. If the market value of the S&P 500 Index®, and of BankAmerica common stock specifically, decreased 10%, the fair value of our common stock as of December 31, 2005 would change as follows:
Demographic changes include the aging of the baby boomers, reaching their high earning years at a time when investment yields from fixed rate products are at historically low points. This challenge has been met by the insurance industry by offering various types of fixed and variable products aimed at this population. The industry’s overall individual life insurance sales in the U.S. were flat in 2005 and reflected a trend towards those financial products with variable rates given the improvement in the equity markets.
The U.S. insurance industry has experienced mergers, acquisitions, consolidations, sales of business lines and marketing arrangements with other financial services providers. These activities have been driven by a need to reduce costs of distribution and to increase economies of scale in the face of growing competition from larger insurers, banks, securities brokers, mutual funds and other non-traditional competitors. We expect further strategic alignments in the financial services industry given changing demographics, technological advances, and customer expectations for one-stop shopping.
regulation of the insurance industry or financial services industry; changes in generally accepted or statutory accounting principles (such as Actuarial Guideline 38, referred to as AXXX, discussed in Capital Resources) or changes in other laws and regulations and their impact; and the various risks discussed in Item 1A “Risk Factors.”
The management of Jefferson-Pilot Corporation (JP) is responsible for the preparation, integrity and fair presentation of the Consolidated Financial Statements of JP and for establishing and maintaining adequate internal control over financial reporting. The accompanying Consolidated Financial Statements, including Notes to Financial Statements, have been prepared by management in accordance with U.S. generally accepted accounting principles (GAAP), and reflect management’s estimates and judgments, the use of which are inherent in the preparation of financial statements. In the opinion of management, the accompanying Consolidated Financial Statements present fairly JP’s financial position and results of operations, giving due consideration to materiality.
JP management assessed the effectiveness of the company’s internal control over financial reporting as of December 31, 2005. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control - Integrated Framework. Based on our assessment we believe that, as of December 31, 2005, the company’s internal control over financial reporting is effective based on those criteria.
JP’s Consolidated Financial Statements and assessment of the effectiveness of our internal control over financial reporting as of December 31, 2005 have been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their reports which appear on page 68 and page 67, respectively.
We have audited management’s assessment, included in the accompanying Report of Management on the Consolidated Financial Statements and Management’s Assessment of Internal Controls Over Financial Reporting, that Jefferson-Pilot Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Jefferson-Pilot Corporation and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We have audited the accompanying consolidated balance sheets of Jefferson-Pilot Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. Our audits also included the financial statement schedules listed in the Index at item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Jefferson-Pilot Corporation and subsidiaries’ internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 10, 2006 expressed an unqualified opinion thereon.
The consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). The insurance subsidiaries also submit financial statements to insurance industry regulatory authorities. Those financial statements are prepared on the basis of statutory accounting principles (SAP) and are significantly different from financial statements prepared in accordance with GAAP. See Note 11.
recognized an accrual release, which increased cost of insurance charge revenue by $13 pretax, and a related unlocking of expected gross profits, which reduced amortization of value of business acquired by $16 pretax. Additionally, the Company experienced strong earnings emergence from favorable claims and reserve development in its group insurance business, primarily in the Canada Life block (see Note 14), reducing insurance and annuity benefits by $25 pretax, partially offset by $5 pretax of additional amortization of deferred policy acquisition costs.
The accounting treatment for all of the Company’s equity investments depends upon the Company’s percentage of ownership and degree of management influence. The Company has two equity investments in which it owns less than 50%, but greater than 20%. The Company does not exercise control over either of these entities; therefore we do not consolidate them, but account for them using the equity method. The related carrying value on the consolidated balance sheets and equity in earnings on the income statement is not material.
