CIGNA's headquarters, along with CIGNA Group Insurance, CIGNA International, portions of CIGNA HealthCare and CIGNA's staff support operations, are located in approximately 450,000 square feet of leased office space at Two Liberty Place, 1601 Chestnut Street, Philadelphia. CIGNA HealthCare is located in approximately 825,000 square feet of owned office space in the Wilde Building, located at 900 Cottage Grove Road, Bloomfield, Connecticut. In addition, CIGNA owns or leases office buildings, or parts thereof, throughout the United States and in other countries. CIGNA believes its properties are adequate and suitable for its business as presently conducted. For additional information concerning leases and property, see Notes 2(H) and 18 to CIGNA's 2007 Financial Statements on pages 75 and 96 of this Form 10-K. This paragraph does not include information on investment properties.
Effective January 1, 2007, CIGNA changed its presentation to report the results of the Run-off Retirement business within Other Operations. Prior period
the Company’s ability to cross sell its various health and related benefit products;
regulations and tax rules related to the administration of employee benefit plans; and
The Company is continuing to improve the performance of and profitably grow the health care operations; as well as continuing to profitably grow the disability and life insurance and international businesses; and managing the risks associated with the run-off reinsurance operations. In the health care businesses, the Company has operational improvement initiatives (see pages 50-52) in place to:
In order to facilitate an understanding and comparison of results of operations and permit analysis of trends in underlying revenue, expenses and income from continuing operations, the following table presents special items, which management believes are not representative of the underlying results of operations. See “Quarterly Financial Data” on page 104 for special items reported quarterly in 2007 and 2006.
a tax benefit primarily from the release of tax reserves and valuation allowances resulting from the completion of the IRS audit for years 2000-2002; and
The impact of these special items on the segments is shown in the “Results of Operations” table within each segment discussion.
Income from continuing operations excluding the special items discussed above decreased in 2007, compared with 2006, principally reflecting lower realized investment gains primarily due to lower gains from sales of equity interests in real estate limited liability entities of $145 million.
These factors were partially offset by higher earnings in the Health Care (see page 48), Disability and Life (see page 52), International (see page 53) and Run-off Reinsurance (see page 53) segments.
Income from continuing operations in 2006, excluding the special items discussed above, increased compared to 2005 principally reflecting:
higher earnings in the International segment driven by growth in the expatriate employee benefits business and the life, accident and health insurance business.
The Company expects full year 2008 income from continuing operations, excluding realized investment results, the results of the guaranteed minimum income benefits (GMIB) business and special items, to be higher than the comparable 2007 amount primarily due to earnings growth in the Health Care, Disability and Life and International segments, tempered by lower earnings in the Run-off Reinsurance segment. The Company’s outlook is subject to the factors cited in the Cautionary Statement on page 64.
Total revenue increased by 7% in 2007, compared with 2006 and decreased by 1% in 2006, compared with 2005. Changes in the components of total revenue are described more fully below.
Net investment income decreased 7% in 2007. This decrease was primarily attributable to share repurchase activity and lower average assets driven by a decline in the Health Care segment resulting from:
a shift in business from guaranteed cost products to administrative services only (ASO) products; and
Net investment income also reflects the impact of yields, which were lower in 2007 and higher in 2006 as a result of changes in interest rates.
Other revenues increased 6% in 2007, as compared with 2006, primarily due to lower losses from futures contracts in the run-off reinsurance operations partially offset by lower other revenues in the Disability and Life segment (see page 52).
Other revenues decreased 54% in 2006, as compared with 2005, primarily due to lower deferred gain amortization associated with the sold retirement benefits business and higher losses from futures contracts in the run-off reinsurance operations.
Realized investment gains (losses) were higher in 2006, compared with 2007 and 2005, primarily due to sales of equity interests in real estate limited liability entities.
See Note 2(B) to the Consolidated Financial Statements for further information on significant accounting policies that impact the Company.
The table that follows presents information about the Company’s most critical accounting estimates, as well as the effects of hypothetical changes in the material assumptions used to develop each estimate.
The Company estimates these liabilities based on assumptions for lapse, partial surrender, mortality, interest rates (mean investment performance and discount rate), and volatility. These assumptions are based on the Company’s experience and future expectations over the long-term period. The Company monitors actual experience to update these estimates as necessary.
Partial surrender refers to the fact that most contractholders have the ability to withdraw substantially all of their mutual fund investments while retaining any available death benefit coverage in effect at the time of the withdrawal. Equity market declines could expose the Company to higher rates of partial surrender, the effect of which is not covered by the Company’s program to substantially reduce market risks.
Liabilities for medical claims payable as of December 31 were as follows:
For the year ended December 31, 2007, actual experience differed from the Company's key assumptions, resulting in $80 million of favorable incurred claims related to prior years’ medical claims payable of 1.3% of the current year incurred claims as reported for the year ended December 31, 2006. For the year ended December 31, 2006, actual experience differed from the Company's key assumptions, resulting in $173 million of favorable incurred claims related to prior years’ medical claims, or 2.6% of the current year incurred claims reported for the year ended December 31, 2005. Specifically, the favorable impact is due to faster than expected completion factors and lower than expected medical cost trends, both of which included an assumption for moderately adverse experience.
The corresponding impact of favorable prior year development on net income was $8 million for the year ended December 31, 2007 and $54 million for the year ended December 31, 2006. The change in the amount of the incurred claims related to prior years in the medical claims payable liability does not directly correspond to an increase or decrease in the Company's net income. See Note 5 to the Consolidated Financial Statements for additional information.
Claims incurred in the most recent month have limited paid claim data, since a large portion of health care claims are not submitted to the Company for payment in the month services have been provided. This makes the completion factor approach less reliable for claims incurred in the most recent month. As a result, in any reporting period, for the estimates of the ultimate claims incurred in the most recent month, the Company primarily relies on medical cost trend analysis, which reflects expected claim payment patterns and other relevant operational considerations. Medical cost trend is impacted by several key factors including medical service utilization and unit costs and the Company’s ability to manage these factors through benefit design, underwriting, provider contracting and the Company's medical management initiatives. These factors are affected by changes in the level and mix of medical benefits offered, including inpatient, outpatient and pharmacy, the impact of copays and deductibles, changes in provider practices and changes in consumer demographics and consumption behavior.
Because historical trend factors are often not representative of current claim trends, the trend experienced for the most recent history along with an analysis of emerging trends, have been taken into consideration in establishing the liability for medical claims payable at December 31, 2007 and 2006. It is possible that the actual medical trend for the current period will develop differently from the expected, which could have a material impact on the Company's medical claims payable and net income.
For each reporting period, the Company evaluates key assumptions by comparing the assumptions used in establishing the medical claims payable to actual experience. When actual experience differs from the assumptions used in establishing the liability, medical claims payable are increased or decreased through current period net income. Additionally, the Company evaluates expected future developments and emerging trends which may impact key assumptions. The estimation process involves considerable judgment, reflecting the variability inherent in forecasting future claim payments. The adequacy of these estimates is highly sensitive to changes in the Company's key assumptions, specifically completion factors, which are impacted by actual or expected changes in the submission and payment of medical claims, and medical cost trends, which are impacted by actual or expected changes in the utilization of medical services and unit costs.
Based on the current mix of business, the Company would reasonably expect the variance between actual and expected incurred medical claims to be within the range of +/- 0% to 1%. This potential variance is expected to be driven evenly by completion factors and monthly medical cost trends. While these ranges are consistent with the more recent variation in actual completion factors and medical trend assumptions, including the impact of recent operational and environmental changes, there is significant uncertainty regarding the ultimate outcome of actual results versus individual assumptions, and accordingly, more precision is not appropriate.
Net liabilities related to these contracts as of December 31 were as follows:
As of December 31, net amounts recoverable related to these contracts from two external reinsurers were as follows:
Additional liabilities associated with the cost of reinsurance as of December 31 were as follows:
The Company estimates the fair value of the assets and liabilities associated with these contracts using assumptions as to market returns and volatility of the underlying equity and bond mutual fund investments, interest rates, mortality, lapse, credit risk and annuity election rates. Changes in fair value are reported in other operating expenses.
The Company has been monitoring annuity election rate experience and, in 2007, increased its assumption related to annuity election rates resulting in a charge (net of reinsurance) of $75 million pre-tax. Also in 2007, the Company completed a review of lapse experience for these contracts. As a result of the review, the Company decreased its lapse assumption resulting in a charge (net of reinsurance) of $11 million pre-tax; because fewer annuitants are expected to lapse coverage, the Company’s expected claims increase. In combination, the Company recognized in the second quarter of 2007 a total charge of $56 million after-tax ($86 million pre-tax) for these changes in the long-term assumptions. This charge is reflected as a special item (see page 40).
