(1) Includes the net increase in deferred policy acquisition costs, amortization of value of business acquired and goodwill, compensation expense, and other operating expenses. Included in 2004 are charges related to the impairment of the individual income protection - closed block deferred policy acquisition costs, value of business acquired, and goodwill balances of $282.2 million, $367.1 million, and $207.1 million, respectively.
(4) Amounts reported for 2004 and 2003 include after-tax losses of $71.3 million and $196.9 million, respectively, from the Canadian branch sale and write-downs.
The Company is the largest provider of group and individual income protection insurance products and a leading provider of life, accident, and long-term care products in the United States and the United Kingdom. The Company believes that its product line, its commitment to high quality service, and its claims management approach position the organization well to compete in this highly competitive business. In addition to competition, portions of the Company’s business are sensitive to economic and financial market factors, including consumer confidence, employment levels, and the level of interest rates.
Total segment operating revenue was $10.4 billion in 2004, compared to $10.2 billion in 2003. Segment operating performance improved during 2004 relative to the prior year for the U.K. operation, the Colonial segment, and many of the U.S. brokerage lines of business. Although the U.S. group income protection business performance in 2004 was below the Company’s long-term expectations, the Company believes that this business continues to show improvement due to the actions taken over the past several quarters to increase the profitability in this business, as evidenced by the decline in the benefit ratio during 2004 relative to the prior year. The Company continues to focus on a balanced mix of profitable business and a disciplined approach to pricing, renewals, and risk selection to improve the profitability of this business. The Company also believes that improvements in the economic environment, such as a higher interest rate environment, greater consumer confidence, and an increase in new jobs, will ultimately contribute to enhanced operating results.
Pressure on new sales and persistency due to the competitive pricing environment and concerns regarding the Company’s financial strength;
Examinations and investigations, including the investigations into broker compensation, the multistate market conduct examination and other claim related investigations, and the multidistrict litigation;
The performance and potential risk associated with the closed block of individual income protection business, specifically concerns regarding reserves, deferred policy acquisition costs, and overall profitability.
During 2004, the Company entered into settlement agreements with state insurance regulators of 48 states upon conclusion of a multistate market conduct examination. Discussions continue with the California Department of Insurance, which did not join the multistate settlement agreements. Throughout 2004, the Company continued to cooperate and provide information in response to other regulatory investigations, as discussed more fully herein and in the “Notes to Consolidated Financial Statements” contained herein in Item 8.
The current interest rate environment continues to be a challenge for the Company, with low interest rates and a limited supply of investments which meet the Company’s quality, yield, and duration requirements. The Company intends to maintain its interest margins in its reserves and will lower the discount rate on new income protection claims if necessary to do so. The Company has hedging strategies in place wherein, with the current interest rate environment, it expects that approximately 50 percent of its 2005 operating cash flows and cash flows from maturities of investments are hedged at rates that meet or exceed the desired margins.
Successful implementation of the changes required by the multistate market conduct regulatory settlement agreements and restoration of more consistent claim management performance;
During 2004, certain of the Company’s insurance subsidiaries entered into settlement agreements with state insurance regulators upon conclusion of a multistate market conduct examination led by Maine, Massachusetts, and Tennessee relating to disability claims handling practices. A total of 48 states and the District of Columbia are parties to the settlement agreements. In addition, the U.S. Department of Labor (DOL), which had been conducting an inquiry relating to certain ERISA plans, is a party to the settlement agreements, and the Office of the New York Attorney General, which had engaged in its own investigation of the Company’s claims handling practices, notified the Company that it was in support of the settlement and was, therefore, closing its investigation on this issue. The examination report did not make any findings of violations of law or market conduct regulations. However, the examination report did identify areas of concern. These became the focus of specific changes and enhancements to the Company’s disability claims handling operations which are designed to assure each claim decision is made in a consistently high quality manner.
payment of a fine in the amount of $15.0 million to be allocated among the states and jurisdictions that joined the agreements and a potential fine of $145.0 million in the future if certain standards are not met in examinations at the end of approximately two years.
The Company has also agreed to enhance certain aspects of its claim operations, including making changes to its organization and procedures to improve the consistency of and the support for each claim decision and create an easier process for claimants. First, the Company is increasing the number of experienced claims professionals involved in making claim decisions, as well as more heavily involving higher levels of management in signing off on adverse claim decisions. Doing so will not only put more experienced people into closer contact with claim decisions, but it should also improve turnaround times and clarify accountability for claims decisions. Second, to improve the support for the initial claim decisions, the Company is modifying its policies regarding medical information, including guidelines for the use of independent medical evaluations and the process for handling claimants with multiple medical conditions. Third, to make it easier for a claimant to understand and proceed through the claim process, the Company is adding a number of service components, including referring certain claims to field personnel who will meet with the claimant in an effort to make the process less burdensome. Also, there will be an additional telephone hotline available to claimants who seek additional assistance. Finally, to further assure consistency in the initial claim decision, the Company is adding a position of quality compliance consultant to assess the totality of the claim decision and to focus on issues of compliance and documentation.
entitles the holder to contract adjustment payments at the annual rate of 3.165 percent, payable quarterly, and (b) a 1/40 or 2.5 percent ownership interest in a senior note issued by the Company due May 15, 2009 with a principal amount of $1,000, on which the Company will pay interest at the initial annual rate of 5.085 percent, payable quarterly. Upon settlement of the common stock purchase contract and successful remarketing of the senior note element of the units, the Company will receive proceeds of approximately $300.0 million and will issue between 17.7 million and 20.4 million shares of common stock. Prior to settlement of the common stock purchase contract in May 2007, the purchase contract element of these units will have a dilutive effect on the Company’s net income per common share, assuming dilution, when the average market price of the Company’s common stock during the period exceeds the threshold appreciation price of $16.95 per share. After settlement of the common stock purchase contract in 2007, the weighted average common shares outstanding for computing net income per common share, both basic and assuming dilution, will increase by the actual number of shares issued.
In the second quarter of 2004, the Company acquired Integrated Benefits Management, a provider of case management services, at a price of $0.7 million. This acquisition will further broaden the relationship and distribution partnerships of the Company’s wholly-owned subsidiary, GENEX Services, Inc.
In conjunction with the restructuring of its Argentinean operation, the Company reduced its ownership position in this operation to 40 percent during the fourth quarter of 2004 and reported a before-tax loss of $4.7 million. The Company also recognized from this transaction a tax benefit of $7.4 million, for a net after-tax gain of $2.7 million on the 2004 transaction. The Company wrote down the book value of the Argentinean operation to the estimated fair value less cost to sell during the fourth quarter of 2003 and at that time recognized an impairment loss of $13.5 million before tax and $11.3 million after tax.
During the first quarter of 2003, Unum Limited acquired the United Kingdom group income protection business of Sun Life Assurance Company of Canada (UK) Ltd (Sun Life) together with the renewal rights to Sun Life’s group life business, at a price of approximately $37.2 million.
Transition to the provisions of FIN 46 at December 31, 2003 required the Company to consolidate four special purpose entities whose purposes are to support the Company’s investment objectives. Prior to December 31, 2003, these entities were accounted for as fixed maturity securities in the available-for-sale portfolio and carried at fair value which was derived from the fair value of the underlying assets. These entities are securitized asset trusts and contain specific financial instruments that do not include the Company’s common stock or debt. Three of these entities are trusts holding forward contracts to purchase unrelated equity securities. Each of these trusts also holds a defeasance swap contract for highly rated bonds to provide principal protection for the investments. The fair value of the underlying forward and swap contracts was $133.9 million at December 31, 2003, which was equivalent to the fair value at which they would have been reported as fixed maturity securities prior to the adoption of FIN 46. The fourth entity is a trust containing a highly rated bond for principal protection, unrelated equity securities, and several partnership equity investments. The Company contributed the bond and partnership investments into the trust at the time it was established. The purpose of this trust was to allow the Company to maintain its investment in the partnerships while at the same time protecting the principal of the investment. The fair values of the bond, equity securities, and partnerships were $61.8 million, $7.0 million, and $51.7 million, respectively, at December 31, 2003, which were equivalent to the fair values at which they would have been reported as fixed maturity securities. The adoption of FIN 46 and FIN 46(R) had no impact on the fair value of total invested assets reported in the Company’s consolidated statements of financial condition.
Adoption of FIN 46 and FIN 46(R) also resulted in the de-consolidation of a trust that currently holds $300.0 million of junior subordinated debt securities of the Company and has issued a similar amount of mandatorily redeemable preferred securities. The impact of the de-consolidation was the elimination of the company-obligated mandatorily redeemable preferred securities of subsidiary trust holding solely junior subordinated debt securities of the company included in the consolidated statements of financial condition and an increase of $300.0 million in long-term debt. See the “Notes to Consolidated Financial Statements” contained herein in Item 8 for further discussion of FIN 46.
The Company has two reinsurance contracts for which DIG Issue B36 is applicable. Transition to the provisions of DIG Issue B36 required the Company to value the credit risk provisions in these contracts as derivatives. The derivatives are now reported in the Company’s consolidated statements of financial condition at their current fair values, with the change in fair value since inception of the reinsurance contracts up to the date of adoption reported as a 2003 cumulative effect of accounting principle change. The Company includes in miscellaneous assets a deposit asset for one of the applicable reinsurance contracts. The deposit asset previously included unrealized gains or losses on the marketable securities held in the trust. Under the provisions of DIG Issue B36, any net unrealized gain is attributed to the value of the embedded derivative and is reported as such in fixed maturity securities. Any net unrealized loss will be attributed to the marketable securities held in the trust and reported as an adjustment to the deposit asset, with the related effects on claim reserves reflected in the reinsurance receivable for claim reserves.
The adoption of DIG Issue B36 resulted in an increase in fixed maturity securities of $61.3 million to record the fair value of the embedded derivatives, a decrease of $116.1 million in miscellaneous assets, $18.4 million in reinsurance receivable, and $134.5 million in accumulated other comprehensive income (net unrealized gain on securities) to eliminate the previously reported adjustment to fair value of the marketable securities held in the trust and the related effects on claim reserves, and a $39.9 million cumulative effect of accounting principle change, net of $21.4 million in tax. See Item 8, Notes 1 and 5 of the “Notes to Consolidated Financial Statements” for further discussion.
Continued declines in the performance of equity investment markets combined with steadily increasing pension liabilities reduced the Company’s U.S. and foreign pension plans funding levels such that in December 2002, in accordance with the provisions of SFAS 87, the Company recorded a $145.0 million non-cash minimum pension liability adjustment, net of tax, to accumulated other comprehensive income in stockholders’ equity. In December 2003, as a result of improvements in the performance of the equity investment markets, the Company reduced the non-cash minimum pension liability adjustment by $19.7 million, net of tax.
The Company’s net periodic benefit cost for its U.S. and foreign pension plans increased in 2003 due to the decline in the stock market and the general decline in overall corporate bond yields used to establish the discount rate for projecting the benefit obligation. The net periodic benefit cost for 2003 was $51.8 million compared to a $2.7 million net periodic benefit cost for 2002.
As previously discussed, in December 2002, the Company recorded a $145.0 million non-cash minimum pension liability adjustment, net of deferred federal income tax, to accumulated other comprehensive income in stockholders’ equity.
Claim reserves, unlike policy reserves, are subject to revision as current claim experience and projections of future factors affecting claim experience change. In a reporting period, actual experience may deviate from the long-term assumptions used to determine the claim reserves. The Company reviews annually, or more frequently as appropriate, emerging experience to ensure that its claim reserves make adequate and reasonable provision for future benefits and expenses. The Company’s reserves for group and individual income protection products include a provision for future payments, other than legal expenses, on all claim related lawsuits for which the cause of action has already occurred. This includes known lawsuits and those yet to be filed. The reserve amount is the Company’s estimate of the payments on all such lawsuits based on past payments and expected future payments.
purchased is below or above the investment yield of the existing investment portfolio, it is likely that the discount rate on new claims will be established below or above the discount rate on existing claims. It is the Company’s intent to use a discount rate that provides some margin for adverse movement in the investment portfolio yield rate.
The Company has liability for claims that have been incurred but not reported to the Company and must establish a liability for these claims equal to the present value of the expected benefit payments. In addition to the discount rate and claim resolution rate, the incidence rate is also a primary assumption in the IBNR reserve. The incidence rate is the rate at which new claims per thousand insured lives are submitted to the Company. The incidence rate is affected by many factors including the age of the insured, the insured’s occupation or industry, the benefit plan design, and certain external factors such as consumer confidence and levels of unemployment. The Company establishes the incidence assumption using a historical review of actual incidence results along with an outlook of future incidence expectations. As the actual claims are reported and claim reserves are established, the accuracy of the IBNR emerges. While the Company expects its IBNR reserve to be appropriate over the long term, it will not always equal, in a particular reporting period, the actual reserve established for a reported claim. For example, a 10 basis point deviation in the actual incidence rate from that assumed in the IBNR reserve would have resulted in an increase or decrease of approximately $10.0 million in claim reserves established during a quarter in 2004, relative to the IBNR reserve previously established to cover those claims.
The increase in all other reserves is driven by growth within the U.K. operations and the long-term care line of business along with the first quarter of 2004 reserve charge of $110.6 million in the Individual Income Protection - Closed Block segment. Additionally, all other reserves for group income protection increased $40.5 million in the fourth quarter of 2004 for the reserve charge related to settlement of the multistate market conduct examination.
Accounting Standards No. 60, Accounting and Reporting by Insurance Enterprises. The estimated premium income in the early years of the amortization period is higher than in the later years due to higher anticipated policy persistency in the early years, which results in a greater proportion of the costs being amortized in the early years of the life of the policy. Amortization of deferred costs on traditional products is adjusted to reflect the actual policy persistency as compared to the anticipated experience. The Company will experience accelerated amortization if policies terminate earlier than projected.
Deferred costs related to group and individual income protection products are generally amortized over a twenty-year period, with approximately 75 percent and 90 percent of the original deferred costs related to group income protection products expected to be amortized by years ten and fifteen, respectively. For individual income protection policies, approximately 55 percent and 80 percent of the original deferred costs are expected to be amortized by years ten and fifteen, respectively. Deferred costs for group and individual long-term care products are amortized over a twenty-year period, with approximately 45 percent and 70 percent of the original deferred costs expected to be amortized by years ten and fifteen, respectively.
Due to the Company’s actual persistency experienced in recent years relative to what was expected when policies were issued, the Company lowered its premium persistency assumptions for costs deferred in 2002 and thereafter for certain of its products to reflect the Company’s current estimate of persistency. This accelerates the amortization of group income protection and group life acquisition costs deferred in those years into the early life of the policy.
The Company’s ability and intent to retain the security for a sufficient period of time for it to recover.