Debt and equity securities are classified as either securities held-to-maturity, which are stated at amortized cost and consist of securities the Company has the positive intent and ability to hold to maturity, or securities available-for-sale, which are stated at fair value with net unrealized gains and losses included in accumulated other comprehensive income, net of deferred income taxes and adjustments to deferred policy acquisition costs and value of business acquired. Fair value is based on quoted market prices from observable
Dividend and investment income are recognized when earned. Amortization of premiums and accrual of discounts on investments in debt securities are reflected in earnings over the contractual terms of the investments in a manner that produces a constant effective yield. Investment securities are regularly reviewed for impairment based on criteria that include the extent to which cost exceeds market value, the duration of the market decline, and the financial health of and specific prospects for the issuer. Unrealized losses that are considered to be other-than-temporary are recognized in realized gains and losses. See Note 4 for further discussion of the Company’s policies regarding identification of other-than-temporary impairments. Realized gains and losses on dispositions of securities are determined by the specific-identification method.
Mortgage loans on real estate are stated at unpaid balances, net of estimated unrecoverable amounts. In addition to a general estimated impairment allowance, a specific allowance for unrecoverable amounts is provided for when a mortgage loan becomes impaired. Changes in the allowances are reported as realized investment gains (losses) within the consolidated statements of income. Mortgage loans are considered impaired when it becomes probable the Company will be unable to collect the total amounts due, including principal and interest, according to the contractual terms of the loan. Such an impairment is measured based upon the present value of expected cash flows discounted at the effective interest rate on both a loan-by-loan basis and by measuring aggregated loans with similar risk characteristics. Interest on mortgage loans is recorded until collection is deemed improbable. Policy loans are stated at their unpaid balances.
hedged (i.e., as a fair value hedge or cash flow hedge). The Company accounts for changes in fair values of derivatives that are not part of a hedge or do not qualify for hedge accounting through investment income in the period of the change. For derivatives that are designated and qualify as cash flow hedges, the effective portion of the gain or loss realized on the derivative instrument is reported as a component of other comprehensive income and reclassified into earnings in the same period during which the hedged transaction impacts earnings. The remaining gain or loss on these derivative instruments is recognized in investment income during the period of the change. Effectiveness of the Company’s hedge relationships is assessed and measured on a quarterly basis.
Our traditional individual and group insurance products are long-duration contracts. Deferred policy acquisition costs related to these products are amortized over the expected premium paying periods using the same assumptions for anticipated premium revenue that are used to compute liabilities for future policy benefits. For fixed universal life and annuity products, these costs are amortized at a constant rate based on the present value of the estimated future gross profits to be realized over the terms of the contracts. Estimates of future gross profits are determined based upon assumptions for mortality, interest spreads, lapse rates, and policy fees earned.
The carrying amounts of deferred policy acquisition costs and value of business acquired are adjusted
Deferred policy acquisition costs and value of business acquired are reviewed periodically to determine that the unamortized portion does not exceed the expected recoverable amounts. No significant impairments occurred during the three years ending December 31, 2005.
Separate account assets and liabilities represent variable annuity and variable universal life funds segregated for the benefit of the related policyholders who bear the investment risk of their account balances. The separate account assets and liabilities, which are equal, are recorded at fair value. Policyholder account deposits and withdrawals, investment income and realized investment gains and losses in the separate accounts are excluded from the amounts reported in the consolidated statements of income. Fees charged on separate account policyholder account balances are included in universal life and investment product charges in the consolidated statements of income. The amounts of minimum guarantees or other similar benefits related to these policies are negligible.
Property and equipment, which is included in other assets in the consolidated balance sheets, is stated at cost and depreciated principally by the straight-line method over estimated useful lives of 30 to 50 years for buildings, approximately 10 years for other property and equipment and 3 to 5 years for computer hardware and software. Accumulated depreciation was $247 and $223 at December 31, 2005 and 2004. Property and equipment is adjusted for impairment whenever events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. In such cases, the cost basis of the property and equipment is reduced to fair value with the impairment loss being included in realized gains and losses.