· basis point decrease in interest rates used for projecting claim exposure (7 year Treasury rates) - $30 million
In addition, if annuitants' account values as of December 31, 2007 declined by 10% due to the performance of the underlying mutual funds, the approximate after-tax decrease in net income net of estimated reinsurance recoverable would be approximately $35 million.
Collectibility of reinsurance recoverables requires an assessment of risks that such amounts will not be collected, including risks associated with reinsurer default and disputes with reinsurers regarding applicable coverage.
The amount of reinsurance recoverables in the Run-off Reinsurance segment, net of reserves, represents management’s best estimate of recoverability, including an assessment of the financial strength of reinsurers. The ultimate amounts received are dependent, in certain cases, on the resolution of disputes with reinsurers, including the outcome of arbitration and litigation proceedings.
A 10% reduction of net reinsurance recoverables due to uncollectibility at December 31, 2007, would reduce net income by approximately $15 million after-tax.
See Note 9 to the Consolidated Financial Statements for additional information.
The Company estimates these liabilities with actuarial models using various assumptions including discount rates and an expected return on plan assets.
The declining interest rate environment has resulted in an accumulated unrecognized actuarial loss of $0.4 billion at December 31, 2007. The actuarial loss adjusted for unrecognized changes in market-related asset values is amortized over the remaining service life of pension plan participants if the loss exceeds 10% of the market-related value of plan assets or 10% of the projected benefit obligation, whichever is greater. As of December 31, 2007, approximately $0.3 billion of the adjusted actuarial loss exceeded 10% of the projected benefit obligation. As a result, approximately $35 million after-tax will be expensed in 2008 net income. For the year ended December 31, 2007, $77 million after-tax was expensed in net income.
· the accrued pension benefit liability would increase by approximately $200 million as of December 31, 2007 resulting in an after-tax decrease to shareholders’ equity of approximately $130 million as of December 31, 2007.
If the expected return on domestic qualified pension plan assets decreased by 50 basis points, annual pension costs for 2008 would increase by approximately $10 million, after-tax.
A favorable change is an increase in these key assumptions and would result in impacts to annual pension costs, the accrued pension liability and shareholders’ equity in an opposite direction, but similar amounts.
Determining whether a decline in value is “other than temporary” includes an evaluation of the reasons for and the significance of the decrease in value of the security as well as the duration of the decrease.
The Company recognized "other than temporary" impairments of investments in fixed maturities as follows (after-tax, excluding policyholder share):
See Note 10(A) to the Consolidated Financial Statements for a discussion of the Company’s review of declines in fair value.
For all fixed maturities with cost in excess of their fair value, if this excess was determined to be other-than-temporary, the Company's net income as of December 31, 2007 would have decreased by approximately $81 million after-tax.
The Health Care segment includes medical, dental, behavioral health, prescription drug and other products and services that may be integrated to provide consumers with comprehensive health care solutions. This segment also includes group disability and life insurance products that were historically sold in connection with certain experience-rated medical products that continue to be managed within the health care business.
The Health Care segment's earnings in all years presented were impacted by favorable after-tax prior year claim development of $8 million, $54 million and $137 million, in 2007, 2006 and 2005, respectively.
The amount of prior year claim development recorded in 2006 and in 2005 was attributable to better than expected completion factors reflecting shorter claims processing times due to more timely submission of claims as well as higher auto adjudication rates. Additionally, lower than expected medical cost trends also contributed to the favorable results. These results were driven by lower inpatient, outpatient and pharmacy service utilization and successful provider contracting initiatives as well as the mix of services provided.
Excluding such prior year claim development and the special items noted in the table above, segment earnings in 2007 increased over 2006 due to:
aggregate medical membership growth of approximately 800,000 members, including growth in the voluntary/ limited benefits business.
Excluding prior year claim development and the special items noted in the table above, segment earnings for 2006 were higher than 2005 due to:
higher earnings from the specialty businesses associated with core medical members;
lower losses in the Medicare Part D program of $11 million after-tax.
These factors were partially offset by lower results in the guaranteed cost business reflecting premium increases which were less than medical cost increases and lower experience-rated earnings.
The table below shows premiums and fees for the Health Care segment:
2 Includes premiums of $82 million for 2006 associated with the health care members in Tucson, Arizona (see Medical Membership below).
5Other medical premiums include risk revenue for stop-loss and specialty products.
Premiums and fees reflect the loss in 2006 of a large prescription drug contract of $1.1 billion in the experience-rated business. The loss of this contract had minimal impact to earnings, however the final settlement of this contract did result in net cash outflows in 2006.
Other revenues. Other revenues for the Health Care segment consist of revenues earned on direct channel sales of certain specialty products, including behavioral health and disease management.
Other revenues increased 11% in 2007 and 9% in 2006 primarily due to business growth.
Excluding prior year claim development and the loss of a large prescription drug contract, medical claims expense increased 14% in 2006, compared with 2005. This increase was due to the impact of medical trend as demonstrated by a worsening in the medical cost ratio in the guaranteed cost business to 85.8% from 84.1%, the introduction of Medicare Part D in 2006 and the impact of Star HRG, which was acquired in July 2006.
Other operating expenses. Other operating expenses include expenses related to both retail and mail order pharmacy, disease management, voluntary and limited benefits and Medicare claims administration businesses.
Excluding these items, other operating expenses increased in 2007, compared with 2006, reflecting membership growth and higher spending on information technology, including market facing capabilities. This increase was partially offset by productivity savings which were reflected in lower operating expenses per member due to the success of various expense reduction initiatives.
2 Includes minimum premium members, who have a risk profile similar to experience-rated funding arrangements. The risk portion of minimum premium revenue is reported in experience-rated medical premium whereas the self funding portion of minimum premium revenue is recorded in fees.
3 Includes approximately 25 thousand members obtained through the acquisition of Mid-South Administrative Group, LLC, which was effective January 1, 2007, and includes 340 thousand members related to Sagamore Health Network, which was acquired on August 1, 2007.
During 2007, medical membership increased by 8.3%, including members from the August 1, 2007 acquisition of Sagamore Health Network, Inc. Excluding this acquisition, medical membership increased 4.7% due to growth in the service business.
The Company continues to devote its efforts to becoming the leading health service organization. As such, the Company is focused on several initiatives including developing and enhancing a consumer focused service model. This effort is expected to require significant investments over the next 3-5 years. These investments will enable the Company to grow its membership and to improve operational effectiveness and profitability by developing innovative products and services that promote consumer engagement at a competitive cost. Executing on these operational improvement initiatives is critical to attaining a leadership position in the health care marketplace.
In July 2006, the Company acquired Star HRG, a leading provider of low cost health plans and other employee benefits coverage for hourly and part-time workers and their families. This acquisition complements the Company’s existing product portfolio by giving the Company the capability to offer voluntary health insurance coverage. Also in 2006, the Company acquired vielife, a U.K. based leading provider of integrated online health management and coaching programs and entered into a long-term agreement with the University of Michigan to access certain intellectual property related to identification of health risks and employer worksite health and wellness programs.
Underwriting and pricing products effectively. One of the Company’s key priorities is to achieve strong profitability in a competitive health care market. The Company is focused on effectively managing pricing and underwriting decisions at both the case and overall business level, particularly for the
providing a diverse product portfolio that meets current market needs as well as emerging consumer-directed trends;
maintaining a strong clinical quality in medical, specialty health care and disability management.
The Company formed strategic alliances with New York-based MVP Health Care/Preferred Care in September 2006 and with Minnesota-based HealthPartners in April 2006. The Company believes that its medical management model, focus on clinical quality and ability to integrate health and related benefit solutions position the Company to continue to improve membership results.
The Company is focused on the development and enhancement of a service model that is capable of meeting the challenges brought on by the increasing product and service complexity and the heightened expectations of health care consumers. The Company continues to invest in the development and implementation of systems and technology to improve the member and provider service experience, enhance its capabilities and improve its competitive position.