Private placement fixed maturity securities had a fair value of approximately $3.8 billion, or 11.6 percent of total fixed maturity securities at December 31, 2004. Private placement fixed maturity securities do not have readily determinable market prices. For these securities, the Company uses internally prepared valuations combining matrix pricing with vendor purchased software programs, including valuations based on estimates of future profitability, to estimate the fair value. Additionally, the Company obtains prices from independent third-party brokers to establish valuations for certain of these securities. The Company’s ability to liquidate its positions in some of these securities could be impacted to a significant degree by the lack of an actively traded market, and the Company may not be able to dispose of these investments in a timely manner. Although the Company believes its estimates reasonably reflect the fair value of those securities, the key assumptions about the risk-free interest rates, risk premiums, performance of underlying collateral (if any), and other factors involve significant assumptions and may not reflect those of an active market. The Company believes that generally these private placement securities carry a credit quality comparable to companies rated Baa or BBB by major credit rating organizations.
Risk free interest rates of 3.61 percent for five-year maturities to 4.83 percent for 30-year maturities were derived from the current yield curve for U.S. Treasury Bonds with similar maturities.
Changes in the fair value of fixed maturity securities, other than declines that are determined to be other than temporary, are reported as a component of other comprehensive income in stockholders’ equity. If it is subsequently determined that any of these securities are other than temporarily impaired, the impairment loss is reported as a realized investment loss in the consolidated statements of operations. The recognition of the impairment loss does not affect total stockholders’ equity to the extent that the decline in value had been previously reflected in other comprehensive income.
The economic outlook, either domestic or foreign, may be less favorable or may have a more significant impact on the borrower than anticipated, and as such, the security may not recover in value.
Reinsurance is a contractual agreement whereby the Company’s reinsurance partners assume a defined portion of the risk for future benefits payable under reinsurance contracts. The reinsurance receivable reported as an asset in the Company’s consolidated statements of financial condition includes amounts due from the Company’s reinsurers on current claims and estimates of amounts that will be due on future claims. Policy reserves and claim reserves reported in the Company’s consolidated statements of financial condition are not reduced for reinsurance. The reinsurance receivable is generally equal to the policy reserves and claim reserves related to the risk being reinsured. The Company reduces the reinsurance receivable if recovery is not likely due to the financial position of the reinsurer or if there is disagreement between the Company and the reinsurer regarding the liability of the reinsurer.
The goodwill reported as an asset in the Company’s consolidated statements of financial condition at December 31, 2004 is attributable primarily to the acquisition of Paul Revere Life Insurance Company (individual income protection - recently issued business) and GENEX Services, Inc. (disability management services business). The impairment testing for goodwill involves estimating the fair value of the individual income protection block of recently issued business and the fair value of the disability management services business based upon the present value of future cash flows using assumptions such as future sales, morbidity experience, portfolio yield rate, and the rate of return at which the Company believes the market would price the businesses for purchase. Adverse changes in any of these factors could result in an impairment of goodwill for either or both of the blocks of business.
The Company records a valuation allowance to reduce deferred tax assets to the amount that is more likely than not to be realized. The Company’s valuation allowance relates primarily to assets for foreign net operating loss carryforwards and assets for the Company’s basis in certain of its foreign subsidiaries that are not likely to be realized in the future based on management’s expectations using currently available evidence. In evaluating the ability to recover deferred tax assets, the Company has considered all available positive and negative evidence including past operating results, the existence of cumulative losses in the most recent years, forecasted earnings, future taxable income, and prudent and feasible tax planning strategies. In the event the Company determines that it most likely would not be able to realize all or part of its deferred tax assets in the future, an increase to the valuation allowance would be charged to earnings in the period such determination is made. Likewise, if it is later determined that it is more likely than not that those deferred tax assets would be realized, the previously provided valuation allowance would be reversed.
The calculation of the Company’s tax liabilities involves dealing with uncertainties in the application of complex tax laws in a multitude of jurisdictions, both domestic and foreign. The amount of income taxes paid by the Company is subject to ongoing audits in various jurisdictions, and a material assessment by a governing tax authority could affect profitability. The Company records tax liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on management’s estimate of whether, and to the extent which, additional taxes will probably be due. However, due to the complexity of the tax laws and uncertainties in their interpretation, the ultimate resolution may result in a payment that is materially different from the current estimate of the probable tax liabilities. If the estimate of the tax liabilities proves to be less than the ultimate assessment, an additional charge to expense would result. If payment of these amounts ultimately proves to be less than the recorded amounts, the reversal of the liabilities would result in tax benefits being recognized in the period when the Company determines the liabilities are no longer probable. Management believes that adequate accruals have been provided for all years presented.
Cash outlays for income taxes are not expected to exceed income tax expense during the next three years.
Premiums for fully insured products are reported as premium income while the fees for administrative services only (ASO) products, wherein the risk and responsibility for funding claim payments remains with the customer, are included in other income. Sales, together with persistency of the existing block of business and the Company’s renewal program, are an indicator of growth in the Company’s premium and fee income. Trends in new sales, as well as existing market share, are also indicators of the Company’s potential for growth in its respective markets and the level of market acceptance of price changes and new product offerings. Sales may fluctuate significantly due to case size and timing of sales submissions. Negative media attention or downgrades in the financial strength ratings of the Company’s insurance subsidiaries may adversely affect the Company’s ability to grow sales and renew its
existing business. Sales growth was not expected during 2004 for the Company’s group income protection and its group life and accidental death and dismemberment lines of business, particularly in the large-employer market, as the Company continued with the strategy it implemented in 2003 to shift its business mix so as to increase its share of its small and mid-employer markets. The Company intends to maintain its disciplined approach to pricing, renewals, and risk selection, with a focused effort on balancing growth and profitability. While managing its business mix in this disciplined manner, the Company expects to continue to be a leading provider in the large-employer market segment.
The Company has field sales personnel who specialize in (1) employer-provided plans for employees and (2) supplemental benefit plans that include multi-life income protection and long-term care product offerings and products sold to groups of employees through payroll deduction at the workplace. These field sales personnel partner with Company representatives from claims, customer service, and underwriting who work in conjunction with independent brokers and consultants to present coverage solutions to potential customers and to manage existing customer accounts. The Company utilizes a distribution model for the sale of individual income protection and individual long-term care insurance products whereby independent brokers and consultants are provided direct access to a sales support center centrally located in the Company’s corporate offices. The Company intends to maintain its focus on workplace customers and increased integration between individual multi-life and group offerings by continuing to provide highly focused field support. The Company also utilizes an agency sales force to market the products offered by its Colonial segment.
As previously discussed in Item 1 contained herein, the Company’s reporting segments include the following six business segments: Income Protection, Life and Accident, Colonial, Individual Income Protection - Closed Block, Other, and Corporate. The segments remain unchanged from prior year reporting other than the separation of the Individual Income Protection - Closed Block from the Income Protection segment. Prior year numbers have been reclassified to conform to the current segment reporting.
In the following segment financial data and discussions of segment operating results, “operating revenue” excludes net realized investment gains and losses. “Operating income” or “operating loss” excludes net realized investment gains and losses, income tax, results of discontinued operations, and cumulative effect of accounting principle change. These are considered non-GAAP financial measures. A non-GAAP financial measure is a numerical measure of a company’s performance, financial position, or cash flows that excludes or includes amounts that are not normally excluded or included in the most directly comparable measure calculated and presented in accordance with accounting principles generally accepted in the United States (GAAP).
These non-GAAP financial measures of “operating revenue” and “operating income” or “operating loss” differ from revenue and income (loss) from continuing operations before income tax and cumulative effect of accounting principle change as presented in the Company’s consolidated operating results reported herein and in income statements prepared in accordance with GAAP due to the exclusion of before-tax realized investment gains and losses. The Company measures segment performance for purposes of Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information, excluding realized investment gains and losses because management believes that this performance measure is a better indicator of the ongoing businesses and the underlying trends in the businesses. The Company’s investment focus is on investment income to support its insurance liabilities as opposed to the generation of realized investment gains and losses, and a long-term focus is necessary to maintain profitability over the life of the business. Realized investment gains and losses are dependent on market conditions and not necessarily related to decisions regarding the underlying business of the Company’s segments. However, income or loss excluding realized investment gains and losses does not replace net income or net loss as a measure of the Company’s overall profitability. The Company may experience realized investment losses, which will affect future earnings levels as the underlying business is long-term in nature and requires that the Company be able to earn the assumed interest rates in its liabilities.
Included in the 2004 before-tax operating loss by segment of $288.7 million is a before-tax charge of $127.0 million related to the settlement of the multistate market conduct examination and a before-tax charge of $967.0 million related to the restructuring of the individual income protection-closed block business. Included in the 2003 before-tax operating loss by segment of $261.4 million is a before-tax charge of $894.0 million related to group income protection reserve strengthening.
The Income Protection segment includes group long-term and short-term income protection insurance, recently issued individual income protection insurance, group and individual long-term care, and managed disability. Shown below are financial results for the income protection segment. In the sections following, financial results and key ratios are also presented for the major lines of business within the segment.
The Company anticipated relatively weaker sales comparisons throughout 2004 relative to 2003 for both group and individual income protection products, primarily as a result of the competitive pricing environment and, to a lesser extent, due to the adverse publicity surrounding the Company. The Company intends to continue to emphasize profitable premium growth through a balance of new sales, renewal programs, and persistency of the existing block of business. The Company expects sales in early 2005 to be slightly lower than 2004 results but to increase during the latter part of the year.
The Company monitors persistency of its existing business and reflects adverse changes in persistency in the current period’s amortization of deferred policy acquisition costs. One way in which the Company monitors persistency is at the overall block of business level (i.e., group long-term income protection, group short-term income protection, and group life). Persistency, at the overall block of business level, is the year-to-date rate at which existing business for all issue years in the block of business at the beginning of the period remains inforce at the end of the period. In determining whether additional amortization of deferred policy acquisition costs is required due to adverse persistency, the Company measures persistency by issue year (i.e., the rate at which existing business for that specific issue year at the beginning of the period remains inforce at the end of the period). The rate of persistency for an overall block of business may improve while individual issue years within the overall block of business may deteriorate and require additional amortization of deferred policy acquisition costs.
Shown below are financial results and key performance indicators for group income protection.
(3) Included in these ratios is the 2004 before-tax charge of $116.7 million related to the settlement of the multistate market conduct examination and the 2003 before-tax reserve strengthening of $894.0 million. Excluding these charges, the before-tax operating income (loss) ratios for 2004 and 2003 would have been 6.6% and 4.2%, respectively.
As previously discussed, during the fourth quarter of 2004 the Company recorded a charge in conjunction with the settlement of the multistate market conduct examination. The charge decreased operating income for group income protection $116.7 million. Excluding that charge, group income protection would have reported operating income of $209.2 million for 2004.
Operating revenue for group income protection improved primarily due to increases in premium income. Premium income for the U.S. brokerage business was fairly flat period to period. The growth in group long-term income protection premium income occurred in the Company’s United Kingdom business and was primarily attributable to continued strong sales growth. Premium income in the United Kingdom group long-term income protection business was $501.8 million in 2004 compared to $371.2 million in 2003. A portion of that reported growth also resulted from the favorable foreign currency exchange rate in 2004 relative to 2003. When measured in its local currency, the growth rate in premium income in the United Kingdom’s group long-term income protection line was approximately 20.8 percent year over year. Net investment income increased in 2004 compared with 2003 due to the growth in invested assets supporting this line of business and a retrospective adjustment of the amortization of the purchase discount on mortgage-backed securities, offset somewhat by lower investment portfolio yields due to a decline in market interest rates and less prepayment income on fixed maturity securities. Included in other income are ASO fees of $56.1 million for 2004 and $46.5 million for 2003.
The settlement of the multistate market conduct examination resulted in a 2004 charge of $39.7 million for benefit costs and reserves from claims reopened from the reassessment and $40.5 million for additional benefit costs and reserves for claims already incurred and currently in inventory that are anticipated as a result of the claim process changes being implemented. Excluding those reserve charges as well as the 2003 reserve strengthening previously discussed, the benefit ratio for 2004 declined compared to 2003. Contributing to the decline in the 2004 benefit ratio relative to 2003 was a decrease in the submitted claim incidence rate for group long-term income protection. This reduced benefits and change in reserves approximately $55.0 million relative to the prior year. The Company believes the incidence levels are driven in part by economic trends, including consumer confidence. Also contributing to the decrease in the benefit ratio in 2004 relative to 2003 was an increase in premium per insured life primarily due to rate increases placed on poorer performing business through the 2004 renewal program. Partially offsetting the factors contributing to the decline in the benefit ratio was a lower claim discount rate used for new claims occurring in 2004 relative to the rate used in 2003, which resulted in the establishment of higher claim reserves in 2004 of approximately $25.0 million had the lower discount rate not been used. For group short-term income protection, the benefit ratio was lower primarily due to a decline in paid claim incidence in 2004 compared to the prior year.
Costs capitalized during 2004 for group income protection were lower than in the prior year due to an updated analysis of costs associated with the acquisition of new business and due to the decrease in sales. The amortization of value of business acquired increased during 2004 due to the previously discussed United Kingdom transaction with Swiss Life. Operating expenses for 2004 include a charge of $36.5 million, related to the settlement of the multistate market conduct examination, for the incremental direct operating expenses to conduct the two-year reassessment process for group income protection and for a portion of the fine.
As discussed under “Cautionary Statement Regarding Forward-Looking Statements,” certain risks and uncertainties are inherent in the Company’s group income protection business. Components of claims experience, including, but not limited to, incidence levels and claims duration, may be worse than expected. The Company, similar to all financial institutions, has some exposure in a severe and prolonged economic recession, but many of the Company’s products can be re-priced, which would allow the Company to reflect in its pricing any fundamental change which might occur in the risk associated with a particular industry or company within an industry. Although approximately 25 percent of the Company’s overall block of group income protection business is in the manufacturing and wholesale/retail industry segments, which tend to be economically sensitive, the Company believes it has a well-diversified book of insurance exposure, with no disproportionate concentrations of risk in any one industry.
The Company expects to price new business and re-price existing business, at contract renewal dates, in an attempt to mitigate the effect of incidence levels, claims duration, and other factors, including interest rates, on new claim liabilities. Given the competitive market conditions for the Company’s income protection products, it is uncertain whether pricing actions can entirely mitigate the effect.
Operating revenue for group income protection improved due to increases in both premium income and net investment income. The growth in premium income during 2003 compared to the prior year was due to new sales growth in 2002 and favorable renewal activity and improved persistency on the existing block of business. Also contributing to the increase in premium income was the strong sales growth in the United Kingdom group income protection business. Premium income in the Company’s United Kingdom group long-term income protection business increased 41.2 percent, or $108.4 million, in 2003 relative to 2002. A portion of that reported growth also resulted from the favorable foreign currency exchange rate in 2003 relative to 2002. When measured in its local currency, the growth rate in premium income in the United Kingdom’s group long-term income protection was approximately 30.0 percent year over year. Net investment income grew primarily due to the growth in invested assets supporting this line of business. Included in other income are ASO fees of $46.5 million for 2003 and $33.9 million for the prior year.