The Company has policies in force containing two primary types of sales inducements: 1) day-one bonuses on fixed annuities, which are in the form of either an increased interest rate for a stated period or an additional premium credit; and 2) persistency-related interest crediting bonuses. These bonuses are accrued over the period in which the policy must remain in force for the policyholder to qualify for the inducement. Capitalized sales inducements are amortized using the same methodology and assumptions used to amortize deferred policy acquisition costs. The unamortized balance of our deferred sales inducement asset is reported in other assets within the consolidated balance sheets.
Liabilities related to no-lapse guarantees (secondary guarantees) on universal life-type products are included in other policy liabilities within the consolidated balance sheets. These liabilities are calculated by multiplying the benefit ratio (present value of total expected secondary guarantee benefits over the life of the contract divided by the present value of total expected assessments over the life of the contract) by the cumulative assessments recorded from contract inception through the balance sheet date less the cumulative secondary guarantee benefit payments plus interest. If experience or assumption changes result in a new benefit ratio, the reserves are unlocked to reflect the changes in a manner similar to deferred policy acquisition costs and value of business acquired. The accounting for secondary guarantee benefits impacts, and is impacted by, estimated future gross profits used to calculate amortization of deferred policy acquisition costs, value of business acquired, deferred sales inducements and unearned revenue.
Revenue from universal life-type and annuity products includes charges for the cost of insurance, initiation and administration of the policy and surrender of the policy. Revenue from these charges is recognized in the year assessed to the policyholder, except that any portion of an assessment that relates to services to be provided in future years is deferred as unearned revenue and is recognized as income over the period during which services are provided based upon estimates of future gross profits. The net of amounts deferred and amounts recognized is reflected in universal life and investment product charges in the consolidated statements of income. The effects of changes in estimates of future gross profits, referred to as unlockings, on unearned revenue are reflected in the consolidated statements of income within universal life and investment product charges in the period such revisions occur.
The Company accounts for stock incentive awards in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25), and accordingly, recognizes no
SFAS 123 requires the presentation of pro forma information as if the Company had accounted for its employee and director stock options under the fair value method of that Statement. The Company currently discloses the amortization of fair value of these grants over the explicit vesting period for participants, with acceleration at retirement. Beginning in 2006, expense will be recognized evenly up through the retirement eligibility date or immediately for participants already eligible for retirement. The following is a reconciliation of reported net income and pro forma information as if the Company had adopted the fair value expensing provisions of SFAS 123 for its employee and director stock option awards.
As discussed later under New Accounting Pronouncements, the Company will adopt a new accounting method for stock-based compensation in 2006.
On February 16, 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments, an amendment of FASB Statements No. 133 and 140” (SFAS 155). SFAS 155 eliminates the exemption from applying SFAS 133, “Accounting for Derivative Instruments and Hedging Activities,” to interests in securitized financial assets. In cases in which a derivative would otherwise have to be bifurcated, this Statement allows the election of fair value measurement on an instrument-by-instrument basis at acquisition, at issuance, or when a previously recognized financial instrument is subject to a remeasurement event. SFAS 155 also clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives. This Statement is effective for all financial instruments acquired, issued, or subject to a remeasurement event after the beginning of the first fiscal year that begins after September 15, 2006. The Statement is not expected to have an immediate impact on our consolidated financial condition or results of operations.
On December 19, 2005, the FASB issued FASB Staff Position SOP 94-6-1, “Terms of Loan Products That May Give Rise to a Concentration of Credit Risk” (FSP 94-6-1). FSP 94-6-1 was issued to emphasize the requirement to assess the adequacy of disclosures for all lending products and the effect of changes in market
or economic conditions on the adequacy of those disclosures. It specifically addresses nontraditional loan products that give rise to a concentration of credit risk, such as interest-only loans. FSP 94-6-1 was effective as of December 19, 2005. The Company does not invest in significant amounts of nontraditional loan products and FSP 94-6-1 will not have an immediate impact on our disclosures.