The Company’s health advocacy capabilities support its recent membership growth. The Company must be able to deliver those capabilities efficiently and cost-effectively. The Company must continue to identify additional cost savings to further improve its competitive cost position. Savings generated from the Company’s operating efficiency initiatives provide capital to make investments that will enhance its capabilities in the areas of consumerism, particularly product development, the delivery of member service and health advocacy and related technology. See Note 6 to the Consolidated Financial Statements for further information on initiatives to reduce operating expenses.
Excluding the impact of reserve studies and the special item noted in the table above, segment earnings increased in 2007, compared with 2006, driven by continued strong disability results, higher net investment income due to higher average assets and yields, and more favorable accident and group universal life claims experience. In addition, segment earnings reflect effective operating expense management and strong earned premium growth.
Excluding the impact of the reserve studies, segment earnings decreased in 2006, compared with 2005 driven by lower net investment income due to lower average assets partially offset by higher yields and lower earnings in the workers' compensation case management business.
Other revenues. Other revenues decreased 19% in 2007, compared with 2006, due to the loss of a significant customer in the workers’ compensation case management business in the fourth quarter of 2006.
Other revenues decreased 19% in 2006, compared with 2005, due to cancellations in the workers’ compensation case management business.
Excluding the pre-tax impact of reserve studies, the increase in benefits expense in 2007, compared with 2006, was primarily related to the net growth in earned premiums which was partially offset by more favorable mortality experience in the accident and specialty businesses. The loss ratio in the disability business remained constant while the loss ratio in the accident and specialty businesses improved in 2007.
operating expenses include an $11 million pre-tax charge for severance. Excluding this charge, other operating expense decreased in 2007 compared with 2006 primarily reflecting lower workers' compensation case management expenses due to declining business volumes, partially offset by business
growth in the disability, life and accident businesses. The expense ratio improved reflecting effective operating expense management. Excluding the severance charge, other operating expenses increased in 2006 as compared to 2005 primarily reflecting business growth in the disability, life and accident businesses, partially offset by lower workers’ compensation case management expenses due to declining business volumes. The expense ratio increased slightly due to investments in information systems.
Benefits and expenses increased 16% in 2007 and 21% in 2006, primarily due to business growth, particularly in South Korea. While benefits and expenses increased in 2007, the loss ratio improved in the life, accident and health business. In addition, expense ratios in the life, accident and health and expatriate benefits businesses continue to be strong due to effective expense management.
The Company reinsured a guaranteed minimum death benefit (GMDB) under certain variable annuities issued by other insurance companies. These GMDB variable annuities are essentially investments in mutual funds combined with a death benefit. The Company has equity and other market exposures as a result of this product.
The determination of liabilities for GMDB requires the Company to make critical accounting estimates. The Company describes the assumptions used to develop the reserves for these death benefits, and provides the effects of hypothetical changes in those assumptions on page 43. See Note 7 to the Consolidated Financial Statements for additional information about these assumptions and the reserve balances.
The Company also reinsured a guaranteed minimum income benefit (GMIB) under certain variable annuities issued by other insurance companies. All reinsured GMIB policies also have a GMDB benefit that is reinsured. The Company has equity and other market exposures as a result of this product.
The Company’s Run-off Reinsurance operations reinsured workers’ compensation and personal accident business in the London market and the United States.
The Company purchased retrocessional coverage in these markets to substantially reduce the risk of loss on these contracts. Disputes involving a number of these reinsurance and retrocessional contracts have been substantially resolved and some of the disputed contracts have been commuted. See “Litigation and Other Legal Matters” in Note 20(E) to the Consolidated Financial Statements for more information.
The Company’s reserves for underlying reinsurance exposures assumed by the Company, as well as for amounts recoverable from retrocessionaires, are considered appropriate as of December 31, 2007, based on current information. However, it is possible that future developments could have a material adverse effect on the Company’s consolidated results of operations and, in certain situations, could have a material adverse effect on the Company’s financial condition. The Company bears the risk of loss if its payment obligations to cedents increase or if its retrocessionaires are unable to meet, or successfully challenge, their reinsurance obligations to the Company.
Excluding the special item noted in the table above, segment results in the Run-off Reinsurance segment in 2007 improved as compared to 2006. This was predominantly due to an increase in earnings from several settlements and commutations that were favorable to the Company’s reserve position at the time, as well as higher earnings in the workers’ compensation and personal accident business, resulting from more favorable claim development. These factors were partially offset by losses of $35 million after-tax in the GMIB product due to higher annuitization experience and declines in interest rates.
Benefits and expenses increased significantly in 2007, compared to 2006, primarily due to an increase in liabilities of $86 million pre-tax for the guaranteed minimum income benefits business, related to the assumption changes for
Benefits and expenses decreased 63% in 2006 compared to 2005 due to larger equity market improvements in 2006, leading to lower benefits expense for the guaranteed minimum death benefit business. In addition, in the workers’ compensation and personal accident businesses, reserve increases related to both retrocessional credit risk and claim experience were lower in 2006 than 2005.
The COLI portion of this business has contributed the majority of the earnings in 2007 and 2006 for Other Operations. Federal legislation enacted in 1996 affected certain policies sold by the COLI business by eliminating on a prospective basis the tax deduction for policy loan interest for most leveraged COLI products. There have been no sales of this particular product since 1997. As a result of an Internal Revenue Service initiative to settle tax disputes regarding leveraged products, some customers have surrendered their policies and management expects earnings associated with these products to continue to decline. Management does not expect this to have a significant impact on the future operating results of the segment.
From April 1, 2004 through March 31, 2006, the Company had a modified coinsurance arrangement relating to the single premium annuity business sold to the buyer. Under the arrangement, the Company retained the invested assets supporting the reinsured liabilities. These invested assets were held in a business trust established by the Company. Effective April 1, 2006, the buyer converted this modified coinsurance arrangement to an indemnity reinsurance structure and took ownership of the trust assets.
Excluding the special items noted in the table above, segment earnings for Other Operations decreased in 2006 primarily due to:
lower earnings in the corporate-owned life insurance business resulting from unfavorable expense items which was partially offset by favorable mortality experience;
lower deferred gain amortization in the individual life insurance and annuity business; and
Corporate reflects amounts not allocated to segments, such as interest expense on corporate debt and on uncertain tax positions, net investment income on unallocated investments, intersegment eliminations, compensation cost for stock options and certain corporate overhead expenses, such as directors’ fees.
Excluding the special items noted in the table above, Corporate results in 2007, compared with 2006, reflect higher net interest expense resulting from the issuance of additional debt combined with lower average assets due to share repurchase activity. In addition, the increase in segment loss also reflects the absence in 2007 of certain favorable expense items recorded in 2006.
Excluding the special items noted in the table above, the increase in segment loss in 2006 compared with 2005, primarily reflects the impact of less favorable tax adjustments.
The industry is under continuing review by government agencies and regulators with respect to payment practices. On February 13, 2008, State of New York Attorney General Andrew M. Cuomo announced an industry-wide investigation into the use of data provided by Ingenix - a system used to calculate payments for services provided by out-of-network providers. The Company has received a subpoena from the New York Attorney General’s office in connection with this investigation and intends to fully cooperate and respond appropriately. The Company is also a defendant in a putative class action brought on behalf of members asserting that due to the use of Ingenix data, the Company improperly underpaid claims. The Company denies the allegations and will vigorously defend itself in the case.
In addition to the above referenced development, there are certain other matters that present significant uncertainty, which could result in a material adverse impact on consolidated results of operations. See Note 20(D) “Regulatory and Industry Developments” and Note 20(E) “Litigation and Other Legal Matters” in the Consolidated Financial Statements for further information.
matching investment maturities to the estimated duration of the related insurance and contractholder liabilities (see page 62 for additional information).
The Company’s insurance and HMO subsidiaries are subject to regulatory restrictions (see “Solvency Regulation” on page 58) that limit the amount of dividends or other distributions
(such as loans or cash advances) these subsidiaries may provide to the parent company without prior approval of regulatory authorities. The Company does not expect these restrictions to limit the use of operating cash flows of the insurance and HMO subsidiaries for the Company’s general corporate purposes.
Cash flows from operations for the years ended December 31 were as follows:
Cash provided by investing activities primarily consisted of net sales of investments of $495 million, partially offset by net purchases of property and equipment of $180 million (including $118 million of Health Care capitalized software) and net cash used in acquisitions of $42 million.
Cash used in financing activities primarily reflected net cash outflows of $948 million consisting of dividends paid and repurchase of common stock totaling $1.2 billion, partially offset by $248 million from issuance of common stock to employees under the Company's stock plans. In addition, there were net withdrawals of contractholder deposit funds of $193 million. Partially offsetting these out flows were net proceeds from long-term debt of $120 million, consisting of $498 million of net proceeds from the issuance of long-term debt partially offset by long-term debt repayment of $378 million.