The benefit ratio for group income protection increased in 2003 relative to 2002. Excluding the impact of the 2003 reserve strengthening for group income protection, the benefit ratio was 92.0 percent for 2003, higher than in 2002, with the increase attributable to group long-term income protection. Both submitted and paid claim incidence for group long-term income protection increased from 2002. This increased benefits and change in reserves for 2003 approximately $75.0 million relative to 2002. The Company believes this to be driven in part by economic trends, including lower consumer confidence. Claim resolution rates for group long-term income protection in 2003 were lower than 2002. The impact on benefits and change in reserves for the lower claim resolution rate was an increase of approximately $75.0 million. Also contributing to the increase in the benefit ratio for group long-term income protection was the lower claim reserve discount rate used for new claims occurring in 2003. For group short-term income protection, the 2003 benefit ratio was higher than in 2002, primarily due to an increase in paid claim incidence.
There was no additional amortization of deferred policy acquisition costs related to persistency for 2003, but expected amortization, as determined when the costs were initially capitalized, continues to increase year over year due to the continued growth in the deferred policy acquisition cost asset balance related to new sales growth in the block of business and acceleration of expected amortization for costs capitalized in 2002 and subsequent years. For 2002, the additional amortization related to persistency was $12.9 million.
Shown below are financial results and key performance indicators for individual income protection - recently issued.
The increase in the benefit ratio for 2003 compared to 2002 was due to higher submitted incidence, offset partially by an increase in the net claim resolution rate.
Premium income increased during 2004 compared to 2003 primarily due to new sales growth in previous periods. New annualized sales for long-term care were $38.2 million, $70.9 million, and $87.2 million for 2004, 2003, and 2002, respectively. Changes in the product offering during 2003 have decreased the 2004 growth in individual long-term care sales relative to historical trends. This is expected to continue and will result in a slower rate of growth in premium income. Net investment income increased due to the continued growth in invested assets supporting this line of business. Persistency in this line of business remains high and stable.
Submitted claim incidence for long-term care was higher in 2004 than in 2003. The net claim resolution rate was also higher in 2004 compared to 2003. Results for long-term care continue to be volatile due to the relatively small size of this block of business.
Submitted and paid claim incidence for individual long-term care decreased in 2003 from 2002 levels, while group long-term care experienced increased paid claim incidence and stable submitted incidence. The 2003 net claim resolution rate was lower than 2002 for individual long-term care, driven by lower claim recoveries. The net claim resolution rate increased for group long-term care in 2003 relative to 2002.
The Company’s primary focus for 2005 for Income Protection will continue to be profitability enhancement, with an emphasis on the core markets and a balanced mix of business. In 2005, the Company expects moderate, disciplined year over year sales growth in line with overall industry growth, although growth relative to 2004 may not be experienced until mid- 2005. The Company will continue in 2005 with its disciplined approach to pricing and also with the strategy of shifting its business mix from the large-employer market to the small and mid-employer markets. The Company expects to continue to generate sales in the large-employer market, although below historical growth levels, and to be a leading provider in this market segment.
The Life and Accident segment includes insurance for life, accidental death and dismemberment, cancer, and critical illness marketed primarily to employers and multi-life employee groups by the Company’s sales force through independent brokers and consultants. Shown below are financial results and key performance indicators for the life and accident segment.
The Company considers the group life and accidental death and dismemberment products as being complementary to its group income protection products. In 2005, the Company expects moderate, disciplined sales growth in line with overall industry growth. The Company intends to continue its disciplined approach to risk selection and pricing and to focus on profitability and a more balanced mix of business between large, medium, and small employer markets. The Company will continue to concentrate on sales growth and increased profitability for its voluntary brokerage and other lines.
The sales increase in 2003 relative to 2002 was primarily attributable to a 13.1 percent growth in sales of life products and a 9.1 percent growth in income protection product sales.
The life and income protection product lines each reported an increase in the benefit ratio compared to the prior year. The individual short-term income protection line reported a decrease in claim incidence for 2003 compared with the prior year while the average claim duration for closed claims was above the prior year. The average indemnity for individual short-term income protection was higher than 2002. For accident and sickness, the claim incidence rate increased slightly in 2003 relative to 2002. In the life product line, average paid claims decreased in 2003 compared to last year. The 2003 incidence rate for the cancer products and the critical illness products decreased from the prior year.
(1) Included in this ratio is the 2004 before-tax reserve strengthening of $110.6 million. Excluding this charge, the benefit ratio for 2004 would have been 152.9%.
Year Ended December 31, 2004 Compared with Year Ended December 31, 2003
As previously discussed, in the first quarter of 2004, the Company restructured its individual income protection - closed block business wherein three of its insurance subsidiaries entered into reinsurance agreements that effectively provide approximately 60 percent reinsurance coverage for the Company’s overall consolidated risk above a specified retention limit. If losses to the reinsurer exceed a specified aggregate limit, any further losses will revert to the Company. These reinsurance transactions were effective as of April 1, 2004. The Company transferred cash equal to $521.6 million of ceded reserves plus an additional $185.8 million in cash for a before-tax prepaid cost of insurance which was deferred and will be amortized into earnings over the expected claim payment period covered under the Company’s retention limit. The amortization of the prepaid cost was $4.9 million for 2004 and is expected to be approximately $5.4 million in 2005.
Included in the loss for 2004 were the first quarter restructuring charges of $282.2 million, $367.1 million, and $207.1 million related to the write-down of deferred policy acquisition costs, value of business acquired, and goodwill, respectively, and $110.6 million for the claim reserve charge, for a total of $967.0 million. In addition, during the fourth quarter of 2004 the Company recorded a charge in conjunction with the settlement of the multistate market conduct examination. The charge decreased operating income for this segment by $8.6 million. See “2004 Strategic Transactions and Events” contained in Item 7 herein for additional details.
Premium income decreased relative to the prior year due to the expected decline in this closed block of business. Net investment income declined in 2004 relative to the prior year due to a decline in the portfolio yield rate and due to lower prepayments on mortgage-backed securities, offset somewhat by a retrospective adjustment of the amortization of the purchase discount on mortgage-backed securities. Net investment income was also negatively impacted due to the cash held during the first half of 2004 in conjunction with the pending transfer of cash for the reinsurance agreements entered into as part of the restructuring of this block. Other income includes the underlying results of certain blocks of reinsured business.
The increase in the benefit ratio for 2004 relative to 2003, excluding the $110.6 million claim reserve charge in the first quarter of 2004, was due to a decrease in the claim resolution rate relative to the level of 2003, offset somewhat by a decrease in claim incidence rates in 2004 relative to 2003 levels.
Premium income decreased in 2003 relative to the prior year due to the expected decline in this closed block of business and also due to a reinsurance transaction. As previously discussed, during 2003, the Company reinsured a block of individual income protection policies previously sold through trade associations. The transaction, with an effective date of April 1, 2003, reduced 2003 premium income in the individual income protection - closed block by approximately $16.1 million. The $31.2 million before-tax loss on this transaction, of which $29.6 million related to this segment, was deferred and is being amortized into income based upon expected future premium income on the policies ceded.
The increase in the benefit ratio for 2003 relative to 2002 was due to a decrease in the net claim resolution rate compared to the level of 2002.
The Other operating segment includes results from products no longer actively marketed (with the exception of certain individual income protection products), including individual life and corporate-owned life insurance, reinsurance pools and management operations, group pension, health insurance, and individual annuities. It is expected that operating revenue and income in this segment will decline over time as these business lines wind down. Management expects to reinvest the capital supporting these lines of business in the future growth of the Income Protection, Life and Accident, and Colonial segments. The closed lines of business have been segregated for reporting and monitoring purposes.
Total operating revenue for individual life and corporate-owned life insurance was $40.0 million, $39.9 million, and $42.2 million in 2004, 2003, and 2002, respectively. Operating income for the same periods was $38.2 million, $33.5 million, and $41.6 million.
Group pension, health insurance, individual annuities, and other closed lines of business had operating revenue of $144.6 million, $150.4 million, and $159.1 million in 2004, 2003, and 2002, respectively, and operating income (losses) of $(1.5) million, $(1.5) million, and $7.0 million. Decreases in operating revenue and income are expected to continue as these lines of business wind down.
Operating revenue in the Corporate segment was $66.0 million in 2004, compared to $31.6 million in 2003 and $34.0 million in 2002. As previously discussed, during the fourth quarter of 2004, the Company obtained a judgment in refund litigation for federal income tax paid for tax year 1984, plus interest, and as such, recognized $14.0 million of operating revenue in the Corporate segment related to the interest portion of the anticipated refund. Also included in 2004 revenue is a $9.4 million curtailment gain related to changes in the Company’s retiree medical plan. See Note 10 of the “Notes to Consolidated Financial Statements” contained herein in Item 8 for further discussion of the curtailment gain.
During 2003, the Company entered into an agreement to sell its Canadian branch. In conjunction with the classification of the Canadian branch as an asset held for sale, the Company tested the goodwill related to the Canadian branch for impairment and determined that the balance of $190.9 million was impaired. The Company also recognized a loss of $6.0 million after tax to write down the value of bonds in the Canadian branch investment portfolio to market value. These two charges, which total $196.9 million after tax, were included in the 2003 loss from discontinued operations. The Company recognized an additional loss of $0.4 million after tax in the first quarter of 2004 to further write down the value of bonds in the Canadian branch investment portfolio to market
value. The transaction closed April 30, 2004, and in the second quarter of 2004, the Company reported a loss of $70.9 million after tax on the sale of the branch.
See Note 2 of the “Notes to Consolidated Financial Statements” contained herein in Item 8 for further discussion of the Company’s discontinued operations.
The long-term nature of the Company’s insurance liabilities also allows it to invest in less liquid investments to obtain superior returns. A maximum of 10 percent of the total investment portfolio may be invested in below-investment-grade securities, two percent in equity type instruments, up to 35 percent in private placements, and five percent in commercial mortgage loans. The remaining assets can be held in publicly traded investment-grade corporate securities, mortgage-backed securities, asset-backed securities, and U.S. government agencies and municipal securities. The Company does not currently intend to invest in additional real estate.
The maximum investment per issuer group is limited based on internal limits established by the Company’s board of directors and is more restrictive than the five percent limit generally allowed by the state insurance departments which regulate the type of investments the Company’s insurance subsidiaries are allowed to own. These internal limits are as follows:
Derivative instruments may be used to hedge interest rate risk and match liability duration and cash flows consistent with the plan approved by the board of directors.
The allocation of assets and the selection and timing of the acquisition and disposition of investments are subject to ratification by the investment subcommittee of the board of directors on a weekly basis. These actions are also reviewed and approved by the board of directors on a quarterly basis.
These investment policies and guidelines are reviewed and appropriately adjusted by the board of directors annually, or more frequently if deemed necessary.
As previously discussed, the Company sold its Canadian branch effective April 30, 2004. Historical information pertaining to the Canadian branch is reported as discontinued operations in the consolidated financial statements and as such, the historical assets and liabilities are reported separately in the Company’s consolidated statements of financial condition. The Company retained a portion of the Canadian branch fixed maturity bond portfolio according to the terms of the transaction. Because the specific investments to be transferred to the buyer had not been identified for reporting periods ended prior to the closing, the disclosures on the following pages for 2003 and 2002 will in some instances necessarily include the total Canadian branch investment portfolio, including those transferred to the buyer at the close of the transaction, with appropriate disclosure noting that the information includes fixed maturity securities reported separately as discontinued operations in the consolidated statements of financial condition.
Net investment income was $2,158.7 million in 2004, virtually flat with the amount reported in 2003. The overall yield in the portfolio was 6.93 percent as of December 31, 2004, and the weighted average credit rating was A3. The overall yield in the portfolio, including fixed maturity securities reported as discontinued operations, was 7.15 percent at the end of 2003. In the current low interest rate market, the Company expects that the portfolio yield will continue to gradually decline, until the market rates increase above the level of the overall yield, due to lower yields on new purchases.
As of December 31, 2004, the Company’s exposure to below-investment-grade fixed maturity securities was approximately 6.4 percent of the carrying value of invested assets excluding ceded policy loans, compared to 7.8 percent at the end of 2003 and 10.4 percent at the end of 2002. This asset class had increased during 2002 primarily from downgrades of existing securities that were previously investment-grade rather than the purchase of additional below-investment-grade securities. During the first quarter of 2003, the Company initiated a program to reduce its below-investment-grade fixed maturity securities holdings to comply with its investment policy regarding diversification and to better position the investment portfolio in the then current environment and reduce exposure to potential credit-related losses. The program was substantially complete at the end of the first quarter of 2003, with sales of approximately $760.9 million in market value and $758.6 million in book value. Gross gains of $23.1 million and gross losses of $20.8 million were recognized on the sale of these securities during the first quarter of 2003.
The Company reported before-tax realized investment gains and losses during the last three years as shown in the following chart, which excludes an estimate of realized investment gains and losses in 2003 and 2002 related to the fixed maturity securities reported as discontinued operations. Impairment losses were recognized as a result of management’s determination that the value of certain fixed maturity and equity securities had other than temporarily declined during the applicable reporting period, as well as the result of further declines in the values of fixed maturity and equity securities that had initially been written down in a prior period. The value of the securities was determined to have other than temporarily declined or to have further declined from the initial impairment based on the factors discussed herein in “Critical Accounting Policies.” Additional investment losses may occur during 2005.
$20.5 million loss during the third quarter of 2004 on securities issued by a large domestic based airline. The company continues to be plagued by a high cost structure and faces liquidity problems if costs are not substantially reduced in the short-term. The securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the third quarter of 2001. At the time of the impairment loss, these securities had been in an unrealized loss position for a period of greater than three years. The circumstances of this impaired investment have no impact on other investments.
$9.0 million aggregate loss during 2004 on structured securities issued by a trust and collateralized by a pool of high yield bonds. The Company performs a periodic review of the estimated cash flows associated with all of its securitized high yield securities. During each of the 2004 quarterly reviews, it was determined that an adverse change in estimated cash flows had occurred for these securities. The investment was originally purchased as part of the Company’s below-investment-grade strategy. At the time of the initial impairment loss, these securities had been in an unrealized loss position for a period of greater than two years but less than three years. The circumstances of this impaired investment have no impact on other investments.
for a period of greater than one year but less than two years. The circumstances of this impaired investment have no impact on other investments.
$26.4 million loss during the first quarter of 2003 on securities issued by a related entity of a U.S. based energy company. The securities were issued by a utility company that services an industrial site in England and whose 98 percent parent filed for insolvency in December 2001. This issuer was excluded from the parent’s insolvency filing due to the financial separation from the parent and was operating as a going concern during 2002. Despite the financial separation, the issuer’s securities were downgraded to below-investment-grade in the fourth quarter of 2001. The Company initially recognized an impairment loss on these securities at the time of the parent’s insolvency filing in 2001. These bonds were secured by a second lien on the real estate holdings of the company. The Company closely monitored this security and the value of the collateral during 2002. Following extensive negotiations during 2002 and the first quarter of 2003 with the company’s two other lenders, financial advisors, and counsel, it was determined that the investment was further impaired. Prior to its impairment loss in 2003, the investment had been in an unrealized loss position for a period of greater than 270 days but less than one year. The circumstances of this impaired investment have no impact on other investments.