In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AcSEC) issued Statement of Position (SOP) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts” (SOP 05-1). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments”. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of a feature or coverage within a contract. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. Retrospective application of SOP 05-1 to previously issued financial statements is not permitted. The Company is currently evaluating the impact of the adoption of this pronouncement on our consolidated financial condition and results of operations.
In November 2005, the FASB issued FSP No. 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards” (FSP 123R-3), which provides an alternative method to calculate the beginning pool of excess tax benefits against which excess future deferred tax assets could be written off
In February 2006, the FASB issued FSP No. 123(R)-4, “Classification of Options and Similar Instruments Issued as Employee Compensation That Allow for Cash Settlement upon the Occurrence of a Contingent Event” (FSP 123R-4), which is effective upon adoption of SFAS 123-R. This FSP requires companies to classify employee stock options and similar instruments with contingent cash settlement features as liability awards under SFAS 123-R unless the following requirements are met: (1) the contingent event that permits or requires cash settlement (a) is not considered probable of occurring and (b) is not within the control of the employee, and (2) the award includes no other features that would require liability classification. We do not award stock options or similar instruments that allow employees to elect cash settlement; therefore, FSP 123R-4 does not impact our consolidated financial statements.
The Company plans to adopt the provisions of SFAS 123-R under the modified prospective method on January 1, 2006. Under this method, the fair value of all employee stock options vesting on or after the adoption date will be included in the determination of net income. The fair value of stock options will be estimated using an appropriate fair value option-pricing model considering assumptions for dividend yield, expected volatility, risk-free interest rate and expected life of the option. The fair value of the option grants will be amortized on a straight-line basis over the implicit service period of the employee, considering retirement eligibility. The adoption of SFAS 123-R will reduce our earnings per share similarly to what is illustrated in the pro forma disclosures discussed above. However, the consideration of retirement eligibility when determining the vesting period may affect this impact.
Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement, and Modernization Act of 2003
In March 2004, the FASB’s Emerging Issues Task Force (“EITF”) reached a final consensus on Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“EITF 03-1”). EITF 03-1 established impairment models for determining whether to record impairment losses associated with investments in certain equity and debt securities. It also required the accrual of income on a level-yield basis following an impairment of debt securities, where reasonable estimates of the timing and amount of future cash flows can be made. The application of EITF 03-1 was to be effective for reporting periods beginning after June 15, 2004. In September 2004, the FASB issued FSP EITF 03-1-1, “Effective Date
In November 2005, the FASB issued FSP FAS No. 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (FSP 115-1), which addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. This FSP also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. FSP 115-1 amends SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities” and nullifies certain requirements of EITF 03-1. FSP 115-1 is effective for reporting periods beginning after December 15, 2005. We believe our existing policies for recognizing other-than-temporary impairments are consistent with the guidance in FSP FAS 115-1; therefore, the adoption of FSP 115-1 is not expected to have a material impact on our consolidated financial condition or results of operations. See Note 4 for discussion of investment impairments and related disclosures.
In December 2003, the FASB issued SFAS No. 132 (Revised), “Employers’ Disclosures about Pensions and Other Postretirement Benefits” (SFAS 132-R) which revises employers’ disclosures about pension plans and other postretirement benefit plans. It does not require change in the measurement or recognition of those plans. This statement was effective for financial statements with fiscal years ending after December 15, 2003. See Note 13 for the related disclosures.
In July 2003, the AcSEC issued SOP No. 03-1, “Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts” (the SOP or SOP 03-1). The SOP addresses: (i) separate account presentation; (ii) accounting for an insurance company’s proportionate interest in separate accounts; (iii) transfers of assets from the general account to a separate account; (iv) valuation of certain insurance liabilities and policy features such as guaranteed minimum death benefits and annuitization benefits; and (v) accounting for sales inducements. The SOP was effective January 1, 2004 and was adopted through an adjustment for the cumulative effect of a change in accounting principle amounting to $17. Our cumulative effect related primarily to the establishment of additional policy liabilities for secondary guarantees contained in our newer products and accounting for sales inducements resident in certain of our older policies.