Cash flows from operating activities decreased by $76 million in 2006 from 2005 and were affected by the following significant items:
net cash outflows in 2006 of $216 million to originate commercial mortgage loans held for sale (see Note 10 to the Consolidated Financial Statements for additional information);
higher net cash outflows in 2006 of $48 million associated with futures contracts related to run-off reinsurance (see Note 7 to the Consolidated Financial Statements for additional information);
Cash used in financing activities primarily consisted of dividends on and repurchases of common stock of $2.8 billion, repayment of long-term debt of $100 million and net withdrawals of contractholder deposit funds of $124
Interest expense on long-term debt and capital leases was as follows:
Under a universal shelf registration statement filed with the SEC in 2006, the Company is permitted to take advantage of its status as a “well-known seasoned issuer” and may issue debt, equity or other securities from time to time, with amount, price and terms to be determined at the time of sale. See Note 12 to the Consolidated Financial Statements for additional information about the Company’s debt issuances.
In addition, the Company has $500 million remaining under an effective shelf registration statement filed with the Securities and Exchange Commission (SEC), which may be issued as debt securities, equity securities or both. Management and the Board of Directors will consider market conditions and internal capital requirements when deciding whether the Company should issue new securities.
In June 2007, the Company amended and restated its five year revolving credit and letter of credit agreement for $1.75 billion, which permits up to $1.25 billion to be used for letters of credit. The credit agreement includes options, which are subject to consent by the administrative agent and the committing bank, to increase the commitment amount up to $2.0 billion and to extend the term of the agreement. The Company entered into the agreement for general corporate purposes, including support for the issuance of commercial paper and to obtain statutory reserve credit for certain reinsurance arrangements. There were no amounts outstanding under the credit facility nor any letters of credit issued as of December 31, 2007.
The availability of resources at the parent/holding company level is partially dependent on dividends from the Company’s subsidiaries, most of which are subject to regulatory restrictions and rating agency capital guidelines. The Company expects, based on current projections for cash activity (including projections for dividends from subsidiaries), to have sufficient liquidity to meet its obligations, including:
debt service requirements and dividend payments to the Company shareholders; and
However, if the Company's projections are not realized, the demand for funds could exceed available cash if:
a substantial increase in funding is required for the Company's program to reduce the equity market risks associated with the guaranteed minimum death benefit contracts; or
In those cases, the Company has the flexibility to satisfy liquidity needs through short-term borrowings, such as revolving credit and line of credit agreements of up to $1.75 billion.
company’s adjusted surplus to its required surplus (“RBC ratio”). The RBC ratio is designed to reflect the risk profile of insurance companies. Within certain ratio ranges, regulators have increasing authority to take action as the RBC ratio decreases. There are four levels of regulatory action, ranging from requiring insurers to submit a comprehensive plan to the state insurance commissioner to requiring the state insurance commissioner to place the insurer under regulatory control. At December 31, 2007, the RBC ratio of each of the Company’s primary insurance subsidiaries was above the level that would require regulatory action. The RBC framework described above for insurers has been extended by the NAIC to health organizations, including HMOs. Although not all states have adopted these rules at December 31, 2007, at that date, each of the Company’s active HMOs had a surplus that exceeded either the applicable state net worth requirements or, where adopted, the levels that would require regulatory action under the NAIC’s RBC rules. External rating agencies use their own RBC standards to evaluate capital adequacy as part of determining a company’s rating.
subsequent payments have been excluded from the table as their amount and timing is uncertain given a review of tax years only recently begun.
Operating leases and certain Outsourced service arrangements. For additional information, see Note 18 to the Consolidated Financial Statements.
The Company, through its subsidiaries, is contingently liable for various financial guarantees provided in the ordinary course of business. See Note 20 to the Consolidated Financial Statements for additional information on guarantees.
The Company’s commercial mortgage loans are made exclusively to commercial borrowers; therefore there is no exposure to either prime or sub-prime residential mortgages. These fixed rate loans are diversified by property type, location and borrower to reduce exposure to potential losses. Loans are secured by the related property and are generally made at less than 75% of the property’s value. The Company routinely monitors and evaluates the status of its commercial mortgage loans by reviewing loan and property-related information, including cash flows, expiring leases, financial health of the borrower and major tenants, loan payment history, occupancy and room rates for hotels and market conditions. The Company evaluates this information in light of current economic conditions as well as geographic and property type considerations.
“Problem” bonds and commercial mortgage loans are either delinquent by 60 days or more or have been restructured as to terms (interest rate or maturity date). “Potential problem” bonds and commercial mortgage loans are fully current, but management believes they have certain characteristics that increase the likelihood that they may become “problems.” These characteristics include, but are not limited to, the following:
Sustained weaknesses in certain sectors of the economy and the possibility of rising interest rates for an extended period may cause additional investment losses. These investment losses could materially affect future results of operations, although the Company does not currently expect them to have a material effect on its liquidity or financial condition.
The Company’s assets and liabilities include financial instruments subject to the risk of potential losses from adverse
See Notes 7 and 20(B) to the Consolidated Financial Statements for further discussion of guaranteed minimum death benefits and guaranteed minimum income benefit contracts, respectively.
hypothetical changes in market rates for interest and foreign currencies primarily for fixed maturities and commercial mortgage loans; and
hypothetical changes in market prices for equity exposures primarily for equity securities and contracts that guarantee minimum income benefits.
In addition, hypothetical effects of changes in equity indices and foreign exchange rates are presented separately for futures contracts used in a program for guaranteed minimum death benefits.
changes in the fair values of other significant assets and liabilities such as goodwill, deferred acquisition costs, taxes, and various accrued liabilities have been excluded; because they are not financial instruments, their primary risks are other than market risk.
risks and exposures associated with guaranteed minimum death benefit (see Note 7 to the Consolidated Financial Statements) and income benefit contracts (see Note 20(B) to the Consolidated Financial Statements); and
CAUTIONARY STATEMENT FOR PURPOSES OF THE “SAFE HARBOR” PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF
increased medical costs that are higher than anticipated in establishing premium rates in the Company’s health care operations, including increased use and costs of medical services;
challenges and risks associated with implementing operational improvement initiatives and strategic actions in the health care operations, including those related to: (i) offering products that meet emerging market needs, (ii) strengthening underwriting and pricing effectiveness, (iii) strengthening medical cost and medical membership results, (iv) delivering quality member and provider service using effective technology solutions, and (v) lowering administrative costs;
heightened competition, particularly price competition, which could reduce product margins and constrain growth in the Company’s businesses, primarily the health care business;
significant stock market declines, which could, among other things, result in increased pension expenses of the Company’s pension plan in future periods and the recognition of additional pension obligations;
risks associated with security or interruption of information systems, which could, among other things, cause operational disruption; and
challenges and risks associated with the successful management of the Company’s outsourcing projects or key vendors, including the agreement with IBM for provision of technology infrastructure and related services.
This list of important factors is not intended to be exhaustive. Other sections of this Form 10-K, including the “Risk Factors” section, and other documents filed with the Securities and Exchange Commission include both expanded discussion of these factors and additional risk factors and uncertainties that could preclude the Company from realizing the forward-looking statements. The Company does not assume any obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law.
pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets and liabilities of the company;
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorization of management and directors of the company; and
Management assessed the effectiveness of the Company’s internal controls over financial reporting as of December 31, 2007. In making this assessment, Management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Based on Management’s assessment and the criteria set forth by COSO, it was determined that the Company’s internal controls over financial reporting are effective as of December 31, 2007.
Common stock (par value per share, $0.25; shares issued, 351; 160)
All weighted average shares, per share amounts and references to stock compensation for all periods presented have been adjusted to reflect the three-for-one stock split effective June 4, 2007 (see Note 4). Par value and treasury stock were not affected by the stock split and, as a result, the Company reclassified $48 million from additional paid-in capital to common stock to reflect the issuance of approximately 191 million additional shares at par value.
Beginning in 2007, the Company reports the results of the run-off retirement business in Other Operations. Prior periods have been restated to conform to this presentation.
Certain insignificant reclassifications have been made to prior years' amounts to conform to the 2007 presentation.
realized gains on the disposition of certain directly-owned real estate investments in 2007 and 2006 as discussed in Note 11; and
tax benefits recognized in connection with past divestitures as discussed in Note 16.
