- - -------- (a) Includes investment income and net realized investment gains (losses).
Management's discussion and analysis reviews the consolidated financial condition of UNUM at December 31, 1998, and 1997, the consolidated results of operations for the past three years and, where appropriate, factors that may affect future financial performance.
The Private Securities Litigation Reform Act of 1995 ("the Act") provides a "safe harbor" for forward-looking statements which are identified as such and are accompanied by the identification of important factors which could cause a material difference from the forward-looking statements. UNUM claims the protection afforded by the safe harbor in the Act. Certain information contained in this discussion, or in any other written or oral statements made by UNUM, is or may be considered as forward-looking; for example, disclosures regarding "Quantitative and Qualitative Information About Market Risk," the "Year 2000 Date Conversion" and reserves discussed in the Disability Insurance segment contain such information. Forward-looking statements are those not based on historical information, but rather, relate to future operations, strategies, financial results or other developments, and contain terms such as "may," "expects," "should," "believes," "anticipates," "intends," "estimates," "projects," "goals," "objectives" or similar expressions. Although UNUM has used appropriate care in developing forward-looking statements, such statements are based upon estimates and assumptions that are subject to significant risks, business, economic and competitive uncertainties, and other factors, many of which are beyond UNUM's control or, with respect to future business decisions, are subject to change.
Certain risks and uncertainties are inherent in UNUM's business. Therefore, UNUM cautions the reader that revenues and income could differ materially from those expected to occur depending on factors which may be global or national in scope, related to the insurance industry generally, or applicable to UNUM specifically. Such factors are general economic conditions including changes in interest rates and the performance of financial markets, changes in domestic and foreign laws, regulations and taxes, competition, industry consolidation, competitor demutualization, credit risks and other factors. Insurance reserve liabilities can fluctuate as a result of changes in numerous factors, and such fluctuations can have material positive or negative effects on earnings. These factors include, but are not limited to, interest rates, incidence rates and recovery rates. Incidence and recovery rates may be influenced by many factors, including but not limited to, the emergence of new diseases, new trends and developments in medical treatments, general economic and societal conditions of the markets where UNUM has operations, and the effectiveness of risk management programs. UNUM disclaims any obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future developments or otherwise.
On November 22, 1998, UNUM entered into an agreement with Provident Companies Inc. ("Provident"), pursuant to which UNUM and Provident will merge under the name UNUMProvident Corporation ("UNUMProvident"). Under the merger agreement, each outstanding share of Provident common stock will be reclassified and converted into 0.73 of a share of UNUMProvident common stock and each outstanding share of UNUM common stock will be converted into one share of UNUMProvident common stock. The merger will be accounted for as a pooling of interests.
Certain information contained in this discussion about the merger, or in any other written or oral statements made by UNUM, regarding the impact of the merger on future operations, is considered as forward-looking, and should be read as such (see previous section on "Forward-Looking Information"). In connection with the proposed merger, UNUM is evaluating its processes and assumptions used to calculate the discount rate for claim reserves of certain disability businesses so that they may be more consistent with those used by Provident. Upon completion of the merger, UNUM will reduce the rates used to discount unpaid claims reserves for group long term disability, individual disability and the disability businesses of UNUM Limited. The preliminary estimates of discount rate reductions will result in an estimated increase to UNUM's unpaid claims reserves upon consummation of the merger of approximately $230 million on a pretax basis. Additionally, it is expected that upon completion of the merger the combined entity, UNUMProvident, will record an expense for merger related costs of approximately $210 million on a pretax basis. These costs include amounts for severance and related costs, early retirement, exit costs for duplicate facilities and asset impairments, and merger related costs such as investment banker, legal and accountant fees. The estimated merger related expenses represent management's best estimates based on available information at this time. Actual charges may differ from these estimated amounts when these items are finalized.
This management's discussion and analysis focuses on results on a pretax operating income basis, which is defined as income (loss) before income taxes exclusive of realized investment gains (losses) and special items. Realized investment gains (losses) are excluded from this discussion as management believes the volatility in gains and losses associated with the selling of invested assets in the financial markets is not representative of ongoing operations. Special items are excluded from this discussion as management considers them as being not representative of our ongoing operations and believes a discussion of the results on a pretax operating income basis provides a better understanding of the results of ongoing operations. While management believes that pretax operating income provides relevant and useful information, it does not replace income before income taxes and net income calculated in accordance with generally accepted accounting principles as a measure of UNUM's profitability. Therefore, this discussion should be read in conjunction with the Consolidated Financial Statements, Notes to Consolidated Financial Statements and Selected Consolidated Financial Data included elsewhere in the Form 10-K. The following table summarizes pretax operating income (loss) for the four business segments and Corporate for the years ended December 31, 1998, 1997 and 1996, and is followed by a discussion of the special items for those periods and a reconciliation of income (loss) before income taxes to pretax operating income (loss).