In June 2004, the FASB issued FSP No. 97-1 “Situations in Which Paragraphs 17(b) and 20 of FASB Statement No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments, Permit or Require Accrual for an Unearned Revenue Liability” (FSP 97-1). FSP 97-1 clarifies the accounting for unearned revenue liabilities of certain universal-life type contracts under SOP 03-1. The Company’s adoption of FSP 97-1 on July 1, 2004 had no impact on the Company’s consolidated financial position or results of operations.
The FASB issued FIN 46-R in December 2003. Under FIN 46-R, an enterprise consolidates a variable interest entity (VIE), as defined, if the enterprise absorbs a majority of the VIE’s expected losses, receives a majority of its expected residual returns, or both, as a result of ownership, contractual or other financial interests in the VIE. Prior to FIN 46-R, entities were generally consolidated by an enterprise only when it had a controlling financial interest through ownership of a majority voting interest in the entity. In accordance with FIN 46-R, effective December 31, 2003, the Company deconsolidated Jefferson Pilot Capital Trust A and Jefferson Pilot Capital Trust B (the Trusts), VIEs that issued $300 of redeemable preferred securities in private placement transactions in 1997. As a result of the deconsolidation of the Trusts, the consolidated balance sheets now reflect junior subordinated debentures purchased from the Company by the Trusts in 1997, which had previously been eliminated in consolidation. Interest expense on the junior subordinated debentures is presented as interest expense in the consolidated statements of income and is presented as an operating cash outflow on the consolidated statements of cash flow.
For the years ended December 31, 2005, 2004 and 2003, 598,430, 165,736 and 1,247,825 stock options, weighted for the portion of the period they were outstanding, with a weighted average exercise price of $51.10, $52.97 and $46.83 per share, were excluded from the computation of diluted earnings per share because the options, based upon the application of the treasury stock method, were anti-dilutive.
In its securities lending program, the Company generally receives cash collateral in an amount that is in excess of the market value of the securities loaned. Market values of securities loaned and collateral are monitored daily, and additional collateral is obtained as necessary. The market value of securities loaned and collateral received amounted to $259 and $267 at December 31, 2005 and $5 and $5 at December 31, 2004.
Changes in amounts affecting net unrealized gains included in other comprehensive income, reduced by deferred income taxes, were as follows:
See Note 6 for discussion of amortization of deferred policy acquisition costs, value of business acquired and deferred sales inducements.
Information about total gross realized gains and losses on securities, including other-than-temporary impairments, follows:
Information about gross realized gains and losses on available-for-sale securities, including other-than-temporary impairments, follows:
Investments in debt and equity securities include 1,791 issuers. Debt and equity securities include investments in Bank of America of $432 and $477 as of December 31, 2005 and 2004. No other corporate issuer represents more than one percent of investments.
As of December 31, 2005, the Company’s commercial mortgage loan portfolio was comprised of conventional real estate mortgages collateralized primarily by retail (32%), industrial (23%), office (20%), apartment (12%), and hotel (8%) properties. Our mortgage loan underwriting standards emphasize the credit status of a prospective borrower, quality of the underlying collateral and loan-to-value relationships. Approximately 29% of stated mortgage loan balances as of December 31, 2005 are for properties located in South Atlantic states, approximately 21% are for properties located in Pacific states, approximately 13% are for properties located in West South Central states and approximately 10% are for properties located in Mountain states. No other geographic region represents as much as 10% of December 31, 2005 mortgage loans.