Variable interest entities. During 2007, certain real estate joint ventures and the remaining entity that issues investment products liquidated their primary assets and liabilities. As a result, as of December 31, 2007, the Company consolidated $5 million in assets and $5 million in liabilities as the primary beneficiary of one real estate joint venture and no longer consolidates any assets or liabilities related to collateralized loan obligations (CLOs). As of December 31, 2006, the Company consolidated $57 million in assets and $47 million in liabilities related to real estate joint ventures, and $55 million in assets and $26 million in liabilities related to CLOs.
Deferred acquisition costs. Effective January 1, 2007, the Company implemented the American Institute of Certified Public Accountants’ (AICPA) Statement of Position (SOP) 05-1, "Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts." The SOP requires that deferred acquisition costs be expensed in full when the original contract is substantially changed by election or amendment of an existing contract feature or by replacement with a new contract. There were no material effects to the consolidated financial statements at implementation. Although substantial contract changes are not expected to occur, the effect of this SOP in future periods may vary based on the nature and volume of any such contract changes.
Liabilities for pension benefits and other postretirement benefits are recorded in accounts payable, accrued expenses and other liabilities on the Company’s balance sheet.
Business combinations. In 2007, the FASB issued SFAS No. 141 (revised 2007, referred to as SFAS No. 141R,) “Business Combinations,” to require fair value measurements for all future acquisitions, including contingent purchase price and contingent assets or liabilities of the entity to be acquired. This standard also expands the definition of “business combination” to include all transactions or events in which an entity obtains control of a business, requires acquisition related and restructuring costs to be expensed as incurred and requires changes in deferred tax asset valuation allowances and acquired income tax uncertainties after the acquisition date to be reported in income tax expense. SFAS No. 141R is effective for all business combinations beginning in 2009. The effect of these new requirements on the Company’s financial condition and results of operations will depend on the volume and terms of acquisitions in 2009 and beyond, but will likely increase the amount and change the timing of recognizing expenses related to acquisition activities.
Noncontrolling interests in subsidiaries. In 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51," to require that noncontrolling interests in subsidiaries be presented as part of equity of the consolidated group, separate from the parent shareholders' equity. In addition, net income and components of other comprehensive income of the subsidiary must be allocated between the controlling and noncontrolling interests and presented separately based on relative ownership interests or contractual arrangements. These new presentation requirements must be applied through retrospective restatement of prior financial statements beginning in 2009. The Company is presently evaluating the impact of these new requirements, but does not expect material changes to the results of operations or financial condition.
Fair value option. In 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," which permits entities to choose fair value measurement of many financial instruments with subsequent
changes in fair value to be reported in net income for the period. This choice is made for each individual financial instrument, is irrevocable and, after implementation, must be determined when the entity first commits to or recognizes the financial instrument. Implementation is required in the first quarter of 2008 with any changes in the measurement of existing financial instruments to be reported as an adjustment to the opening balance of retained earnings. The Company does not currently expect to elect the fair value option for any financial assets and liabilities at implementation. For financial assets and liabilities acquired subsequently, the Company will determine whether to use the fair value election at the time of acquisition.
In the normal course of business, the Company enters into transactions involving various types of financial instruments. These financial instruments may include:
Most financial instruments that are subject to fair value disclosure requirements are carried in the consolidated financial statements at amounts that approximate fair value. The following table shows the fair values and carrying values of the Company’s financial instruments not carried at fair value that are subject to fair value disclosure requirements, at the end of 2007 and 2006:
Fair values of financial instruments are based on quoted market prices when available. When market prices are not available, management generally estimates fair value based on discounted cash flow analyses, which use current interest rates for similar financial instruments with comparable terms and credit quality. Management estimates the fair value of the liabilities for contractholder deposit funds using the amount payable on demand. In certain cases, the estimated fair value of a financial instrument may differ significantly from the amount that could be realized if the instrument were sold immediately.
Fixed maturities and equity securities. Fixed maturities include bonds, mortgage- and other asset-backed securities and preferred stocks redeemable by the investor. Equity securities include common stocks and preferred stocks that are non-redeemable or redeemable only by the issuer. These investments are primarily classified as available for sale and are carried at fair value with changes in fair value recorded in accumulated other comprehensive income (loss) within shareholders’ equity. Fixed maturities and equity securities are considered impaired, and their cost basis is written down to fair value through earnings, when management expects a decline in value to persist (i.e. the decline is “other than temporary”). Fixed maturities and equity securities include certain trading and hybrid securities carried at fair value with changes in fair value reported in other revenues for trading securities and in realized investment gains and losses for hybrid securities, beginning after the implementation of SFAS No. 155 on January 1, 2007.
Other long-term investments. Other long-term investments include investments in unconsolidated entities. These entities include certain limited partnerships and limited liability companies holding real estate, securities or loans. These investments are carried at cost plus the Company’s ownership percentage of reported income or loss in cases where the Company has significant influence, otherwise the investment is carried at cost. Also included in other long-term investments are loans to unconsolidated real estate entities secured by the equity interests of these real estate entities, which are carried at unpaid principal balances (mezzanine loans).
Net investment income. When interest and principal payments on investments are current, the Company recognizes interest income when it is earned. The Company stops recognizing interest income when interest payments are delinquent or when certain terms (interest rate or maturity date) of the investment have been restructured. Net investment income on these investments is only recognized when interest payments are actually received.
Cash equivalents consist of short-term investments that will mature in three months or less from the time of purchase. The Company reclassifies immaterial cash overdraft positions to “accounts payable, accrued expenses and other liabilities” when the legal right of offset does not exist.
Property and equipment is carried at cost less accumulated depreciation. When applicable, cost includes interest, real estate taxes and other costs incurred during construction. Also included in this category is internal-use software that is acquired, developed or modified solely to meet the Company’s internal needs, with no plan to market externally. Costs directly related to acquiring, developing or modifying internal-use software are capitalized. Unamortized internal-use software costs were $304 million at December 31, 2007, and $270 million at December 31, 2006. Amortization expense for internal use software was $111 million in 2007, $97 million in 2006 and $85 million in 2005. Most of the unamortized internal-use software costs relate to the Company’s health care business initiatives to enhance systems and processes designed to support business growth and service to customers.
The Company incurred total costs of approximately $1.1 billion for a multi-year project that began in 1999 and was substantially completed in 2005, of which $453 million has been capitalized and $660 million has been expensed as incurred. Amortization, which commenced in phases as members migrated to the new systems, is over a 7.5 year period. Accumulated amortization for this project was $327 million at December 31, 2007 and $239 million at December 31, 2006.
For other capitalized costs, the Company calculates depreciation and amortization principally using the straight-line method based on the estimated useful life of each asset.
Goodwill represents the excess of the cost of businesses acquired over the fair value of their net assets. The Company evaluates goodwill for impairment annually based on discounted cash flow analyses and writes it down through earnings if impaired. Substantially all goodwill relates to the Health Care segment.
Because benefit payments may be made over an extended time period, the Company discounts certain claim liabilities related to group long-term disability and workers’ compensation. Discount rate assumptions are based on projected investment returns for the asset portfolios that support these liabilities and range from 3.5% to 6.5%. When estimates change, the Company records the adjustment in benefits and expenses in the period in which the change in estimate is identified. At December 31, discounted liabilities associated with the long-term disability and certain workers’ compensation businesses were $3.1 billion in 2007 and 2006.
The Company's estimate of the liability for medical claims incurred but not yet reported is primarily calculated using historical claim payment patterns and expected medical cost trends. The Company analyzes the historical claim payment patterns by comparing the dates claims were incurred, generally the dates services were provided, to the dates claims were paid to determine “completion factors”, which are a measure of the time to process claims. A completion factor is calculated for each month of incurred claims. The Company uses historical completion factors combined with an analysis of current trends and operational factors to develop current estimates of completion factors. The Company estimates the ultimate liability for claims incurred in each month by applying the current estimates of completion factors to the current paid claim data. The difference between this estimate of the ultimate liability and the current paid claim data is the estimate of the remaining claims to be paid for each incurral month. These monthly estimates are aggregated and included in the Company's Health Care medical claims payable at the end of each reporting period. Completion factors are used to estimate the health care medical claims payable for all months where claims have not been completely resolved and paid, except for the most recent month as described below.