$18.1 million loss during the first quarter of 2003 on securities issued by a Norwegian based energy services company engaged in offshore seismic surveying and floating production. The impairment loss was taken after further analysis of available information indicated the company’s lack of near term liquidity and that overall industry conditions in the energy sector had negatively affected the operations more than previous analysis had indicated. The securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the third quarter of 2002. At the time of the impairment loss, these securities had been continuously in an unrealized loss position for a period of greater than three years. The circumstances of this impaired investment have no impact on other investments.
reduced potential legal liabilities. At the time of the impairment loss, these securities had been continuously in an unrealized loss position for a period of greater than 1 year but less than two years. The circumstances of this impaired investment have no impact on other investments.
$11.0 million loss during the third quarter of 2003 on securities issued by a travel services company located in the United Kingdom. The impairment loss was taken following discussions between the issuer and its creditors regarding difficulties in the issuer’s businesses due to geopolitical unrest and persistent weakness in demand for leisure travel and requests for certain waivers and consents of debt covenants. These securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the first quarter of 2003. At the time of the impairment loss, these securities had been continuously in an unrealized loss position for a period of greater than 270 days but less than one year. The circumstances of this impaired investment have no impact on other investments.
$44.0 million loss during the second quarter of 2002 on securities issued by a Canadian telecommunications company engaged in transporting voice and data over its global fiber optic network. This company had an investment-grade rating immediately prior to the time its parent company unexpectedly withdrew its support for the subsidiary in April 2002. The investment was subsequently downgraded to below-investment-grade in the second quarter of 2002. Prior to its impairment loss, the investment had been in an unrealized loss position for a period of greater than two years but less than three years. The Company owns fixed maturity securities issued by another regulated subsidiary under common ownership, but this investment has not been negatively impacted, is not considered impaired, and was in an unrealized gain position at December 31, 2004.
$25.1 million loss during the fourth quarter of 2002 on securities issued by a subsidiary of a U.S. based company engaged in the electricity business in the United Kingdom. As this industry’s operating environment in the United Kingdom weakened over the past few years due to competitive pricing pressures, the company remained encumbered with a number of above-market price power purchase agreements resulting in significant operating losses. The parent company had previously provided equity support and had committed an additional $700.0 million to this subsidiary to be used primarily to renegotiate these contracts. The company had an investment-grade rating prior to the time the parent company unexpectedly withdrew its promised support in October 2002, which resulted in a downgrade to below-investment-grade. The company defaulted on its October interest payments, and the parent company was subsequently placed in administration in the United Kingdom. Prior to its impairment loss, the investment had been in an unrealized loss position for a period of greater than three years. The Company holds securities in a related subsidiary and has also recognized an other than temporary impairment loss on that related subsidiary.
reported that it would seek bankruptcy protection. Both Moody’s and Standard & Poor’s downgraded the security during the first quarter of 2002. The investment was originally purchased as part of the Company’s below-investment-grade strategy. At the time of the impairment loss, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The circumstances of this impaired investment have no impact on other investments.
$4.7 million aggregate loss during the first three quarters of 2004 on the sale of securities linked to the credit of a U.S. based supermarket chain. These securities are participation certificates in a trust, benefiting from first mortgage liens on a portfolio of strategically key real estate properties which are net leased on a non-cancelable basis to the supermarket chain. The supermarket chain experienced deterioration in its market position and financial performance over the last several years, and its credit rating was lowered from investment-grade to below-investment grade in the first quarter of 2001. At the time of the initial sale in 2004, these securities had been continuously in an unrealized loss position for a period of greater than three years. The circumstances of this investment have no impact on other investments.
$28.1 million aggregate loss during the third and fourth quarters of 2003 on securities issued by a leading producer of performance products for the automotive industry and nylon fibers for the carpet industry. The company’s operations had been severely impacted by the increased price of raw materials and energy as well as a weakening demand for its products. In addition, the company was involved in an environmental pollution lawsuit with a potentially large negative impact. These securities had an investment-grade rating until downgraded to below-investment-grade in the first quarter of 2002. At the time of sale, the investment had been continuously in an unrealized loss position for a period of greater than three years. The circumstances of this investment have no impact on other investments.
$25.2 million loss during the fourth quarter of 2003 on the sale of securities guaranteed by an Italian dairy company. The loss was incurred after it was revealed that the guarantor had engaged in massive fraud, ultimately leading to the company’s bankruptcy. The guarantor had been rated investment-grade until December 2003. At the time of the sale, the investment had been in an unrealized loss position for a period of less than 90 days. The Company also owns $22.5 million of fixed maturity securities of a wholly-owned Canadian subsidiary of the parent company. Although the financial and operating profiles of the subsidiary are separate from the parent and no other than temporary impairment was deemed to exist, in conjunction with the classification of the Canadian branch as an asset held for sale, the Company recognized a loss of $4.0 million to write down the value of these securities, which are held in the Canadian branch investment portfolio, to market value. This loss is included in the loss from discontinued operations.
$11.1 million aggregate loss during the second and fourth quarters of 2003 on the sale of unsecured debt and private, secured debt obligations issued by a major domestic airline. The Company sold the securities to reduce its exposure to the airline. These securities had an investment-grade rating until downgraded in the third quarter of 2001. At the time of sale, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The circumstances of this investment have no impact on other investments.
$9.2 million aggregate loss during the second and fourth quarters of 2003 on the sale of securities issued by a provider of phone, cable, and internet services. This company’s operations were severely impacted by the decline in the telecommunications market and thus, the decision was made to reduce the exposure to this company. These securities were originally purchased as part of the Company’s below-investment-grade strategy. At the time of sale, this security had been continuously in an unrealized loss position for a period of greater than three years. The circumstances of this investment have no impact on other investments.
Realized Investment Losses during 2002 from Sale of Fixed Maturity Securities
downgraded to below-investment-grade in the second quarter of 2002, and, at the time of sale, had been in an unrealized loss position for a period of greater than 90 days but less than 180 days. The circumstances of this investment have no impact on other investments.
The Company realized $5.9 million in losses on the sale of securities issued by an energy services company engaged in offshore seismic surveying and floating energy production. Industry conditions in the energy sector, which is cyclical and driven by the supply and demand for oil and gas, had impacted profit margins, and the company lacked liquidity in the near-term. The investment was downgraded to below-investment-grade status in the second quarter of 2002, causing the investment holdings of this issuer to exceed the Company’s individual issuer group limits established by the Company’s board of directors. As a result, the Company sold the securities in order to lower its overall holding of securities issued by this company. At the time of sale, the investment had been in an unrealized loss position for a period of more than three years. The circumstances of this investment have no impact on other investments.
The Company realized $3.9 million in losses on the sale of a below-investment-grade structured security backed by a pool of high yield bonds. The continued high level of defaults in the high-yield market and in this pool in particular continued to impact the credit quality of this investment. A review of the investment led to the conclusion that, while a decline in the level of defaults in the general market was expected, no improvement in the prospects for this structured security was expected. This conclusion resulted from the deterioration of the underlying pool of high yield bonds and the deteriorating performance record of the pool’s manager. The investment was downgraded to below-investment-grade status in the third quarter of 2001 and, at the time of sale, had been in an unrealized loss position for a period of greater than 270 days but less than 360 days. The circumstances of this investment have no impact on other investments.
Fixed maturity securities at December 31, 2004, included $32.4 billion, or 99.7 percent, of bonds and derivative instruments and $109.1 million, or 0.3 percent, of redeemable preferred stocks. The following table shows the fair value composition by internal industry classification of the fixed maturity bond portfolio and the associated unrealized gains and losses.
Financial Institutions: This sector entered the recent economic cycle with record capital levels and strong profitability. Credit quality continues to improve in the banking sector, having reached its highest level in the past 20 years by some measurements. Results through the end of 2004 reflected strong fee income, solid profitability, and increased commercial and consumer loan growth. Profitability and credit quality are expected to remain strong for the group in 2005, as is the pace of consolidation. Challenges for the bank sector in 2005 include asset-liability management, narrowing net interest margins, and expense management. The brokerage sector also reported strong results, driven primarily by an increase in mergers and acquisitions along with continued strength in fixed-income markets. Approximately $29.4 million of the unrealized losses in this industry sector can be attributed to certain principal protected equity linked notes held by the Company, including those disclosed in the following discussion of “Gross Unrealized Losses on Fixed Maturity Bonds $10 Million or Greater.”
The following table shows the length of time the Company’s below-investment-grade fixed maturity bonds had been in a gross unrealized loss position as of December 31, 2004. The fair value and gross unrealized losses are categorized by the relationship of the current fair value to amortized cost for those securities on December 31, 2004. The fair value to amortized cost relationships are not necessarily indicative of the fair value to amortized cost relationships for the securities throughout the entire time that the securities have been in an unrealized loss position nor are they necessarily indicative of the relationships subsequent to December 31, 2004.
Unrealized losses on investment-grade fixed maturity securities principally relate to changes in interest rates or changes in market or sector credit spreads which occurred subsequent to the acquisition of the securities. These changes are generally temporary and are not recognized as realized investment losses unless the securities are sold, a decision is made that it is unlikely that the Company will hold the securities until recovery, or the securities become other than temporarily impaired. Generally, below-investment-grade fixed maturity securities are more likely to develop credit concerns. As previously discussed under “Critical Accounting Policies” contained herein, in determining whether a decline in fair value below amortized cost of a fixed maturity security is other than temporary, the Company utilizes a formal, well-defined, and disciplined process to monitor and evaluate its fixed income investment portfolio. It includes certain members of senior management in addition to the Company’s other investment and accounting professionals. The process results in a thorough evaluation of problem investments and the recording of realized losses on a timely basis for investments determined to have an other than temporary impairment.
The Company has a significant interest in, but is not the primary beneficiary of, a special purpose entity which is a collateralized bond obligation asset trust in which the Company holds interests in several of the tranches and for which the Company acts as investment manager of the underlying securities. The Company’s investment in this entity was reported at fair value with fixed maturity securities in the consolidated statements of financial condition. The fair value of this investment was derived from the fair value of the underlying assets. The fair value and amortized cost of this investment was $25.6 million and $24.8 million, respectively, at December 31, 2004, and $27.0 million and $26.1 million, respectively, at December 31, 2003.
The Company invested in additional mortgage loans during 2004 and expects that during 2005 it will continue to invest in additional commercial mortgage loans either through the secondary market or through loan originations. This will allow the Company to leverage its operational structure currently in place for its existing mortgage loan portfolio and to utilize an additional investment category in its portfolio strategies.
The Company uses a comprehensive rating system to evaluate the investment and credit risk of each mortgage loan and to identify specific properties for inspection and reevaluation. The Company establishes an investment valuation allowance for mortgage loans based on a review of individual loans and the overall loan portfolio, considering the value of the underlying collateral. Investment valuation allowances for real estate held for sale are established based on a review of specific assets. If a decline in value of a mortgage loan or real estate investment is considered to be other than temporary or if the asset is deemed permanently impaired, the investment is reduced to estimated net realizable value, and the reduction is recognized as a realized investment loss. Management monitors the risk associated with these invested asset portfolios and regularly reviews and adjusts the investment valuation allowance. At December 31, 2004, the balance in the valuation allowances for real estate was $9.3 million. No valuation allowance was held for mortgage loans at December 31, 2004.
Almost all hedging transactions are associated with the individual and group long-term care and the individual and group income protection product portfolios. All other product portfolios are periodically reviewed to determine if hedging strategies would be appropriate for risk management purposes.
During the years ended December 31, 2004, 2003, and 2002, the Company recognized net gains of $29.1 million, $79.6 million, and $45.4 million, respectively, on the termination of cash flow hedges and reported $29.2 million, $79.1 million, and $42.1 million, respectively, in other comprehensive income and $(0.1) million, $0.5 million, and $3.3 million, respectively, as a component of realized investment gains and losses. The Company amortized $20.7 million, $17.3 million, and $12.4 million of net deferred gains into net investment income in 2004, 2003, and 2002, respectively.
The Company also has embedded derivatives in modified coinsurance contracts recognized under DIG Issue B36. The derivatives recognized under DIG Issue B36 are not designated as hedging instruments, and the change in fair value is reported as a realized investment gain or loss during the period of change. The Company recognized $88.6 million and $0.8 million in net realized investment gains during 2004 and 2003, respectively, due to the change in value of the embedded derivatives recognized under DIG Issue B36.
The Company has an investment program wherein it simultaneously enters into repurchase agreement transactions and reverse repurchase agreement transactions with the same party. The Company nets the related receivables and payables in the consolidated statements of financial condition as these transactions meet the requirements for the right of offset. As of December 31, 2004, the Company had $396.3 million face value of these agreements in an open position that were offset. The Company also uses the repurchase agreement market as a source of short-term financing. The Company had no contracts for this purpose outstanding at December 31, 2004.
Investing cash inflows consist primarily of the proceeds from the sales and maturities of investments. Investing cash outflows consist primarily of payments for purchases of investments. The Company generated less in proceeds from maturities of available-for-sale securities in 2004 than in 2003, primarily due to a decrease in principal prepayments on mortgage-backed securities and bond calls during 2004. The Company received less in proceeds from sales of available-for-sale securities during 2004 compared to 2003 due to the Company’s sales and subsequent purchases during 2003 related to the reduction and restructuring of its below-investment-grade portfolio.
During 2004, the Company had cash inflows of $18.8 million in conjunction with the sale of its Japanese operations. The Company transferred cash of $31.7 million in conjunction with the 2004 disposition of the Canadian branch, as well as fixed maturity securities with a fair value and book value of approximately $1,099.4 million and $957.7 million, respectively. While no cash was exchanged in the previously discussed 2004 Swiss Life transaction, the Company assumed reserves of approximately $279.6 million and received fixed maturity securities of approximately $259.0 million and other miscellaneous assets of approximately $5.2 million, for a net purchase price of $15.4 million. In 2004, the Company had cash outflows of $0.7 million to acquire Integrated Benefits Management.
During 2003, the Company had cash inflows of $110.0 million related to the acquisition of Sun Life. The Company also received fixed maturity securities of approximately $118.4 million and other miscellaneous assets and liabilities of approximately $20.3 million and assumed reserves of approximately $285.9 million relative to the Sun Life acquisition, for a net purchase price of $37.2 million.
Financing cash flows consist primarily of borrowings and repayments of debt, issuance or repurchase of common stock, and dividends paid to stockholders. Proceeds of $300.0 million were provided from the Company’s May 2004 sale of adjustable conversion-rate equity security units. Proceeds from the offering were used to restore the Company’s insurance subsidiaries’ risk-based capital to the approximate overall level that existed prior to the individual income protection - closed block reinsurance transaction and to provide additional liquidity at the holding company level.
The Company’s combined offering in May 2003 provided $575.0 million in proceeds from the issuance of long-term debt, less underwriting discounts of $17.2 million, and $547.7 million in net proceeds from the issuance of common stock. These proceeds were used primarily to increase the capitalization of the Company’s insurance subsidiaries and to repay amounts loaned to the Company from its insurance subsidiaries. Proceeds from the issuance of long-term debt in 2002 were $400.0 million, used primarily to refinance existing commercial paper borrowings. See “Debt” as follows for further information on the Company’s debt offerings.