The Company sold certain securities that had been classified as held-to-maturity, due to significant declines in credit worthiness. The net amortized costs of sold securities were $1, $24, and $29 for 2005, 2004 and 2003. The realized gains on the sales of these securities, some of which were previously impaired, were $0, $1 and $9 for 2005, 2004 and 2003.
One statistic to which we pay particular attention with respect to debt securities is the Fair Value to Amortized Cost ratio. Securities with a fair value to amortized cost ratio in the 90%-99% range are typically securities that have been impacted by increases in market interest rates or sector spreads. Securities in the
80%-89% range are typically securities that have been impacted by increased market yields, specific credit concerns or both. These securities are monitored to ensure that the impairment is not other-than-temporary. Securities with a fair value to amortized cost ratio less then 80% are considered to be “potentially distressed securities,” and are subjected to rigorous review. The following factors are considered: the length of time a security’s fair value has been below amortized cost, industry factors or conditions related to a geographic area that are negatively affecting the security, downgrades by rating agencies, the valuation of assets specifically pledged to support the credit, the overall financial condition of the issuer, past due interest or principal payments, and our intent and ability to hold the security for a sufficient time to allow for a recovery in value.
Certain swaps serve as economic hedges but do not qualify for hedge accounting under SFAS 133. These swaps are marked to market through realized gains. The Company’s realized investment gains from these swaps were $1, $1 and $0 in 2005, 2004 and 2003.
For the years ended December 31, 2005, 2004 and 2003 the Company recognized other comprehensive income related to cash flow hedges, net of taxes, of $(6), $(3) and $(5). The Company does not expect to reclassify a significant amount of net gains (losses) on derivative instruments from accumulated other comprehensive income to earnings during 2006.
The Company also invests in debt securities with embedded options, which are considered to be derivative instruments under SFAS 133. These derivatives are marked-to-market through realized investment gains and were insignificant for 2005, 2004 and 2003.
As discussed in Note 2, investment income allocated to the Individual Products, AIP and Benefit Partners segments is reduced by a default charge intended to replicate expected credit losses over an economic cycle. In 2003, the Company unlocked its deferred policy acquisition cost and VOBA models with respect to the default charge assumption, resulting in a favorable adjustment to realized gains and losses.
The liability for future policy benefits associated with ordinary life insurance policies was determined using initial interest rate assumptions ranging from 2.0% to 11.5% and, when applicable, uniform grading over 10 to 30 years to ultimate rates ranging from 2.0% to 6.5%. Interest rate assumptions for weekly premium, monthly debit and term life insurance products generally fall within the same ranges as those pertaining to ordinary life insurance policies.
Credited interest rates for universal life-type products ranged from 3.0% to 9.0% in 2005, 2004 and 2003. The average credited interest rates for universal life-type products were 4.5%, 4.6 % and 5.0 % for 2005, 2004 and 2003. For annuity products, credited interest rates generally ranged from 2.8% to 8.8% in 2005, 3.0% to 8.0% in 2004 and 3.0% to 7.6% in 2003. The average credited interest rates for annuity products were 4.1%, 4.4% and 4.9% for 2005, 2004 and 2003.
Assumed mortality rates are generally based on experience multiples applied to select and ultimate tables commonly used in the industry. Withdrawal assumptions for individual life insurance policies are based on historical Company experience and vary by issue age, type of coverage and policy duration.
The subsidiary issued $300 of funding agreements in June 2005. The initial funding agreements were issued at a variable rate and provide for quarterly interest payments, indexed to the 3-month LIBOR plus 7 basis points, with principal due at maturity on June 2, 2008. Concurrent with this issuance, the subsidiary executed an interest rate swap for a notional amount equal to the proceeds of the funding agreements. The swap qualifies for cash flow hedge accounting treatment and converts the variable rate of the funding agreements to a fixed rate of 4.28%.