The Company generally conducts its international business through foreign operating entities that maintain assets and liabilities in local currencies, which are generally their functional currencies. The Company uses exchange rates as of the balance sheet date to translate assets and liabilities into U.S. dollars. Translation gains or losses on functional currencies, net of applicable taxes, are recorded in accumulated other comprehensive income (loss). The Company uses average exchange rates during the year to translate revenues and expenses into U.S. dollars.
The Company records compensation expense for stock awards and options over their vesting periods based on the estimated fair value of the stock options, which is calculated using an option-pricing model. Compensation expense is recorded for restricted stock grants and deferred stock units over their vesting periods based on fair value, which is equal to the market price of the Company’s common stock on the date of grant.
The Company’s participating life insurance policies entitle policyholders to earn dividends that represent a portion of the earnings of the Company’s life insurance subsidiaries. Participating insurance accounted for approximately 2% of the Company’s total life insurance in force at the end of 2007, 2006 and 2005.
The Company and its domestic subsidiaries file a consolidated United States federal income tax return. The Company’s foreign subsidiaries file tax returns in accordance with applicable foreign law. U.S. taxation of foreign affiliates may differ in timing and amount from taxation under foreign laws. Reportable amounts, including credits for foreign tax paid by those affiliates, are reflected in the U.S. tax return of the affiliates’ domestic parent.
The Company generally recognizes deferred income taxes when assets and liabilities have different values for consolidated financial statement and tax reporting purposes. Note 16 contains detailed information about the Company’s income taxes.
Intangible assets (primarily purchased customer relationships, software and trademarks) associated with the acquisition are being amortized on a straight-line basis over periods from 3 to 10 years.
The results of Star HRG are included in the accompanying consolidated financial statements from the date of the acquisition.
On August 10, 2007, the Company completed the sale of its Chilean insurance operations, which was classified as a discontinued operation in 2007. The Company recognized an impairment loss in 2007 for this business of $19 million after-tax primarily relating to the write-off of unrecoverable tax assets and foreign currency translation losses. The assets and liabilities of the Chilean insurance operations, which were held for sale, were reported in other assets and accounts payable, accrued expenses and other liabilities. Amounts as of December 31, 2006 have been reclassified to conform to this presentation.
During 2006, the Company entered into negotiations to sell its Brazilian life insurance business and classified this business as a discontinued operation. The Company recognized an impairment loss in 2006 with respect to this business of $17 million after-tax, primarily related to the write-off of unrecoverable foreign tax credits and foreign currency translation losses. The sale, which is subject to regulatory approvals, is expected to close in 2008.
In 2004, the Company sold its retirement benefits business, excluding the corporate life insurance business, for cash proceeds of $2.1 billion. The sale resulted in an initial after-tax gain of $809 million, of which $267 million after-tax was recognized immediately and the remaining amount was deferred. The Company recognized deferred gain amortization in other revenues in the Run-off Retirement segment as follows:
The following outstanding employee stock options as of December 31, were not included in the computation of diluted earnings per share because their effect would have increased diluted earnings per share (antidilutive) as their exercise price was greater than the average share price of the Company's common shares for the period.
Activity in medical claims payable was as follows for the years ended December 31:
For the year ended December 31, 2006, actual experience differed from the Company's key assumptions, resulting in favorable incurred claims related to prior years’ medical claims payable of $173 million, or 2.6% of the current year incurred claims as reported for the year ended December 31, 2005. The favorable impact in 2006 is due to better than expected completion factors and faster time to process claims as well as lower than expected medical cost trends, all of which included an assumption for moderately adverse experience.
The Company has undertaken several initiatives to realign its organization and consolidate support functions in an effort to increase efficiency and responsiveness to customers.
In the fourth quarter of 2006, the Company completed a review of staffing levels in the health care operations and in supporting areas. As a result, the Company recognized in other operating expenses a charge for severance costs of $37 million pre-tax ($23 million after-tax). The Company substantially completed this program in 2007.
In 2005, the Company implemented a plan to further streamline operations in the health care business and in supporting areas. As a result, the Company recognized in other operating expenses a total charge for severance costs of $51 million pre-tax ($33 million after-tax). The Company substantially completed this program in 2006.
The Company’s reinsurance operations, which were discontinued in 2000 and are now an inactive business in run-off mode, reinsured a guaranteed minimum death benefit under certain variable annuities issued by other insurance companies. These variable annuities are essentially investments in mutual funds combined with a death benefit. The Company has equity and other market exposures as a result of this product.
The majority of the Company's exposure arises under annuities that guarantee that the benefit received at death will be no less than the highest historical account value of the related mutual fund investments on a contractholder’s anniversary date. Under this type of death benefit, the Company is liable to the extent the highest historical anniversary account value exceeds the fair value of the related mutual fund investments at the time of a contractholder’s death. Other annuity designs that the Company reinsured guarantee that the benefit received at death will be:
the contractholder’s account value as of the last anniversary date (anniversary reset); or
Benefits paid and incurred are net of ceded amounts. Incurred benefits reflect the favorable or unfavorable impact of a rising or falling equity market on the liability. As discussed below, losses or gains have been recorded in other revenues as a result of the program to reduce equity market exposures.
The following provides information about the Company’s reserving methodology and assumptions for guaranteed minimum death benefits as of December 31, 2007:
The reserves include an estimate for partial surrenders that essentially lock in the death benefit for a particular policy based on annual election rates that vary from 0-33% depending on the net amount at risk for each policy and whether surrender charges apply.
The gross mean investment performance assumption is 5% considering the Company's program to reduce equity market exposures using futures contracts (described below). This is reduced by fund fees ranging from 1-3% across all funds.
The mortality assumption is 70-75% of the 1994 Group Annuity Mortality table, with 1% annual improvement beginning January 1, 2000.
The lapse rate assumption is 0-15%, depending on contract type, policy duration and the ratio of the net amount at risk to account value.
The table below presents the account value, net amount at risk and average attained age of underlying contractholders for guarantees in the event of death, by type of benefit as of December 31. The net amount at risk is the death benefit coverage in force or the amount that the Company would have to pay if all contractholders had died as of the specified date, and represents the excess of the guaranteed benefit amount over the fair value of the underlying mutual fund investments.
The Company expects to adjust the contract positions and may enter into other contract positions over time, to reflect changing equity market levels and changes in the investment mix of the underlying variable annuity investments.
The Company had a reinsurance recoverable of $2.1 billion at December 31, 2007 and $2.5 billion at December 31, 2006 from Prudential Retirement Insurance and Annuity Company resulting from the sale of the retirement benefits business, which was primarily in the form of a reinsurance arrangement. The reinsurance recoverable is secured primarily by fixed maturities and commercial mortgage loans held in a business trust established by the reinsurer. This recoverable is reduced as the Company's reinsured liabilities are paid or directly assumed by the reinsurer.
The Company had a reinsurance recoverable of $4.7 billion at December 31, 2007, and $4.8 billion at December 31, 2006, from The Lincoln National Life Insurance Company resulting from the 1998 sale of the Company’s individual life insurance and annuity business through an indemnity reinsurance arrangement. The reinsurance recoverable is secured primarily by fixed maturities held in a business trust established by the reinsurer in 2007.
The Company's Run-off Reinsurance operations reinsured workers’ compensation and personal accident business in the London markets and the United States.
Pension benefits. The Company’s pension plans were underfunded by $628 million in 2007 and $843 million in 2006 and had related accumulated benefit obligations of $4.0 billion as of December 31, 2007 and $4.1 billion as of December 31, 2006.
The Company funds its qualified pension plans at least at the minimum amount required by the Employee Retirement Income Security Act of 1974 (ERISA).
The Company did not make domestic pension plan contributions in 2007 or 2006 to its primary qualified domestic pension plan and does not expect to make, nor is the Company required to make, domestic pension plan contributions in 2008.
The Company contributed $544 million in 2005 for minimum funding requirements for the domestic pension plan and for voluntary contributions to the domestic and international pension plans.
The Company expects to recognize in 2008 $57 million of pre-tax loss from amortization of past experience and $9 million of pre-tax gain from amortization of prior service cost.
Other postretirement benefits. Unfunded retiree health benefit plans had accumulated benefit obligations of $283 million at December 31, 2007, and $315 million at December 31, 2006. Retiree life insurance plans had accumulated benefit obligations of $143 million as of December 31, 2007 and $150 million as of December 31, 2006.
Plan assets. The following summarizes the fair value of assets related to pension plans as of December 31:
The Company may elect to increase its matching contributions if the Company’s annual performance meets certain targets. A substantial amount of the Company’s matching contributions are invested in the Company common stock. The Company’s expense for these plans was $35 million for 2007, $42 million for 2006 and $36 million for 2005.