As of December 31, 2004, the Company had $227.0 million of short-term debt payable in 2005. The Company has adequate cash resources to meet this obligation.
At December 31, 2004, the Company had long-term debt, including the adjustable conversion-rate equity security units and the junior subordinated debt securities, totaling $2,862.0 million and short-term debt totaling $227.0 million. At December 31, 2004, the debt to total capital ratio was 35.2 percent compared to 31.6 percent at December 31, 2003. The debt to total capital ratio, when calculated allowing 50 percent equity credit for the Company’s junior subordinated debt securities and 80 percent equity credit for the Company’s adjustable conversion-rate equity security units, was 25.5 percent compared to 24.7 percent at December 31, 2003.
In May 2003, the Company issued 23.0 million 8.25% adjustable conversion-rate equity security units (units) in a public offering for $575.0 million. Each unit has a stated amount of $25 and will initially consist of (a) a contract pursuant to which the holder agrees to purchase, for $25, shares of the Company’s common stock on May 15, 2006 and which entitles the holder to contract adjustment payments at the annual rate of 2.25 percent, payable quarterly, and (b) a 1/40, or 2.5 percent, ownership interest in a senior note issued by the Company due May 15, 2008 with a principal amount of $1,000, on which the Company will pay interest at the initial annual rate of 6.00 percent, payable quarterly. Upon settlement of the common stock purchase contract and successful remarketing of the senior note element of the units, the Company will receive proceeds of approximately $575.0 million and will issue between 43.3 million and 52.9 million shares of common stock.
At December 31, 2004 the Company had capital commitments of approximately $41.3 million to fund certain of its private placement fixed maturity securities and for commercial mortgage loan originations. The funds will be due upon satisfaction of contractual notice from the trustee or issuer of the private placement securities or at closing of the mortgage loans. The amounts may or may not be funded.
A.M. Best Company (AM Best), Fitch Ratings (Fitch), Moody’s Investors Service (Moody’s), and Standard & Poor’s Corporation (S&P) are among the third parties that provide the Company assessments of its overall financial position. Ratings from these agencies for financial strength are available for the individual U.S. domiciled insurance company subsidiaries. Financial strength ratings are based primarily on U.S. statutory financial information for the individual U.S. domiciled insurance companies. Debt ratings for the Company are based primarily on consolidated financial information prepared using generally accepted accounting principles. Both financial strength ratings and debt ratings incorporate qualitative analyses by rating agencies on an ongoing basis. The Company competes based in part on the financial strength ratings provided by rating agencies. A downgrade of the Company’s financial strength ratings can be expected to adversely affect the Company. A downgrade of the financial strength ratings could, among other things, adversely affect the Company’s relationships with distributors of its products and services and retention of its sales force, negatively impact persistency and new sales, particularly large case group sales and individual sales, and generally adversely affect the Company’s ability to compete. Downgrades in the Company’s debt ratings can be expected to adversely affect the Company’s ability to raise capital or its cost of capital.
The maintenance of an NAIC risk-based capital ratio of at least 250 percent.
After-tax operating earnings (excluding special charges) within the Company’s estimates of $450 and $500 million on a GAAP basis in 2004 and 2005, respectively, and after-tax statutory operating earnings of at least $375 million for both periods as well.
Also in May 2004, S&P downgraded the Company’s counterparty credit rating and senior debt rating to BB+ from BBB- while at the same time lowering the counterparty credit and financial strength ratings on the Company’s insurance company subsidiaries to BBB+ from A-, all with a “stable” outlook, citing concerns about the consistency of risk controls and valuation practices, which S&P believes have led to reserve charges and asset impairments in the past several quarters and have also contributed to marginal operating performance in the Company’s U.S. group income protection business. The outlook reflects the effects of strengthened capital adequacy, improved investment risk, and corrective measures taken by the Company to limit the downside on the closed block of individual income protection business and to improve profitability on its U.S. group income protection insurance. The change in the senior debt rating to BB+ represents a below-investment-grade rating.
The table below reflects, as of the date of this filing, the senior debt ratings for the Company and the financial strength ratings for the U.S. domiciled insurance company subsidiaries.
See “Risk Factors - Debt and Financial Strength Ratings” in Part 1, Item 1, contained herein for further discussion.
The Company maintains separate U.S. and foreign pension plans and a U.S. post-retirement benefit plan. The U.S. pension plans comprise the majority of the total benefit obligation and pension expense for the Company. The value of the benefit obligations is determined based on a set of economic and demographic assumptions that represent the Company’s best estimate of future expected experience. These assumptions are reviewed annually. Two of the economic assumptions, the discount rate and the long-term rate of return, are adjusted accordingly based on key external indices. The Company follows Statements of Financial Accounting Standards No. 87, Employers’ Accounting for Pensions, No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions, and No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits in its financial reporting and accounting for its pension and post-retirement benefit plans.
The discount rate is an interest assumption used to convert the benefit payment stream to a present value. The discount rate was determined based on a review of long-term fixed income securities that receive one of the two highest ratings given by a recognized rating agency. In setting the assumption, the Company also has considered the change in the level of interest rates on these securities since the prior year end and the duration of the fixed income indices relative to the duration of the plans’ liabilities. Historically, the Company has used the Moody’s Aa corporate bond index as one of the primary benchmarks in selecting a discount rate. As of December 31, 2003, this index was 6.01 percent. The Company has estimated that the duration of the index is approximately 13 years. The majority of the obligations in the U.S. pension plans, however, is related to active and deferred vested employees, and duration, therefore, is significantly longer, at approximately 21 years. The Company therefore adjusted the Moody’s index upward by approximately 25 basis points to arrive at the discount rate assumptions of 6.25 percent as of December 31, 2003.
As of December 31, 2004, the Company elected to set the discount rate assumption at the measurement date for each of its retirement related benefit plans to reflect the yield of a portfolio of high quality fixed income debt instruments matched against the timing and amounts of projected future benefits. The Company elected a discount rate of 6.05 percent for the U.S. pension plans. Using a similar methodology applied to the postretirement plan cash flows, a discount rate of 5.70 and 6.10 percent was used as of December 31, 2004 and 2003, respectively.
The Company’s U.K. operation maintains a separate defined benefit plan for its employees. The U.K. defined benefit pension plan (Scheme) was closed to new entrants on December 31, 2002. The Scheme assets are invested in pooled funds, with a 62 percent global equity securities allocation. The remainder of the assets is predominantly invested in fixed interest bonds and index linked bonds. The investment policy aims to achieve growth over the medium to long term, subject to an acceptable level of risk and subject to ensuring that the assets under management are sufficient to meet the minimum funding requirements under U.K. legislation. The long-term rate of return assumption is the best estimate of the average annual assumed return that will be produced from the Scheme assets until current benefits are paid. As of December 31, 2004 and 2003, the long-term return on asset assumption for the Scheme was 7.10 percent and 6.50 percent, respectively.
The fair value of plan assets in the Scheme was $80.5 million at December 31, 2004, compared to $62.6 million at year end 2003. Despite the increase in assets in recent years, the liabilities have increased at a faster rate due to declining discount rates. The Scheme has a deficit of $50.2 million at December 31, 2004, compared to $35.9 million at December 31, 2003. The Company contributes to the Scheme in accordance with a schedule of contributions which requires the Company to contribute to the Scheme at the rate of at least 18.2 percent of eligible salaries, sufficient to meet the minimum funding requirement under U.K. legislation. The Company contribution rate of 20.25 percent of eligible salaries is currently being reviewed. Based on the current contribution rate, the Company anticipates it will make a contribution into the Scheme of approximately $11.9 million in 2005.
The Company’s management is responsible for designing, implementing, and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting encompasses the processes and procedures management has established to (i) maintain records that, in reasonable detail, accurately and fairly reflect the Company’s transactions and dispositions of assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America; (iii) provide reasonable assurance that receipts and expenditures are appropriately authorized; and (iv) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.
Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and concluded that, as of December 31, 2004, the Company maintained effective internal control over financial reporting.
The effectiveness of the Company’s internal control over financial reporting and management’s assessment of that effectiveness, as of December 31, 2004, have been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which follows.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the statements of financial condition of UnumProvident and subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004, and our report dated March 7, 2005 expressed an unqualified opinion thereon.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of UnumProvident Corporation and subsidiaries at December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
Continuing Operations: The Company is the largest provider of group and individual income protection products in the United States and the United Kingdom. It markets its integrated and complementary portfolio of products primarily to employers interested in providing benefits to their employees. The Income Protection segment includes group long-term and short-term income protection insurance, individual income protection - recently issued insurance, group and individual long-term care insurance, and disability management services. The Life and Accident segment includes insurance for life, accidental death and dismemberment, cancer, and critical illness. The Colonial segment includes insurance for income protection products, life products, and cancer and critical illness products marketed by the Company’s subsidiary Colonial Life & Accident Insurance Company. The Individual Income Protection - Closed Block segment generally consists of those individual income protection policies in force prior to the Company’s substantial changes in product offerings, pricing, distribution, and underwriting which generally occurred during the period 1994 through 1998. The Other segment includes results from products no longer actively marketed, including individual life and corporate-owned life insurance, reinsurance pools and management operations, group pension, health insurance, and individual annuities. The Corporate segment includes investment earnings on corporate assets not specifically allocated to a line of business, corporate interest expense, and certain corporate income and expense not allocated to a line of business. See Note 14 for further discussion of the operating segments.
Real Estate classified as investment real estate is carried at cost less accumulated depreciation. Real estate acquired through foreclosure is valued at fair value at the date of foreclosure. If investment real estate is determined to be other than temporarily impaired, the carrying amount of the asset is reduced to fair value. Occasionally, investment real estate is reclassified to real estate held for sale when it no longer meets the Company’s investment criteria. Real estate held for
sale is valued net of a valuation allowance that reduces the carrying value to the lower of cost less accumulated depreciation or fair value less estimated cost to sell. Accumulated depreciation on real estate was $14.1 million and $13.2 million as of December 31, 2004 and 2003, respectively.
Policy Loans are presented at unpaid balances directly related to policyholders. Included in policy loans are $2,881.2 million and $2,684.5 million of policy loans ceded to reinsurers at December 31, 2004 and 2003, respectively.
The Company discontinues the accrual of investment income on invested assets when it is determined that collection is uncertain. The Company recognizes investment income on impaired investments when the income is received.
For a derivative not designated as a hedging instrument, the change in fair value is recognized in earnings during the period of change.
Deferred policy acquisition costs related to traditional policies are amortized over the premium paying period of the related policies in proportion to the ratio of the present value of annual expected premium income to the present value of total expected premium income. Such amortization is adjusted annually to reflect the actual policy persistency as compared to the anticipated experience.
A change in the Company’s reporting segments during 2004 required the Company to perform, separately for the individual income protection - closed block segment, loss recognition testing for the recoverability of deferred policy acquisition costs. The testing indicated impairment of $282.2 million. See Note 14 for further discussion.
Goodwill: Goodwill is the excess of the amount paid to acquire a business over the fair value of the net assets acquired. The carrying amount of goodwill is reviewed for impairment annually or whenever events or changes in circumstances indicate that the carrying amount might not be recoverable. If the fair value of the operations to which the goodwill relates is less than the carrying amount of the unamortized goodwill, the carrying amount is reduced with a corresponding charge to expense.
Property and Equipment: Property and equipment is reported at cost less accumulated depreciation, which is calculated on the straight-line method over the estimated useful life. The accumulated depreciation for property and equipment was $468.6 million and $422.4 million as of December 31, 2004 and 2003, respectively.
Policy and Contract Benefits: Policy and contract benefits, principally related to accident and health insurance policies, are based on reported losses and estimates of incurred but not reported losses for traditional life and accident and health products. For interest-sensitive products, benefits are the amounts paid and expected to be paid on insured claims in excess of the policyholders’ policy fund balances.
The annual effective interest rate assumptions used to calculate reserves for future policy and contract benefits are as follows:
Income Tax: Deferred taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial statement purposes and the amounts used for income tax purposes. Deferred taxes have been measured using enacted statutory income tax rates and laws that are currently in effect. A valuation allowance is established for deferred tax assets when it is more likely than not that an amount will not be realized.
Deferred Gain or Loss on Reinsurance: The Company is a party to various reinsurance agreements. Where applicable, gains or losses on these transactions are deferred and amortized into earnings based upon expected future premium income for traditional insurance policies and estimated future gross profits for interest-sensitive insurance policies. The deferred gain on reinsurance included in other liabilities in the consolidated statements of financial condition at December 31, 2004 and 2003 was $236.4 million and $264.9 million, respectively.
Accounting for Participating Individual Life Insurance: Participating policies issued by one of the Company’s subsidiaries prior to its 1986 conversion from a mutual to a stock life insurance company will remain participating as long as the policies remain in force. A Participation Fund Account (PFA) was established for the benefit of all such individual participating life and annuity policies and contracts. The assets of the PFA provide for the benefit, dividend, and certain expense obligations of the participating individual life insurance policies and annuity contracts. The PFA was $353.0 million and $352.3 million at December 31, 2004 and 2003, respectively, and represented approximately 0.7 percent of consolidated assets and 0.8 percent of consolidated liabilities at December 31, 2004 and 2003.
Effective January 1, 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation, and selected the prospective method of adoption allowed under the provisions of Statement of Financial Accounting Standards No. 148 (SFAS 148), Accounting for Stock-Based Compensation - Transition and Disclosure. The recognition provisions apply to all employee awards granted, modified, or settled after January 1, 2003.
The following methods and assumptions are used by the Company in estimating the fair values of its financial instruments:
Fixed Maturity Securities: Fair values are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services or, in the case of private placements, are estimated by discounting expected future cash flows using a current market rate applicable to the yield, credit quality, and maturity of the investments. See Note 4 for the amortized cost and fair values of securities by security type and by maturity date.
The carrying amounts and fair values of the Company’s financial instruments are presented as follows. Certain prior year amounts have been reclassified to conform to current year presentation.
Of the $343.5 million in gross unrealized losses on fixed maturity bonds at December 31, 2004, $286.6 million, or 83.4 percent, are related to investment-grade fixed maturity bonds. Unrealized losses on investment-grade fixed maturity securities principally relate to changes in interest rates or changes in market or sector credit spreads which occurred subsequent to the acquisition of the securities. The gross unrealized loss on below-investment-grade fixed maturity bonds (securities rated below Baa3 by Moody’s Investors Service or an equivalent internal rating) was $56.9 million at December 31, 2004, or 16.6 percent, of the total gross unrealized loss on fixed maturity bonds. Generally, below-investment-grade fixed maturity securities are more likely to develop credit concerns.
As of December 31, 2004, the Company held two securities with a gross unrealized loss of $10.0 million or greater, as follows:
At December 31, 2004, the total investment in below-investment-grade fixed maturity securities was $2,169.6 million or 6.4 percent of the fair value of invested assets excluding ceded policy loans. The amortized cost of these securities was $2,080.9 million.