The junior subordinated debentures were issued in 1997 and consist of $206 at an interest rate of 8.14% and $103 at an interest rate of 8.285%. Interest is paid semi-annually. These debentures mature in 2046, but are redeemable prior to maturity at the option of the Company beginning January 15, 2007, with two-thirds subject to a call premium of 4.07% and the remainder subject to a call premium of 4.14%, each grading to zero as of January 15, 2017.
The Company has 20,000,000 shares of preferred stock authorized (none issued) with the par value, dividend rights and other terms to be set by the Board of Directors, subject to certain limitations on voting rights.
A total of 10,202,948 shares are available for issuance pursuant to outstanding or future awards as of December 31, 2005. The option price is never less than the market value of the Company’s common stock on the award date. Options are exercisable for periods determined by the Committee, not to exceed ten years from the award date, and vest immediately or over periods as determined by the Committee. Restricted and unrestricted stock grants are limited to 10% of the total shares reserved for the Plan. This plan will terminate as to further awards on May 3, 2009, unless terminated earlier by the Board.
The following table summarizes certain stock option information at December 31, 2005:
The Company’s life insurance subsidiaries prepare financial statements on the basis of SAP prescribed or permitted by the insurance departments of their states of domicile. Prescribed SAP includes the Accounting Practices and Procedures Manual of the National Association of Insurance Commissioners (NAIC) as well as state laws, regulations and administrative rules. Permitted SAP encompasses all accounting practices not so prescribed. None of the life insurance subsidiaries utilize permitted practices in the preparation of their statutory financial statements.
A comparison of net income and statutory capital and surplus of the life insurance subsidiaries determined on the basis of SAP to net income and stockholders’ equity of these life insurance subsidiaries on the basis of GAAP was as follows:
Prior to its acquisition, Guarantee Life Insurance Company (Guarantee, which was subsequently merged into JPFIC) converted from a mutual form to a stock life company. In connection with that conversion, Guarantee agreed to segregate certain assets to provide for dividends on participating policies using dividend scales in effect at the time of the conversion, providing that the experience underlying such scales continued. The assets allocated to the participating policies, including revenue there from, will accrue solely to the benefit of those policies. The assets and liabilities relating to these participating policies amounted to $321 and $333 at December 31, 2005 and $323 and $342 at December 31, 2004. The excess of liabilities over the assets represents the total estimated future earnings expected to emerge from these participating policies.
Federal income tax returns for 2000 through 2003 are currently under examination. In the opinion of management, recorded income tax liabilities adequately provide for our expected liability on all remaining open years.
The amounts included within other comprehensive income related to the increase in the minimum pension liability were $2 and $9, net of taxes for 2005 and 2004.
The assumption for long-term rate of return on assets is derived from historical returns on investments of the types in which pension assets are invested. A range of assumptions for long-term rate of return is projected for benchmarks representing each asset class. The upper and lower range limits are based on optimistic and pessimistic assumptions, respectively, and reflect historical returns that are adjusted to reflect factors that might cause future experience to differ from the past, differences between the benchmarks and the plans’ assets, and the effects of asset smoothing. The adjusted rates of return are weighted by target allocations for each asset class to derive limits for a range of overall long-term gross rates of return. Within this range, one rate of return is selected as the best estimate. From that rate the Company subtracts an estimate of expenses, and the result is the basis for the assumed long-term rate of return on assets.
The Company sponsors contributory health care and life insurance benefit plans for eligible retired employees, qualifying retired agents and certain surviving spouses. The Company contributes to a welfare benefit trust from which future benefits will be paid. The Company accrues the cost of providing postretirement benefits other than pensions during the employees’ active service period. The non-pension postretirement expense was $2 in 2005, 2004 and 2003.
The insurance subsidiaries attempt to reduce exposure to significant individual claims by reinsuring portions of certain individual life insurance policies and annuity contracts written. They reinsure the portion of individual life insurance risks in excess of their retention, which ranges from $0.4 to $2.1 for various individual life and annuity products. They also attempt to reduce exposure to losses that may result from unfavorable events or circumstances by reinsuring certain levels and types of accident and health insurance risks underwritten.