Securities in the following table are included in fixed maturities and equities on the Company’s balance sheet. These securities are carried at fair value with changes in fair value reported in other revenues for trading securities and in realized investment gains (losses) for hybrid securities, beginning after the implementation of SFAS No. 155 on January 1, 2007.
Other mortgage-backed assets consist principally of commercial mortgage-backed securities of which $7 million were residential mortgages and home equity lines of credit, all of which were originated utilizing standard underwriting practices and are not considered sub-prime loans.
As of December 31, 2007, the Company had commitments to purchase $15 million of fixed maturities bearing interest at a fixed market rate. The Company expects to disburse all the committed amounts in 2008.
Mortgage loans held by the Company are made exclusively to commercial borrowers; therefore there is no exposure to either prime or sub-prime residential mortgages. The Company’s commercial mortgage loans and real estate investments are diversified by property type, location and, for commercial mortgage loans, borrower. Generally, commercial mortgage loans are carried at unpaid principal balances and are issued at a fixed rate of interest.
In connection with the Company’s investment strategy to enhance investment yields by selling senior participations, commercial mortgage loans include loans that were originated with the intent to sell of $77 million as of December 31, 2007 and $124 million as of December 31, 2006.
As of December 31, 2007, the Company had commitments to extend credit under commercial mortgage loan agreements of $83 million, all of which were at a fixed rate of interest. These loan commitments are diversified by property type and geographic region. As of December 31, 2007, the Company had commitments to contribute additional equity of $10 million to real estate investments. The Company expects to disburse most of the committed amounts in 2009.
As of December 31, 2007, the Company had commitments to contribute:
$219 million to limited liability entities that hold either real estate or loans to real estate entities that are diversified by property type and geographic region; and
As of December 31, 2007 and 2006, the Company did not have a concentration of investments in a single issuer or borrower exceeding 10% of shareholders’ equity.
The Company uses hedge accounting when derivatives are designated, qualify and are highly effective as hedges. Effectiveness is formally assessed and documented at inception and each period throughout the life of a hedge using various quantitative methods appropriate for each hedge, including regression analysis and dollar offset. Under hedge accounting, the changes in fair value of the derivative and the hedged risk are generally recognized together and offset each other when reported in net income.
Derivatives are reported on the balance sheet at fair value with changes in fair values reported in net income or accumulated other comprehensive income.
Using cash flow hedge accounting, fair value changes are reported in accumulated other comprehensive income and amortized into net investment income over the life of the investments purchased. Cash flows are included in operating activities.
To hedge the interest or foreign currency cash flows of fixed maturities and commercial mortgage loans to match associated liabilities. Currency swaps are primarily Canadian dollars, euros, Australian dollars and Japanese yen for periods of up to 14 years.
Using cash flow hedge accounting, fair values are reported in other long-term investments or other liabilities and accumulated other comprehensive income. Net interest cash flows are reported in net investment income and included in operating activities.
Fair values of the swaps are reported in other long-term investments or other liabilities, with changes reported in realized investment gains and losses. Quarterly fees and gains and losses on purchases and sales are also reported in realized investment gains and losses. These cash flows are reported in investing activities.
Net investment income for separate accounts (which is not reflected in the Company’s revenues) was $225 million for 2007, $151 million for 2006, and $154 million for 2005.
The following realized gains and losses on investments for the years ended December 31 exclude amounts required to adjust future policy benefits for certain annuities.
In 2007 and 2006, realized investment results from continuing operations primarily reflect:
losses from real estate due to sales activity and asset write downs.
In 2007 and 2006, realized investment results from discontinued operations reflect gains on sales of directly owned real estate properties held for the production of investment income. Proceeds on these sales have been separately identified in the Company's Consolidated Statements of Cash Flows.
Realized investment gains and losses also included impairments in the value of investments of $40 million in 2007, $44 million in 2006, and $24 million in 2005.
Separate account realized gains in 2005 reflect the impact of transferring separate account assets to the buyer of the Company's retirement benefit business. See Note 3 for additional information.
Maturities of debt and capital leases are as follows (in millions): $3 in 2008, $3 in 2009, $3 in 2010, $452 in 2011, $3 million in 2012 and the remainder in years after 2012. Interest expense on long-term debt and capital leases was $122 million in 2007, $104 million in 2006, and $105 million in 2005.
Accumulated other comprehensive loss excludes amounts required to adjust future policy benefits for certain annuities.
See Note 9 for additional information about the changes in the net postretirement benefits liability adjustment in 2007.
As discussed in Note 2(B), the Company implemented FIN 48 as of January 1, 2007. As a result, total unrecognized tax benefits at January 1, 2007 were $245 million, including $108 million that would impact net income if recognized. At December 31, 2007, total unrecognized tax benefits increased to $260 million, including $124 million that would impact net income if recognized.
The Company classifies net interest expense on uncertain tax positions and any applicable penalties as a component of income tax expense in Corporate, but excludes these amounts from the disclosed FIN 48 liability. At January 1, 2007, the Company had $11 million of accrued interest and accrued an additional $6 million through 2007, which was net of an $8 million benefit associated with the completion of an IRS examination.
Management believes that consolidated taxable income expected to be generated in the future will be sufficient to realize the Company’s net deferred tax assets of $794 million as of December 31, 2007 and $926 million as of December 31, 2006. This determination is based on the Company’s earnings history and future expectations.
$2 million is associated with the disposition of Lovelace Health Systems, Inc. in 2003, and is reflected in discontinued operations.
During 2005, the Congressional Joint Committee on Taxation approved the Company's refund claim relating to a tax loss incurred from the sale of a business in 1999 and the completion of the IRS audit for 2000-2002. Pursuant to this approval, the Company recorded total tax related benefits of $437 million consisting of:
$287 million resulting from capital losses realized in connection with the divestiture of the property and casualty insurance operations in 1999, which is included in income from discontinued operations; and
$62 million related to the divestiture of the Company's Brazilian health care business, which is included in income from discontinued operations.
All weighted average shares, per share amounts and references to stock compensation data for all periods presented have been adjusted to reflect the three-for-one stock split. See Note 4 for more information.
The weighted average fair value of options granted under employee incentive plans was $16.05 for 2007, $14.57 for 2006 and $11.39 for 2005, using the Black-Scholes option-pricing model and the following assumptions:
The expected volatility reflects the Company’s past daily stock price volatility. The Company does not consider volatility implied in the market prices of traded options to be a good indicator of future volatility because remaining maturities of traded options are less than one year. In 2007, the expected option life reflects the Company’s historical experience excluding activity related to options granted under a replacement option feature. Prior to 2007, the Company developed the expected option life by considering certain factors, including assumptions used by other companies with comparable stock option plan features and the Company’s cancellation of a replacement option feature in June 2004.
The grant date fair value of restricted stock vested was: $14 million in 2007, $21 million in 2006 and $13 million in 2005.
Deferred Stock. In 2003, the Company made deferred stock unit grants with 100% vesting in three to six years, dependent on the Company's consolidated earnings per share during this vesting period. Upon meeting the stated performance objectives in 2005, the Board of Directors determined that the vesting period for the deferred stock units would be three years. On vesting in 2006, stock issuance was deferred until January of the year following an employee’s termination from the Company.
Rental expenses for operating leases, principally for office space, amounted to $114 million in 2007, $104 million in 2006 and $121 million in 2005. As of December 31, 2007, future net minimum rental payments under non-cancelable operating leases were approximately $430 million, payable as follows (in millions): $92 in 2008, $81 in 2009, $67 in 2010, $56 in 2011, $42 in 2012 and $92 thereafter.
The Company's operating segments generally reflect groups of related products, except for the International segment which is generally based on geography. In accordance with accounting principles generally accepted in the United States of America, operating segments that do not require separate disclosure may be combined. The Company measures the financial results of its segments using “segment earnings (loss),” which is defined as income (loss) from continuing operations excluding after-tax realized investment gains and losses.
Company's foreign operations was approximately 11% in 2007, and 8% in 2006 and 5% in 2005.
The Company determines segment earnings (loss) consistent with the accounting policies for the consolidated financial statements, except that amounts included in Corporate are not allocated to segments. The Company allocates certain other operating expenses, such as systems and other key corporate overhead expenses, on systematic bases. Income taxes are generally computed as if each segment were filing a separate income tax return. The Company does not report total assets by segment since this is not a metric used to evaluate segment performance or allocation of resources.