The Company has four special purpose entities which support the Company’s investment objectives and which are consolidated under the provisions of FIN 46(R). These entities are securitized asset trusts and contain specific financial instruments that do not include the Company’s common stock or debt. Three of these entities are trusts holding forward contracts to purchase unrelated equity securities. Each of these trusts also holds a defeasance swap contract for highly rated bonds to provide principal protection for the investments. The fair values of the underlying forward and swap contracts equaled $146.6 million as of December 31, 2004, and are reported as fixed maturity securities in the consolidated statements of financial condition. The fourth entity is a trust containing a highly rated bond for principal protection, unrelated equity securities, and several partnership equity investments. The Company contributed the bond and partnership investments into the trust at the time it was established. The purpose of this trust was to allow the Company to maintain its investment in the partnerships while at the same time protecting the principal of the investment. The fair values of the bond, equity securities, and partnerships were $70.9 million, $9.4 million, and $48.6 million, respectively, as of December 31, 2004.
At December 31, 2004, the Company had capital commitments of approximately $25.3 million to fund certain of its private placement fixed maturity securities. The funds are due upon satisfaction of contractual notice from the issuer. These amounts may or may not be funded during the term of the security.
Deposit assets in the form of marketable securities held in trust are reported in miscellaneous assets in the consolidated statements of financial condition. Under the provisions of DIG Issue B36, any net unrealized gain is attributed to the value of the embedded derivative and is reported as such in fixed maturity securities. Any net unrealized loss will be attributed to the marketable securities held in the trust and reported as an adjustment to the deposit asset, with the related effects on claim reserves reflected in the reinsurance receivable for claim reserves.
Mortgage loans are impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. The Company had no impaired mortgage loans at December 31, 2004 or 2003.
At December 31, 2004, the Company had capital commitments of approximately $16.0 million for commercial mortgage loan originations. The funds will be due at closing of the mortgage loans.
The components of the change in the net unrealized gain on securities and the change in the net gain on cash flow hedges included in other comprehensive income (loss) are as follows. Changes related to the fixed maturity securities reported as discontinued operations in the consolidated statements of financial condition are included.
The Company has entered into several foreign currency interest rate swaps whereby it receives a fixed rate of interest denominated in U.S. dollars (functional currency) and pays a fixed rate of interest denominated in a foreign currency. The purpose of these derivatives is to eliminate the variability of functional currency cash flows associated with certain foreign currency denominated securities owned by the Company. The fixed rate the Company pays on the swap is offset by the fixed rate it receives on the foreign currency denominated security.
During 2003, the Company entered into a forward treasury lock which, by taking a long position, allowed the Company to lock in the interest rate on the future purchase of a specific U.S. Treasury bond. This derivative was identified as a cash flow hedge and was used to minimize the interest rate risk related to the settlement price on the reinsurance of an existing block of in force business. Because the settlement price of the ceded reinsurance transaction was partially determined by the change in the interest rate of a specific five year U.S. Treasury bond, the forward treasury lock allowed the Company to hedge the interest rate used in the calculation of the settlement price. The Company terminated the treasury lock, for cash, at the same time the reinsurance transaction settled.
The Company has also used forward starting swaps to hedge the interest rate on the issuance of debt. The Company recognized a loss of $10.6 million during 2002 upon the termination of these swaps and reported the loss in other comprehensive income (loss). The loss is being amortized into earnings as a component of interest expense over the expected remaining life of the hedged debt instrument.
As discussed in Note 1, effective October 1, 2003, the Company adopted the provisions of DIG Issue B36. The adoption of DIG Issue B36 resulted in an increase in fixed maturity securities of $61.3 million to record the fair value of embedded derivatives related to the credit risk provisions of certain reinsurance contracts. The fair value of the embedded derivatives related to these reinsurance contracts was $150.7 million as of December 31, 2004. The change in fair value of DIG Issue B36 derivatives is reported as a realized investment gain or loss.
During 2004, the Company acquired Integrated Benefits Management, a provider of case management services, at a price of $0.7 million. This acquisition will further broaden the relationship and distribution partnerships of the Company’s wholly-owned subsidiary, GENEX Services, Inc.
The estimated net amortization of value of business acquired for each of the next five years is $16.4 million in 2005, $8.4 million in 2006, $8.3 million in each of the years 2007 and 2008, and $9.3 million in 2009.
Changes in the liability for unpaid claims and claim adjustment expenses are as follows. Certain prior year amounts have been reclassified to conform to current year reporting.
The majority of the net balances are related to disability claims with long-tail payouts on which interest earned on assets backing liabilities is an integral part of pricing and reserving. Interest accrued on prior year reserves has been calculated on the opening reserve balance less one-half year’s cash payments at the average reserve discount rate used by the Company during 2004, 2003, and 2002.
die, or reach maximum benefit limits and no longer receive benefit payments from the Company. Generally, claim resolution rates vary by the age of the claimant at the time of disability, duration or length of time since the disability initially occurred, and claim diagnosis. The claim resolution rates for group long-term income protection during the first quarter of 2003 were below levels anticipated for reserves and were lower than those experienced in the full years 2002, 2001, and 2000. The analysis indicated not only a decrease in overall claim resolution rates, but also a change in claim resolution rates by claim duration. The analysis of emerging claim resolution rates and the reasons driving the changes resulted in a reduction in the Company’s long-term expectations with respect to claim resolution rates. The Company’s long-term expectations applied to all claims incurred regardless of the date of incurral. In addition, the Company reviewed the reserve discount rate, which is the interest rate at which future cash flows for benefits and expenses to be paid are discounted to determine the current value of those cash flows. The Company concluded at that time that a change in its discount rate assumptions was not warranted. Based on the April 2003 analysis, in the first quarter of 2003 the Company increased its group long-term income protection claim reserves by $454.0 million before tax, or $295.1 million after tax, to reflect its current estimate of future benefit obligations. The active claim reserve for claims already reported to the Company and still in open claim status was increased by $516.0 million, the IBNR reserve was decreased by $23.0 million, and the reopen reserve was decreased by $39.0 million before tax. The first quarter 2003 change represented a 6.5 percent increase in total net group long-term income protection reserves as of March 31, 2003, which for continuing operations equaled $7.017 billion prior to this increase and equaled $6.618 billion as of December 31, 2002.
The net increase in the reserve liability reported in the preceding table for 2003 for total incurred claims included the $894.0 million for these two reserve strengthenings, all of which was related to prior year incurred claims.
A portion of the reported increase in incurred claims for prior years resulted from the favorable foreign currency exchange rates in each of the three years presented relative to the preceding year, which increased the incurred related to prior years by approximately $128.7 million, $122.7 million, and $96.4 million for the years ended December 31, 2004, 2003, and 2002, respectively.
A reconciliation of the income tax (benefit) attributable to income (loss) from continuing operations computed at U.S. federal statutory tax rates to the income tax expense (benefit) as included in the consolidated statements of operations is as follows. Certain prior year amounts have been reclassified to conform to current year reporting.
The amount of the policyholders’ surplus accounts of the Company’s life insurance subsidiaries at December 31, 2004, was approximately $228.8 million. If the entire policyholder’s surplus accounts were deemed distributed in 2004, the Company would incur a tax of approximately $80.1 million. Under the AJCA, distributions made during 2005 and 2006 by these life insurance subsidiaries, including dividend distributions, are deemed to occur first from the policyholders’ surplus accounts. As a result, the Company’s life insurance subsidiaries expect to distribute the entire balance of their policyholders’ surplus accounts to the holding company during 2005 and 2006, eliminating this future potential tax. No current or deferred federal income taxes have currently been provided on the amounts in the policyholders’ surplus accounts because management considers the conditions under which such taxes would be paid to be remote. Therefore, this provision of the AJCA does not affect the consolidated financial position or results of operations of the Company.
The AJCA also provides a deduction of 85 percent of certain foreign earnings that are repatriated during 2005, up to a maximum of $500.0 million. The Company is currently reviewing its ability to take advantage of this provision and has not yet completed its evaluation. The Company expects to complete this evaluation during the first half of 2005. As a result, the Company has not provided for deferred taxes on basis differences in its foreign subsidiaries which are not expected to result in taxable or deductible amounts. If the Company does determine it is feasible to repatriate any amount of foreign earnings under this provision, the range of possible amounts that the Company would consider for repatriation is between zero and $210.0 million. A repatriation under the provision in this range would result in a reduction of income tax expense in 2005 between zero and $10.0 million.
During 2004, deferred tax assets related to foreign net operating loss carryforwards, for which a full valuation allowance had previously been provided, were reduced by $28.0 million to reflect the proper amount of carryforwards available at December 31, 2004. The Company’s valuation allowance was also decreased by $28.0 million resulting in no net effect on the financial results of the Company.
Total income taxes paid (refunded) during 2004, 2003, and 2002 were $91.5 million, $(3.9) million, and $46.4 million, respectively.
In May 2004, the Company issued 12.0 million 8.25% adjustable conversion-rate equity security units (units) in a private offering for $300.0 million. The Company subsequently registered the privately placed securities for resale by the private investors. Each unit has a stated amount of $25 and will initially consist of (a) a contract pursuant to which the holder agrees to purchase, for $25, shares of the Company’s common stock on May 15, 2007 and which entitles the holder to contract adjustment payments at the annual rate of 3.165 percent, payable quarterly, and (b) a 1/40 or 2.5 percent ownership interest in a senior note issued by the Company due May 15, 2009 with a principal amount of $1,000, on which the Company will pay interest at the initial annual rate of 5.085 percent, payable quarterly. Upon settlement of the common stock purchase contract and successful remarketing of the senior note element of the units, the Company will receive proceeds of approximately $300.0 million and will issue between 17.7 million and 20.4 million shares of common stock. The present value of the quarterly contract adjustment payments, which is included in other liabilities in the consolidated statements of financial condition, and the related purchase contract issuance costs reduced additional paid-in capital by $27.6 million.
quarterly, and (b) a 1/40, or 2.5 percent, ownership interest in a senior note issued by the Company due May 15, 2008 with a principal amount of $1,000, on which the Company will pay interest at the initial annual rate of 6.00 percent, payable quarterly. Upon settlement of the common stock purchase contract and successful remarketing of the senior note element of the units, the Company will receive proceeds of approximately $575.0 million and will issue between 43.3 million and 52.9 million shares of common stock. The present value of the quarterly contract adjustment payments, which is included in other liabilities in the consolidated statements of financial condition, and the related purchase contract issuance costs reduced additional paid-in capital by $37.4 million.
In the first quarter of 2001, the Company completed a long-term debt offering, issuing $575.0 million of 7.625% senior notes due March 1, 2011. In the second quarter of 2002, the Company completed two long-term offerings, issuing $250.0 million of 7.375% senior debentures due June 15, 2032 and $150.0 million of 7.250% public income notes due June 15, 2032. The public income notes are redeemable at the Company’s option, in whole or in part, on or after June 25, 2007.
The Company sponsors several defined benefit pension and postretirement plans for its employees, including non-qualified pension plans. The following tables provide the changes in the benefit obligation and fair value of plan assets and statements of the funded status of the plans. The Company uses a December 31 measurement date for each plan.
The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for pension plans with accumulated benefit obligations in excess of plan assets were $857.9 million, $744.9 million, and $558.6 million, respectively, as of December 31, 2004, and $698.2 million, $603.7 million, and $486.5 million, respectively, as of December 31, 2003.
The Company currently sets the discount rate assumption annually for each of its retirement related benefit plans at the measurement date to reflect the yield of a portfolio of high quality long-term fixed income securities matched against the timing and amounts of projected future benefits.
For measurement purposes at December 31, 2004, the annual rate of increase in the per capita cost of covered health care benefits assumed for 2005 was 8.75 percent for benefits payable to retirees prior to Medicare eligibility and 11.0 percent for benefits payable to Medicare eligible retirees. The rate range was assumed to change gradually to a rate of 5.0 percent for 2008 and remain at that level thereafter. For measurement purposes at December 31, 2003, the annual rate of increase in the per capita cost of covered health care benefits assumed for 2004 was 10.0 percent for benefits payable to retirees prior to Medicare eligibility and 12.0 percent for benefits payable to Medicare eligible retirees. The rate range was assumed to change gradually to a rate of 5.0 percent for 2008 and remain at that level thereafter.
The medical and dental premium used to determine the per retiree employer subsidy are capped. If the cap is not reached by the year 2015, the caps are then set equal to the year 2015 premium. A portion of the current retirees and all future retirees are subject to the cap.
The following table provides the components of the net periodic benefit cost (credit) for the plans described above for the years ended December 31.
To determine the net periodic pension cost for the year 2004, the expected long-term rate of return assumption used for the U.S. pension plan was 8.5 percent. In December 2003, the Company revised the investment policy which resulted in a target asset allocation of 70 percent equities and 30 percent fixed income securities. The long-term rate of return assumption is the best estimate of the average annual assumed return that will be produced from the pension trust assets until current benefits are paid. The determination of the best estimate is based on a “building block” approach. This methodology examines the various elements of the expected return for each asset class, such as inflation, dividends, real return, and risk premium. The expected return for each asset class is calculated as the sum of the individual components. The total expected return for the portfolio equals the weighted average of the return for each asset class, based on the plan’s asset allocations. This long-term rate of return assumption is based on an average expected return of approximately 5.4 percent annually for fixed income investments and 10.0 percent annually for equities. The Company’s expectations for these future investment returns are based on a combination of historical market performance and the Company’s evaluations of investment forecasts prepared by external consultants and economists. The investment portfolio contains a diversified blend of large cap, mid cap, small cap, and convertible equity securities, as well as both investment-grade and below-investment-grade fixed income securities. Investment risk is measured and monitored on an ongoing basis through annual liability measurements, periodic asset/liability studies, and quarterly investment portfolio reviews. Risk tolerance is established through careful consideration of plan liabilities, plan funded status, and corporate financial condition. The plan prohibits the use of derivative instruments.
Equity securities in the U.S. pension plan include the Company’s common stock in the amounts of $8.1 million and $7.1 million at December 31, 2004 and 2003, respectively. The amount of dividends paid during 2004 and 2003 was immaterial.
The Company’s funding policy for its U.S. qualified defined benefit plans is to contribute annually an amount at least equal to the minimum annual contribution required under the Employee Retirement Income Security Act and other applicable laws, and generally, not greater than the maximum amount that can be deducted for federal income tax purposes. The Company did not have any regulatory contribution requirements for 2004; however, in 2004, the Company elected to make a voluntary contribution of $20.0 million to its U.S. qualified defined benefit pension plan. The Company expects to make a voluntary contribution of approximately $23.0 million to its U.S. qualified defined benefit pension plan in 2005. The funding policy for the U.S. non-qualified defined benefit pension plan and postretirement plan is to contribute the amount of the benefit payments made during the year.
The Company’s U.K. operation maintains a separate defined benefit plan (Scheme) for its employees. The Scheme assets are invested in pooled funds, with a 62 percent global equity securities allocation. The remainder of the assets is predominantly invested in fixed interest bonds and index linked bonds. The long-term rate of return assumption is the best estimate of the average annual assumed return that will be produced from the Scheme assets until current benefits are paid. The Company contributes to the Scheme in accordance with a schedule of contributions which requires the Company to contribute to the Scheme at the rate of at least 18.2 percent of eligible salaries, sufficient to meet the minimum funding requirement under U.K. legislation. The Company contribution rate of 20.25 percent of eligible salaries is currently being reviewed. Based on the current contribution rate, the Company anticipates it will make a contribution into the Scheme of approximately $11.9 million in 2005.