Assets related to the Household reinsured business have been placed in irrevocable trusts formed to hold the assets for the benefit of JPFIC and are subject to investment guidelines which identify (1) the types and quality standards of securities in which new investments are permitted, (2) prohibited new investments, (3) individual credit exposure limits and (4) portfolio characteristics. Household has unconditionally and irrevocably guaranteed, as primary obligor, full payment and performance by its affiliated reinsurers. JPFIC has the right to terminate the PPA and COLI reinsurance agreements by recapture of the related assets and liabilities if Household does not take a required action under the guarantee agreements within 90 days of a triggering event.
The life insurance subsidiaries generally assume portions of the life and accident and health risks underwritten by certain other insurers on a limited basis. In March 2004, the Company acquired (via a reinsurance transaction) substantially all of the in-force U.S. group life, disability and dental business of The Canada Life Assurance Company (Canada Life), an indirect subsidiary of Great-West Lifeco Inc. Upon closing, Canada Life ceded, and the Company assumed, approximately $400 of policy liabilities. The Company also received assets, primarily comprised of cash, in support of those liabilities. The deferred policy acquisition costs recorded in the transaction are being amortized over 15 years, representing the expected premium-paying period of the blocks of policies acquired. An intangible asset of $25, attributable to the value of the distribution system acquired in the transaction, was recorded in other assets within the consolidated balance sheets and is being amortized over 30 years, representing the period over which the Company expects to earn premiums from new sales stemming from the added distribution capacity. The revenues and benefits and expenses associated with these blocks are presented in the Company’s consolidated statements of income in a manner consistent with the Company’s accounting policies. Most of the business assumed has subsequently been rewritten to our own policy forms such that the Company is now the direct writer of this business.
The effects of reinsurance on premiums and other considerations, universal life and investment product charges and total benefits were as follows:
The negative benefits assumed amount in 2005 was a result of lapsation within the Canada Life block.
The Company has five reportable segments, which are defined based on the nature of the products and services offered: Individual Products, Annuity and Investment Products (AIP), Benefit Partners, Communications, and Corporate and Other. Within the Individual Products segment, the Company offers a wide array of individual life insurance products including variable life insurance. Approximately 60%, 56%
The segments are managed separately because of the different products, distribution channels and marketing strategies each employs. The Company evaluates performance based on several factors, of which the primary financial measure is reportable segment results, which consists of net income before realized gains and losses and cumulative effect of change in accounting principle. The accounting policies of the business segments are the same as those described in Note 2. Substantially all revenue is derived from sales in the United States, and foreign assets are not material.
Default charges paid to the Corporate and Other segment by Individual, AIP and Benefit Partners were $25, $13, $2 for 2005; $23, $14, $2 for 2004; and $20, $10, $1 for 2003.
The Company allocates depreciation expense to Individual Products, AIP and Benefit Partners, but the related fixed assets are contained in the Corporate and Other segment. In addition, the Company allocates income tax expense to Individual Products, AIP and Benefit Partners, but the related liabilities are contained in the Corporate and Other segment. Substantially all borrowings and related interest expense are contained in the Corporate and Other segment.
The fair values of debt and equity securities and derivative financial instruments have been determined from nationally quoted market prices and by using values supplied by independent pricing services and discounted cash flow techniques.
amounts due to their short-term nature. Similarly, the fair value of the liability for securities sold under repurchase agreements approximates its carrying amount, which includes accrued interest.
The fair value of the junior subordinated debentures was determined based on discounted cash flows using the Company’s current incremental borrowing rates and also considering costs associated with call options on these debentures.
The Company leases electronic data processing equipment and field office space under noncancelable operating lease agreements. The lease terms range from one to seven years. Neither annual rent nor future rental commitments are significant.
In the normal course of business, the Company and its subsidiaries are parties to various lawsuits.