Health Care includes medical, dental, behavioral health, prescription drug and other products and services that may be integrated to support consumer-focused health care programs. This segment also includes group disability and life insurance products that were historically sold in connection with certain experience-rated medical products that continue to be managed within the health care business.
Run-off Reinsurance includes accident, workers’ compensation, international life and health, guaranteed minimum death benefit and guaranteed minimum income benefit reinsurance businesses. The Company stopped underwriting new reinsurance business in 2000.
1 Premiums and/or fees associated with certain specialty products are also included.
Separate account assets are contractholder funds maintained in accounts with specific investment objectives. The Company records separate account liabilities equal to separate account assets. In certain cases primarily associated with the sold retirement benefits business (which was sold in April 2004), the Company guarantees a minimum level of benefits for retirement and insurance contracts written in separate accounts. The Company establishes an additional liability if management believes that the Company will be required to make a payment under these guarantees.
In periods of declining equity markets and declining interest rates, the Company’s liabilities for guaranteed minimum income benefits increase. Conversely, in periods of rising equity markets and rising interest rates, the Company’s liabilities for these benefits decrease.
Annuitants have only recently been able to elect to receive these minimum income benefits due to the expiration of a contractual waiting period. The Company has been monitoring annuity election rate experience and, during 2007, increased its assumption related to annuity election rates resulting in a charge (net of reinsurance) of $75 million pre-tax. Also during 2007, the Company completed a review of lapse experience for these contracts. As a result of the review, the Company decreased its lapse assumption resulting in a charge (net of reinsurance) of $11 million pre-tax; because fewer annuitants are expected to lapse coverage, the Company's expected claims increase. In combination, the Company recognized in 2007 a total charge of $56 million after-tax ($86 million pre-tax) for these changes in long-term assumptions.
These liabilities represent estimates of the present value of net amounts expected to be paid, less the present value of net future premiums expected to be received. Included in net amounts expected to be paid is the excess of the expected value of the income benefits over the values of the annuitant’s accounts at the time of annuitization. The assets associated with these contracts represent receivables in connection with reinsurance that the Company has purchased two external reinsurers (see below).
The volatility assumption is 14-23% varying by equity fund type; 5-7% varying by bond fund type; and 2-3% for money market funds.
The projected interest rate used to calculate the reinsured income benefits at the time of annuitization varies by economic scenario, reflects interest rates as of the valuation date, and has a long-term mean rate of 5-6% and a standard deviation of 12-13%.
As of December 31, 2007, the Company had net liabilities of $313 million related to these contracts and net amounts recoverable from two external reinsurers of $197 million. The Company had an additional liability of $24 million associated with the future cost of reinsurance as of December 31, 2007. As of December 31, 2006, the Company had liabilities of $88 million related to these contracts and net amounts recoverable from two external reinsurers of $46 million. The Company
The maximum potential undiscounted payments that the Company would make under those assumptions would aggregate $881 million before reinsurance recoveries. The Company expects the amount of actual payments to be significantly less than this hypothetical undiscounted aggregate amount. The Company has retrocessional coverage in place from two external reinsurers which covers 55% of the exposures on these contracts. The Company bears the risk of loss if its retrocessionaires do not meet their reinsurance obligations to the Company.
The Company had indemnification obligations to lenders of up to $207 million as of December 31, 2007 related to borrowings by certain real estate joint ventures which the Company either records as an investment or consolidates. These borrowings, which are nonrecourse to the Company, are secured by the joint ventures’ real estate properties with fair values in excess of the loan amounts and mature at various dates from 2008 to 2017. The Company’s indemnification obligations would require payment to lenders for any actual damages resulting from certain acts such as unauthorized ownership transfers, misappropriation of rental payments by others or environmental damages. Based on initial and ongoing reviews of property management and operations, the Company does not expect that payments will be required under these indemnification obligations. Any payments that might be required could be recovered through a refinancing or sale of the assets. In some cases, the Company also has recourse to partners for their proportionate share of amounts paid. There were no liabilities required for these indemnification obligations as of December 31, 2007.
legislation that would grant plan participants broader rights to sue their health plans;
changes in ERISA regulations resulting in increased administrative burdens and costs;
Concentration of risk. South Korea represents the single largest geographic market for the Company’s international businesses. In 2007, South Korea generated 31% of International’s revenues and 41% of its segment earnings. The Company’s International business in South Korea could be vulnerable to adverse consumer credit conditions and geopolitical and economic conditions in that country, which could have a significant impact on the Company’s consolidated results.
Broker compensation. Beginning in 2004, the Company, other insurance companies and certain insurance brokers received subpoenas and inquiries from various regulators, including the New York and Connecticut Attorneys General and the Florida Office of Insurance Regulation relating to their investigations of insurance broker compensation. The Company received a subpoena from the U.S. Attorney’s Office for the Southern District of California in October 2005 and the San Diego District Attorney in March 2006 and has provided information to them about a broker, Universal Life Resources (ULR). On June 6, 2007, the Company received a
On August 1, 2005, two of the Company’s subsidiaries, Connecticut General Life Insurance Company and Life Insurance Company of North America, were named as defendants in a consolidated amended complaint captioned In re Insurance Brokerage Antitrust Litigation, a multi-district litigation proceeding consolidated in the United States District Court for the District of New Jersey. The complaint alleges that brokers and insurers conspired to hide commissions, increasing the cost of employee benefit plans, and seeks treble damages and injunctive relief. Numerous insurance brokers and other insurance companies are named as defendants.
The court permitted plaintiffs to file an amended complaint, which plaintiffs did on May 22, 2007. The defendants filed a motion to dismiss the federal antitrust, RICO and state law claims and a motion to dismiss and for summary judgment regarding the ERISA fiduciary claims. On August 31, 2007, the court granted the defendants’ motion to dismiss the federal antitrust claims. On September 28, 2007, the court granted the defendants’ motion to dismiss plaintiffs’ RICO claims. On January 14, 2008, the court granted summary judgment in favor of defendants as to plaintiffs’ ERISA claims.
Amara cash balance pension plan litigation. On December 18, 2001, Janice Amara filed a purported class action lawsuit, now captioned Janice C. Amara, Gisela R. Broderick, Annette S. Glanz, individually and on behalf of all others similarly situated v. CIGNA Corporation and CIGNA Pension Plan, in the United States District Court for the District of Connecticut against CIGNA Corporation and the CIGNA Pension Plan on behalf of herself and other similarly situated participants in the CIGNA Pension Plan affected by the 1998 conversion to a cash balance formula. The plaintiffs allege various ERISA violations including, among other things, that the Plan’s cash balance formula discriminates against older employees; the conversion resulted in a wear away period (during which the pre-conversion accrued benefit exceeded the post-conversion benefit); and these conditions are not adequately disclosed in the Plan. The plaintiffs were granted class certification on December 20, 2002, and seek equitable relief. A non-jury trial began on September 11-15, 2006. Due to the court’s schedule, the proceedings were adjourned and the trial was completed on January 25, 2007. On February 15, 2008, the court issued a decision finding in favor of CIGNA Corporation and the CIGNA Pension Plan on the age discrimination and wear away claims and finding in favor of the plaintiffs on many aspects of the disclosure claims. The court has ordered the parties to file simultaneous briefs on March 17, 2008 regarding the relief, if any, to be awarded to the plaintiffs on the claims on which the plaintiffs prevailed, and to file responsive briefs on March 31, 2008. The Company will continue to vigorously defend itself in this case.
In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income, comprehensive income and changes in shareholders' equity and cash flows present fairly, in all material respects, the financial position of CIGNA Corporation and its subsidiaries ("the Company") at December 31, 2007 and December 31, 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Annual Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on these financial statements and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
The following unaudited quarterly financial data is presented on a consolidated basis for each of the years ended December 31, 2007 and 2006. Quarterly financial results necessarily rely heavily on estimates. This and certain other factors, such as the seasonal nature of portions of the insurance business, suggest the need to exercise caution in drawing specific conclusions from quarterly consolidated results.
The second quarter of 2007 includes an after-tax charge of $56 million related to the guaranteed minimum income benefit reserve.
The third quarter of 2007 includes an after-tax benefit of $23 million related to an IRS settlement.
The fourth quarter of 2006 includes an after-tax charge of $25 million related to the settlement of the shareholder class action litigation and an after-tax charge of $23 million related to the Company's expense reduction initiatives.