For the year ended December 31, 1997, as compared with the same period in 1996, UNUM reported increased pretax operating income, driven by improved results in the Disability Insurance and Special Risk Insurance segments, resulting primarily from strong premium growth in both segments during 1997.
In connection with entering into the merger agreement with Provident in fourth quarter 1998, UNUM anticipates that as a result of integrating its claim operations with Provident, there will be a temporary increase in claim costs. UNUM expects that fewer claims will be resolved or closed during the period when the two companies are planning and implementing the integration of their claims organizations. The average length of duration for claims will increase, resulting in more benefit payments being paid for a relatively short time until the consolidation of operations is complete. During the fourth quarter of 1998, UNUM increased its unpaid claims reserve by $59.4 million related to the expected increase in disability claim duration on existing claims. This reserve increase was reflected as a $49.0 million increase in benefits to policyholders and a $10.4 million reduction in fee income in the Disability Insurance segment. The reduction
UNUM Life Insurance Company of America ("UNUM America") and First UNUM Life Insurance Company ("First UNUM") closed the sale of their respective tax-sheltered annuity ("TSA") businesses to The Lincoln National Life Insurance Company and Lincoln Life & Annuity Company of New York, both subsidiaries of Lincoln National Corporation, on October 1, 1996. The sale resulted in a deferred pretax gain, of which $72.6 million was recognized in income during 1997, as fees and other income in the Retirement Products segment.
During the fourth quarter of 1996, UNUM executed a definitive reinsurance agreement between UNUM America and Centre Re, a Bermuda-based reinsurance specialist, for reinsurance coverage of the active life reserves of UNUM America's existing United States non-cancellable individual disability block of business. As a result, UNUM recognized a pretax charge of $49.7 million, reflected as operating expenses in the Disability Insurance segment, which represents the present value of the anticipated minimum amount of fees to be paid to Centre Re under the agreement. For additional information regarding the reinsurance agreement see Item 8 Note 6 under the caption "Reinsurance."
In connection with the merger of Commercial Life Insurance Company ("Commercial Life") into UNUM America, the sale of UNUM America's TSA business, as well as UNUM's continued efforts to strengthen its focus on its core products, the company initiated a review of certain products, which resulted in the recognition of pretax charges totaling $39.4 million during third quarter 1996. The charges included the write-off of certain intangible assets and the establishment of a reserve for the present value of expected future losses on certain discontinued products.
For the year ended December 31, 1996, these charges reduced income before income taxes by $13.1 million in the Disability Insurance segment, reflected as $0.5 million of benefits to policyholders, $0.9 million of operating expenses, and $11.7 million as a change in deferred policy acquisition costs; $11.3 million in the Special Risk Insurance segment, reflected as $6.9 million of benefits to policyholders and $4.4 million of operating expenses; and $15.0 million in the Retirement Products segment, reflected as benefits to policyholders.
The following sections discuss the results of the four business segments and Corporate for the years ended December 31, 1998, 1997 and 1996. These discussions are based on pretax operating income (loss), which excludes realized investment gains (losses) and the special items previously described. The summary financial information provided prior to each segment discussion has been adjusted to exclude the impact of special items from all income statement line items, consistent with the discussion of results on a pretax operating income basis.
The Disability Insurance segment includes disability products offered through: UNUM America and First UNUM in North America; UNUM Limited in the United Kingdom; and UNUM Japan Accident Insurance Company Limited ("UNUM Japan"). The products included in this segment are group long term disability ("group LTD"), group short term disability ("group STD"), long term care, individual disability and disability reinsurance operations.
The Disability Insurance segment's pretax operating income increased in 1998, as compared with 1997, primarily as a result of strong premium growth and favorable expense growth for the segment. Unfavorable claims experience in the major product lines and reduced fees and other income for the segment partially offset these favorable factors.