The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Medicare Act) was enacted in December 2003 to add a voluntary prescription drug benefit for Medicare-eligible retirees to be effective January 1, 2006. The Medicare Act allows an employer to choose whether or not to coordinate prescription drug benefits under a retiree medical plan with the Medicare prescription drug benefit or to keep the company plan design as it is and receive a subsidy from the federal government. The Company reviewed the options available as a result of Medicare reform and aligned the options, as appropriate, for each of its designated groups of retirees.
Based on a preliminary analysis of the Medicare Act, it appears that the Company’s retiree medical plans provided to certain current retirees qualify for a government subsidy under the Medicare Act without change to the plans. The Company has included the estimated impact of the subsidy in measuring the accumulated benefit obligation at June 30, 2004, resulting in a reduction of $6.5 million in the accumulated benefit obligation related to benefits attributed to past service. The effect of the subsidy reduced net periodic benefit cost approximately $0.4 million per year, beginning in the third quarter of 2004, due to a reduction in interest cost on the accumulated postretirement benefit obligation.
In June 2004, the Company amended its postretirement medical plan to coordinate with the Medicare Act so that Medicare is the primary payer of prescription drug benefits for current non-grandfathered retirees (those who do not qualify for the government subsidy) and active employees who meet certain age and service requirements. This plan change resulted in a reduction of $5.4 million in the accumulated benefit obligation. The effect of the subsidy reduced net periodic benefit cost approximately $0.8 million per year, beginning in the third quarter of 2004.
The effect of the Medicare Act and the plan changes described herein are considered a significant event, requiring liabilities for the postretirement benefit plan to be remeasured as of June 30, 2004. The weighted average assumption for the discount rate used in the measurement of the Company’s benefit obligations for the postretirement benefit plan changed from 6.10 percent as of December 31, 2003 to 6.40 percent as of June 30, 2004.
In May 2003, the Company issued 52,877,000 shares of common stock, par value $0.10 per share, in a public offering and received approximately $547.7 million in proceeds after deducting underwriting discounts.
Under the broad-based stock plan of 2002, the Company had available up to 2,390,000 shares of common stock for stock option awards to its employees, officers, consultants, and producers, excluding certain senior officers and directors, of which 2,007,375 shares were granted. The stock options have a maximum term of ten years after the date of grant and generally vest after three years. The plan of 2002 was terminated in February 2004 for purposes of any further grants.
Under the broad-based stock plan of 2001, the Company has available up to 2,000,000 shares of common stock for stock option awards to its employees, officers, consultants, and producers, excluding certain senior officers and directors. The stock options have a maximum term of ten years after the date of grant and generally vest after three years. At December 31, 2004, 296,900 shares were available for future grants.
Under the stock plan of 1999, the Company has available up to 17,500,000 shares of common stock for awards to its employees, officers, producers, and directors. Awards may be in the form of stock options, stock appreciation rights, restricted stock awards, dividend equivalent awards, or any other right or interest relating to stock. Stock options have a maximum term of ten years after the date of grant and generally vest after three years. The number of shares available to be issued as restricted stock or unrestricted stock awards under the stock plan of 1999 is limited to 3,500,000 shares. The Company granted 78,594 shares, 1,347,874 shares, and 2,500 shares of restricted stock during 2004, 2003, and 2002, respectively, to certain employees and directors with a weighted average grant date value of $15.14, $10.64, and $28.90, respectively, per common share. Compensation cost recognized in the consolidated statements of operations for restricted stock awards is $4.9 million, $4.3 million, and $0.7 million for 2004, 2003, and 2002, respectively. These amounts are not included in the pro forma adjustments presented in Note 1. At December 31, 2004, 8,365,527 shares were available for future grants under the stock plan of 1999.
For the stock plan of 1999, the broad-based stock plan of 2001, and the broad-based stock plan of 2002, the exercise price for stock options issued shall not be less than the fair market value of the Company’s stock as of the grant date.
For the pro forma information presented in Note 1, the fair values of the stock options and the shares purchased under the ESPP were estimated at the date of grant using a Black-Scholes options-pricing model with the following assumptions:
In the normal course of business, the Company assumes reinsurance from and cedes reinsurance to other insurance companies. The primary purpose of ceded reinsurance is to limit losses from large exposures. However, if the assuming reinsurer is unable to meet its obligations, the Company remains contingently liable. The Company evaluates the financial condition of reinsurers and monitors concentration of credit risk to minimize this exposure. The reinsurance receivable at December 31, 2004 relates to approximately 383 reinsurance relationships. Ten major relationships account for approximately 91 percent of the reinsurance receivable at December 31, 2004, and are all companies rated A or better by A.M. Best Company or are fully securitized by letters of credit or investment-grade
During 2003, the Company reinsured on a 100 percent indemnity coinsurance basis for non-New York policies and a 90 percent indemnity coinsurance basis for New York policies certain of its insurance policies, primarily individual income protection, previously sold through trade associations and ceded approximately $121.0 million of reserves to the reinsurer. The transaction had an effective date of April 1, 2003.
In 1996, the Company executed a definitive reinsurance agreement with Centre Life Reinsurance Limited (Centre Re), a Bermuda-based reinsurance specialist, for reinsurance coverage of the existing United States noncancelable individual income protection active life reserves of one of the Company’s insurance subsidiaries, Unum Life Insurance Company of America. This agreement reinsures all claims incurred on or after January 1, 1996. The Company has the right, but no obligation, to recapture the business without penalty. Under the agreement, Centre Re has an obligation to absorb losses within a defined risk layer. The Company retains the risk for all experience up to Centre Re’s defined risk layer, or attachment point. The attachment point varies with changes in premiums, allowances, claims, investment income, and changes in the market value of the assets, due primarily to interest rate changes or defaults. Once the attachment point is reached, Centre Re assumes the risk for all experience up to a contractually defined risk limit. Any
Included in miscellaneous assets in the consolidated statements of financial condition at December 31, 2004, is a deposit asset for this reinsurance arrangement, which equals the net GAAP reserves less the book value of the assets in the trust. Under the provisions of DIG Issue B36, any net unrealized gain is attributed to the value of the embedded derivative and is reported as such in fixed maturity securities. Any net unrealized loss will be attributed to the marketable securities held in the trust and reported as an adjustment to the deposit asset, with the related effects on claim reserves reflected in the reinsurance receivable for claim reserves.
The Income Protection segment includes insurance for loss of income due to either sickness or injury or the loss of two or more “activities of daily living”, disability management services, and customized disability programs. Included within this segment are group long-term and short-term income protection insurance, individual income protection - recently issued insurance, and group and individual long-term care insurance, as well as various disability management services and programs. The products are marketed primarily to employers and multi-life employee groups by the Company’s sales force, working in conjunction with independent brokers and consultants. The Life and Accident segment includes insurance for life, accidental death and dismemberment, cancer, and critical illness marketed primarily to employers and multi-life employee groups by the Company’s sales force through independent brokers and consultants. The Colonial segment includes insurance for income protection products, life products, and cancer and critical illness products issued by the Company’s subsidiary Colonial Life & Accident Insurance Company and marketed primarily to employees at the workplace through an agency field sales force and brokers. The Individual Income Protection - Closed Block segment generally consists of those individual income protection policies in force prior to the Company’s substantial changes in product offerings, pricing, distribution, and underwriting which generally occurred during the period 1994 through 1998. A minimal amount of new business continued to be sold subsequent to these changes, but the Company ceased selling new policies in this segment at the beginning of 2004 other than update features contractually allowable on existing policies. The Other segment includes products that the Company no longer actively markets, with the exception of certain individual income protection products. The Corporate segment includes investment income on corporate assets not specifically allocated to a line of business, corporate interest expense, and certain corporate income and expense not allocated to a line of business.
Included in benefits and expenses is the amortization of deferred policy acquisition costs and value of business acquired as well as the 2004 impairment charges, which total $856.4 million, related to the restructuring of the individual income protection - closed block business. The expense for these items by segment is as follows:
The Company’s goodwill is reported in the Income Protection Segment, which is the segment expected to benefit from the originating business combinations. Stockholders’ equity is allocated to the operating segments on the basis of an internal allocation formula that reflects the volume and risk components of each operating segment’s business and aligns allocated equity with the Company’s target capital levels for regulatory and rating agency purposes. The internal formula may result in a “negative” equity and “negative” asset amount remaining in the Corporate segment. This formula is modified periodically to recognize changes in the views of capital requirements.
The Company has an agreement with an outside party wherein the Company is provided computer data processing services and related functions. The contract expires in 2013, but the Company may cancel this agreement effective January 2006 or later upon payment of applicable cancellation charges. The aggregate noncancelable contractual obligation remaining under this agreement was $61.8 million at December 31, 2004, with no annual payment expected to exceed $52.1 million.
In 1997 two alleged class action lawsuits were filed in Superior Court in Worcester, Massachusetts (Superior Court) against UnumProvident Corporation (UnumProvident) and several of its subsidiaries, The Paul Revere Corporation (Paul Revere), The Paul Revere Life Insurance Company, The Paul Revere Variable Annuity Insurance Company, and Provident Life and Accident Insurance Company.
On May 22, 2003, UnumProvident, several of its subsidiaries, and some of their officers and directors filed a motion with the Judicial Panel on Multidistrict Litigation seeking to transfer more than twenty class actions and derivative suits now pending against them in various federal district courts to a single district for coordinated or consolidated pre-trial proceedings. Each of these actions, discussed below, contends, among other things, that the defendants engaged in improper claims handling practices in violation of the Employee Retirement Income Security Act (ERISA) or various state laws or failed to disclose the effects of those practices in violation of the federal securities laws. On September 2, 2003, the Judicial Panel on the Multidistrict Litigation entered an order transferring these cases, described below, to the U.S. District Court for the Eastern District of Tennessee for coordinated or consolidated pretrial proceedings. These lawsuits are in a very preliminary stage, the outcome is uncertain, and the Company is unable to estimate a range of reasonably possible losses. Reserves have not been established for these matters. An adverse outcome in one or more of these actions could, depending on the nature, scope, and amount of the ruling, materially adversely affect the Company’s consolidated results of operations in a period, encourage other litigation, and limit the Company’s ability to write new business, particularly if the adverse outcomes negatively impact certain of the Company’s ratings.
Each of these actions purport to be a shareholder’s derivative action brought for the benefit of nominal defendant UnumProvident Corporation against certain current and past members of its Board of Directors and certain executive officers seeking to remedy alleged breaches of fiduciary duties and other violations of claims paying law. Plaintiffs allege, among other things, that the individual defendants established and perpetuated an illegal and improper policy of denying legitimate disability claims, engaged in improper financial reporting, and for certain defendants, engaged in insider trading. Further, plaintiffs allege as a result of their responsibility for and knowledge of the Company’s policies and practices, the individual defendants knew that the Company was violating various state and federal laws, including the federal securities laws, thus exposing the Company to liability and damages. Plaintiff alleges these acts violated, among other things, their fiduciary duties of good faith and loyalty.
On May 7, 2003, Azzolini v. CorTs Trust II for Provident Financial Trust, et al., was filed in the Southern District of New York. This is a federal securities law class action brought by the plaintiff on behalf of himself and a purported Class consisting of all persons who purchased UnumProvident Corporate-Backed Trust Securities (CorTs) certificates pursuant to an initial public offering by an entity unaffiliated with the Company on or about April 18, 2001 through March 24, 2003. Plaintiff seeks to recover damages caused by UnumProvident’s and certain underwriter defendants’ alleged violations of the Securities Act of 1933 and the Securities Exchange Act of 1934. Plaintiff asserts that UnumProvident issued and/or failed to correct false and misleading financial statements and press releases concerning the Company’s publicly reported revenues and earnings directed to the investing public.
Three additional actions alleging similar claims and purporting to be class actions were filed, two in the Southern District of New York, Strahle v. CorTs Trust II for Provident Financing Trust I, et al., and Finke v. CorTs Trust II for Provident Financing Trust I, et al., filed on March 23, 2003 and May 15, 2003, respectively, and the third in the Eastern District of New York, Bernstein v. CorTs for Provident Financing Trust I, et al., filed on July 7, 2003. These actions all have been transferred to the Eastern District of Tennessee for coordinated pre-trial proceedings. On February 18, 2004, the court consolidated each of these actions other than the Bernstein action under the
Azzolini caption. The Bernstein action makes identical allegations as the other actions, but with respect to a different series of CorTs securities.
On March 19, 2004, amended complaints were filed in both the Azzolini and Bernstein actions. The amended complaints assert claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder against UnumProvident and one of its officers. The Azzolini plaintiff seeks to represent a putative class of purchasers of certain CorTs certificates between March 21, 2001 and March 24, 2003. The Bernstein plaintiff seeks to represent a putative class of purchasers of a different series of CorTs certificates between February 8, 2001 and March 10, 2003. On April 19, 2004, the defendants moved to dismiss the complaints in each of these actions. The court has not as of yet ruled on those motions.
On July 15, 2002, the case of Rombeiro v. Unum Life Insurance Company of America, et al., was filed in the Superior Court of Sonoma County, California. It was subsequently removed to the United States District Court for the Northern District of California. On January 21, 2003, a First Amended Complaint was filed, purporting to be a class action. This complaint alleges that plaintiff individually was wrongfully denied disability benefits under a group long-term disability plan and alleges breach of state law fiduciary duties on behalf of himself and others covered by similar plans whose disability benefits have been denied or terminated after a claim was made. The complaint seeks, among other things, injunctive and declaratory relief and payment of benefits. On April 30, 2003, the court granted in part and denied in part the defendants’ motion to dismiss the complaint. On May 14, 2003, the plaintiff filed a Second Amended Complaint seeking injunctive relief on behalf of a putative nationwide class of long-term disability insurance policyholders. The Company denies the allegations in the complaint and will vigorously defend the litigation and any attempt to certify the putative class. This action was transferred to the Eastern District of Tennessee as part of the multidistrict litigation transfer order.
On November 4, 2002, the case of Keir, et al. v. UnumProvident Corporation, et al., was filed in the United States District Court for the Southern District of New York. This case purports to be a class action on behalf of a putative class of group long-term disability participants insured under ERISA plans whose claims were denied or terminated on or after June 30, 1999. The amended complaint alleges that these claimants had their claims improperly challenged and allege that the Company and its insurance subsidiaries breached certain fiduciary duties owed to these participants in ERISA plans in which the Company is the claims adjudicator. The Company maintains that the allegations are false and that the claims, as framed, are not permissible under ERISA’s carefully structured avenues of relief. On April 29, 2003, the court denied the defendants’ motion to dismiss the complaint. The Company denies the allegations in the complaint and will vigorously defend the litigation and any attempt to certify the putative class. This action was transferred to the Eastern District of Tennessee as part of the multidistrict litigation transfer order.
On February 25, 2003, the case of Davis, et al. v. UnumProvident Corporation, et al., was filed in the United States District Court for the Eastern District of Pennsylvania. The plaintiffs are seeking representative status as a class of disability participants insured under ERISA plans. The complaint alleges that these claimants had their claims improperly denied or terminated and that the Company breached certain fiduciary duties owed to these participants in ERISA plans. The complaint also alleges violations under the federal Racketeer Influenced Corrupt Organizations Act (RICO). The complaint seeks reversal of claim denials or contract rescissions and re-determination by an independent person of claims of the named plaintiffs and others similarly situated, appointment of a master to oversee certain claim handling matters, and treble damages under RICO. The Company denies the allegations in the complaint and will vigorously defend the litigation and any attempt to certify the putative class. This action was transferred to the Eastern District of Tennessee as part of the multidistrict litigation transfer order.
On April 30, 2003, the case of Taylor v. UnumProvident Corporation, et al., was filed in the Circuit Court for Shelby County, Tennessee in the Thirteenth Judicial District at Memphis. The plaintiff seeks to represent all individuals who were insured by long-term disability policies issued by subsidiaries of UnumProvident and who did not obtain their coverage through employer sponsored plans and who had a claim denied, terminated, or suspended by a UnumProvident subsidiary after January 1, 1995. Plaintiff alleges that UnumProvident Corporation and its subsidiaries employed various unfair claim practices in assessing entitlement to benefits by class members during this period and, as a result, wrongfully denied legitimate claims. The plaintiff and the class seek contractual, equitable, and injunctive relief. On June 9, 2003, the defendants removed this action to the United States District Court for the Western District of Tennessee. The Company denies the allegations in the complaint and will vigorously defend the litigation and any attempt to certify the putative class. This action was transferred to the Eastern District of Tennessee as part of the multidistrict litigation transfer order.
On September 17, 2003, the case of Rudrud, et al. v. UnumProvident Corporation, et al., was filed in the United States District Court for the District of Massachusetts. The plaintiffs assert claims on behalf of a putative class of disability participants insured under ERISA plans. The complaint alleges that these claimants had their claims improperly denied or terminated and that the Company breached certain fiduciary duties owed to these participants in ERISA plans. The complaint also alleges violations under RICO and Massachusetts state law. The complaint seeks payment of benefits, reversal of claim denials or contract rescissions and re-determination by an independent person of claims of the named plaintiffs and others similarly situated, appointment of a master to oversee certain claim handling matters, restitution and damages, and treble damages under RICO. The Company denies the allegations in the complaint and will vigorously defend the litigation and any attempt to certify the putative class. This action was transferred to the Eastern District of Tennessee as part of the multidistrict litigation order.
The court entered a schedule providing for the completion of all pretrial proceedings in these actions by December 2005. The Company denies the allegations in the complaints and will vigorously defend the litigation and any attempt to certify the putative class.
The parties have engaged in certain limited document discovery in this action on issues unique to this action that are not raised in the other action.
On December 11, 2003, the case of Jewel, et al. v. UnumProvident Corporation, et al., was filed in the Worcester County Superior Court, Commonwealth of Massachusetts. The Company received service of this matter on March 8, 2004. Plaintiffs seek to represent all individual long-term disability policyholders and all participants in group long-term disability plans which are not covered by ERISA who (a) had coverage issued by an insuring subsidiary and (b) whose claims for long-term disability benefits were denied, or whose payments of long-term disability benefits were terminated or suspended, on or after July 1, 1999. Plaintiffs allege that the defendants employed various unfair claim practices and seek declaratory, contractual, and injunctive relief. On April 20, 2004, the defendants answered the complaint by denying generally the allegations and asserting various defenses. On July 15, 2004, plaintiffs filed a motion seeking to certify a plaintiff class. On February 18, 2005, the Court denied that motion. The Company denies the allegations in the complaint and will vigorously defend the litigation.
On July 17, 2003, a qui tam action, The State of California ex rel. Linda Nee and John Metz v. UnumProvident Corporation, et al., was filed under seal in the Superior Court of the State of California, County of Los Angeles. On April 16, 2004, UnumProvident was notified that the Insurance Commissioner decided not to bring an action which permitted the case to go forward with private plaintiffs. The complaint alleges unlawful sales, marketing, and claims handling practices, including delaying or limiting payment for, denying, or terminating claims by California claimants and/or claims that are handled by UnumProvident’s Glendale or other claims centers. The complaint seeks civil penalties and assessments, attorneys’ fees and costs, interest, and such other relief as the court deems proper for violation of California Insurance Code §1871.7(b). In addition, the complaint seeks injunctive relief. The Company denies the allegations in the complaint and will vigorously defend the litigation. On August 5, 2004, the Company filed several motions challenging the sufficiency of the complaint. The court has postponed the hearing of the various motions on several occasions. There is currently no date set for further hearing.
On December 20, 2004, Jeffrey A. Weiller v. New York Life Insurance Company, UnumProvident Corporation, and The Paul Revere Life Insurance Company, was filed in the Supreme Court of the State of New York. This complaint is brought by the plaintiff on behalf of himself and a purported class alleging that UnumProvident schemed to improperly deny or terminate legitimate claims filed under policies issued by several non-UnumProvident insurers on behalf of whom UnumProvident administers claims. On February 18, 2005, the defendants filed a motion to dismiss this action. That motion remains pending. The Company denies the allegations and will vigorously defend against the allegations raised in the complaint.
In June 2004, the Company received a subpoena from the Office of the New York Attorney General (NYAG) requesting documents and information relating to compensation agreements between insurance brokers and the Company and its subsidiaries. The Company has received subpoenas for additional information, including information regarding its quoting process and the placement of reinsurance coverages. Shortly after the NYAG filed a lawsuit in October 2004 against a major insurance broker raising a number of issues relating to broker compensation practices and bid-rigging in the insurance industry, the Company announced its support for complete and timely disclosure of compensation paid to the broker of a customer. The Company has been reviewing its compensation policies and quoting practices both for compliance with applicable legal requirements and in response to various issues raised. The Company has also provided information to the NYAG relating to insurance policies sold to businesses in which Universal Life Resources, Inc. (ULR), acted as a consultant or broker for its client employers. On November 12, 2004, the NYAG filed a lawsuit against ULR alleging that its client employers were not aware of compensation arrangements ULR had with insurers or that the arrangements influenced ULR to steer business to certain insurers. Several insurers were cited in the complaint, including the Company, but not named as defendants. See “Other Litigation” below for other lawsuits involving ULR and its principal, Douglas Cox.
On November 19, 2004, the Maine Bureau of Insurance delivered a formal Letter of Inquiry to Unum Life Insurance Company of America. The inquiry contains a series of questions related to compensation arrangements with producers and quoting practices in the market place. There is also an accompanying request for documents related to compensation arrangements. The Company intends to fully cooperate with the Maine Bureau on this inquiry.
On February 18, 2005, the Massachusetts Attorney General issued a Civil Investigative Demand to Colonial Life & Accident Insurance Company regarding a request for information on insurance sold to various municipalities in the state of Massachusetts and information related to any compensation paid by the Company to agents or brokers who procured that insurance. The Company intends to fully cooperate with the Attorney General with regard to this Demand.
The Company has had discussions with the U.S. Department of Labor (DOL) regarding compliance with ERISA, relating to the Company’s interactions with insurance brokers and to regulations concerning insurance information provided by the Company to plan administrators of ERISA plans, including specifically the reporting of fees and commissions paid to agents, brokers and others in accordance with the requirements of Schedule A of Form 5500. The DOL is pursuing an investigation of the Company concerning these issues, both generally and specifically in connection with certain brokers, including ULR, which is a defendant referred to below under “Other Litigation.” The Company is cooperating with the DOL’s investigation.
In addition, the DOL, which had been conducting an inquiry relating to certain ERISA plans, has joined the settlement agreements. The NYAG, which had engaged in its own investigation of the Company’s claim handling practices, notified the Company that it is in support of the settlement and has closed its investigation on this issue.
In the fourth quarter of 2004, the Company recorded a charge related to the settlement of the multistate market conduct examination of $127.0 million, before tax, or $87.8 million, after tax, comprised of four elements: $27.5 million of incremental direct operating expenses to conduct the two-year reassessment process; $44.0 million for benefit costs and reserves from claims reopened from the reassessment; $40.5 million for additional benefit costs and reserves for claims already incurred and currently in inventory that are anticipated as a result of the claim process changes being implemented; and the $15.0 million fine.
While the multistate examination was in progress, several states continued their own market conduct examinations and investigations, which include claim related as well as certain other state specific issues. Although, Minnesota is participating in the multistate settlement agreements, the Company recently settled three prior market conduct examinations dating back to 1995 and paid a fine of $250,000. California conducted an examination and investigation relating to claims handling and other issues. California chose not to join the multistate settlement agreements, and discussions with the California Department of Insurance have been ongoing relating to various issues, some of which are within the general scope of the multistate examination and others that are outside its scope and relate to California specific issues. Arizona and New Mexico consented to join the multistate settlement agreements. The Company understands that Arizona is in the process of concluding its exam that will focus on non- claim related matters, and New Mexico may, or may not, continue to pursue its own examination which was begun prior to the multistate examination.
In addition to the terms and conditions of the multistate regulatory settlement agreements, these regulatory examinations and investigations could result in, among other things, changes in business practices, including broker compensation and related disclosure practices, changes in practices for quoting business, changes in the Company’s claims handling practices, increases in policy liabilities, reopening of closed or denied claims, changes in governance and other oversight procedures, fines, and other actions by the regulatory agencies. Such results, singly or in combination, could injure the Company’s reputation, cause negative publicity, adversely affect the Company’s ratings, or impair the Company’s ability to sell or retain insurance policies, thereby adversely affecting the Company’s business, and potentially materially adversely affecting the consolidated results of operations in a period, depending on the results of operations of the Company for the particular period. Determination by regulatory authorities that the Company or its insurance subsidiaries have engaged in improper conduct could also adversely affect the Company’s defense of various lawsuits described herein.
On November 17, 2004, an action purporting to seek injunctive relief pursuant to the California Insurance Code, The People of the State of California by and through John Garamendi, Insurance Commissioner of the State of California v. Universal Life Resources, et al., was filed in the Superior Court of the State of California for the County of San Diego. Allegations are made against ULR and several major insurers, including UnumProvident, claiming that the broker was paid undisclosed or inadequately disclosed fees, commissions, and other compensation as kickbacks by the insurer defendants in return for the broker steering its clients to purchase insurance policies and other services from the insurer defendants. In addition to injunctive relief, the complaint purports to seek the imposition of a trust to recover any funds acquired by any practice the Court may find to have been in violation of the Insurance Code or the regulations promulgated thereunder. The case was removed to the United States District Court for the Southern District of California on January 3, 2005. On January 24, 2005, the plaintiff filed a motion to remand the case to state court. The issue of removal has been taken under advisement. The Company denies the allegations of the complaint and will vigorously defend the litigation.
On January 14, 2005, Shell Vacations LLC on behalf of itself and all others similarly situated v. Marsh & McLennan Companies, Inc. et al., was filed in the United States District Court for the Northern District of Illinois. The complaint is a putative class action and alleges violations of the Sherman Act, RICO, federal and state common law, state antitrust laws, and unfair and or deceptive trade practices laws. The allegations are brought against numerous broker organizations and insurers and assert claims based on bid rigging, price fixing, and undisclosed and improper compensation practices. The complaint seeks restitution, disgorgement of profits, establishment of a constructive trust, damages including punitive damages, and trebling of damages and injunctive relief. The Company denies the allegations of the complaint and will vigorously defend the case.
On January 21, 2005, Redwood Oil Company on behalf of itself and all others similarly situated v. Marsh & McLennan Companies Inc., et al., was filed in the United States District Court of the Northern District of Illinois. The complaint is a putative class action and alleges violations of the Sherman Act, RICO, federal and state common law, state antitrust laws, and unfair and or deceptive trade practices laws. The allegations are brought against numerous broker organizations and insurers and assert claims based on bid rigging, price fixing, and undisclosed and improper compensation practices. The complaint seeks restitution, disgorgement of profits, establishment of a constructive trust, and damages as provided by federal and state antitrust laws and by RICO. The Company denies the allegations of the complaint and will vigorously defend the case.
On February 17, 2005, the Judicial Panel on Multidistrict Litigation issued an order transferring several actions related to broker compensation issues that are pending in various district courts to the United States District Court for the District of New Jersey for consolidated or coordinated pre-trial proceedings. In a footnote, the Order identified the Shell Vacations, Redwood Oil, and Boros actions as potential tag along cases, and it appears likely that those actions will be transferred to the District of New Jersey as well. The Company expects to be served with other complaints making similar allegations to those asserted in Shell Vacations, Redwood Oil, and Boros. The Company believes these cases will likely be managed as part of the multidistrict litigation proceedings, or, if filed in state court and not removed, coordinated with the multidistrict litigation proceedings.
In September 2003, United States of America ex. rel. Patrick J. Loughren v. UnumProvident Corporation and GENEX Services, Inc., was filed in the United States District Court for the District of Massachusetts. This is a qui tam action to recover damages and civil penalties on behalf of the United States of America alleging false statements and claims were made or caused to be made by UnumProvident and GENEX to the United States of America in violation of the False Claims Act. The action was originally filed under seal to provide the government the opportunity to investigate the allegations and prosecute the action if they believed that the case had merit and warranted their attention. The government has turned down the option to prosecute the case and as a result the seal was lifted and the case became a matter of public record on December 23, 2004. This litigation relates to the assistance provided to UnumProvident Corporation insurance subsidiary claimants in their pursuit of, or application for, benefits from the Social Security Administration by UnumProvident and GENEX employees, agents or any employees of its subsidiary companies. The Company has filed a motion to dismiss the case in its entirety. The motion is still pending. The Company denies the allegations in the complaint and will vigorously defend the case.
On December 21, 2004, a putative derivative action styled Patrick Leonard, Derivatively on behalf of UnumProvident Corporation v. UnumProvident, et al., was filed in the State of Tennessee Chancery Court for Hamilton County against the Company and various members of its board of directors alleging claims on behalf of the Company against the named director defendants for breach of duty, mismanagement, and corporate waste, challenging certain compensation paid to insurance brokers and alleging insider trading against certain director defendants. The defendants must answer or otherwise respond to the allegations of the complaint by March 28, 2005. The defendants strongly deny the allegations in the complaint and will vigorously defend both the substantive and procedural aspects of the litigation.
At December 31, 2004, the Company’s insurance subsidiaries had on deposit with U.S. regulatory authorities securities with a book value of $284.3 million held for the protection of policyholders. Additionally, securities with a book value of $263.7 million remain in trust for Canadian regulatory authorities at December 31, 2004.
During the fourth and first quarters of 2003, the Company recognized losses of $440.0 million and $454.0 million before tax, respectively, and $286.0 million and $295.1 million after tax, respectively, related to reserve strengthening for group income protection. Additionally, during the fourth quarter of 2003, the Company recognized a loss of $200.2 million before tax and $196.9 million after tax for write-downs related to its discontinued operations. See Notes 2 and 7 for further discussion.