During 1998, market interest rates fell to historically low levels. Management expects the reserve discount rate for certain disability lines will likewise decline as current cash flows are invested in assets at current yields, which are below the composite yield of existing assets purchased in prior years, resulting in higher claim liabilities. Management expects to price new business and reprice existing business, at contract renewal dates, to mitigate the effect on new claim liabilities from this decline in interest rates. However, given the competitive market conditions for UNUM's disability products in the United States and the United Kingdom, it is uncertain whether pricing actions can mitigate the entire effect of interest rate declines. Additionally, in connection with the proposed merger with Provident, UNUM is evaluating its processes and assumptions used to calculate the discount rate for claim reserves for group LTD, individual disability and the disability businesses of UMUM Limited (see "Proposed Merger with Provident" for further information).
Pretax operating income for group STD increased in 1998, as compared with 1997. Key drivers of the increase were premium growth from record sales and improved persistency, and a favorable operating expense ratio. The strong sales levels reflect UNUM's continuing efforts to cross-sell group STD products with other UNUM group products, as well as increasing large case sales. An unfavorable change in the benefit ratio, primarily from increased claims incidence levels and larger size cases, partially offset these favorable factors.
In general, UNUM Limited's earnings expressed in U.S. dollars are affected by fluctuations in the exchange rates used in the translation of earnings from British pounds sterling. The weighted-average exchange rate was approximately $1.66, $1.64 and $1.56 for the years ended December 31, 1998, 1997 and 1996, respectively. At December 31, 1998, the spot rate was approximately $1.66.
During 1998, the long term care ("LTC") and Lifelong Disability Protection ("LDP") blocks of business, while still relatively small, continued to contribute favorably to pretax operating income. LTC and LDP experienced significant premium growth in 1998, as compared with 1997, reflecting the strong sales momentum for these businesses.
The Special Risk Insurance segment includes group life, accidental death and dismemberment, travel and voluntary accident insurance, special risk reinsurance operations, and other special risk insurance products.
Pretax operating income for the Special Risk Insurance segment increased for the year ended December 31, 1998, as compared with 1997, primarily driven by strong premium growth and a lower operating expense ratio across the segment. Additionally, increased fees and other income, largely from reinsurance underwriting management operations, and increased investment income positively affected pretax operating income for this period. Higher benefit ratios in certain product lines partially offset these increases. UNUM's participation in Lloyd's of London syndicates experienced a higher benefit ratio, especially in the fourth quarter, as new information was received about the profitability of open syndicate years. The profitability of the Lloyd's of London market and the syndicates in which UNUM participates may continue to deteriorate and impact future pretax operating income. UNUM is conducting a strategic review of its reinsurance businesses, including the Lloyd's of London syndicates, to determine the appropriateness of their fit within the context of the UNUMProvident merged entity. The review could result in the sale of some or all of the reinsurance businesses. Due to the nature of the risks underwritten and the relative size of the blocks of businesses, several of the products in the Special Risk Insurance segment can exhibit claims variability.
Solid sales results and stable persistency continued during the year and were the primary drivers of group life premium growth of 22.3% in 1998. Claim block acquisitions generated one-time premiums for group life of $0.2 million and $3.6 million, respectively, for 1997 and 1996, and for reinsurance operations of $5.1 million and $16.3 million, respectively, for 1998 and 1996. Management intends to pursue additional claim block acquisitions in the future.
The increase in pretax operating income for 1997, as compared with 1996, was primarily due to strong premium growth in the group life business, lower expense ratio across most lines, increased investment income and additional fees and other income predominately from reinsurance underwriting management operations. These favorable factors were partially offset by higher benefit ratios in certain lines of business.
(b) Information relating to sales is presented as an indicator of premium growth in the segment. Benefit ratios and operating expense ratios show the relative relationships among data to earned premiums in the segment's income statement.
Pretax operating income for the Colonial Products segment increased for the year ended December 31, 1998, as compared with 1997. The increase was primarily attributable to additional investment income and a reduced benefit ratio in the accident, sickness and disability product line, partially offset by an increase in interest credited and a higher benefit ratio in the cancer product line. The increase in investment income and interest credited, is largely due to the assumption of worksite-marketed universal life insurance under reinsurance agreements Colonial entered into in 1998 and 1997. During 1998, management continued to implement organizational changes to focus on specific distribution channels to market Colonial products.
The Retirement Products segment includes products no longer actively marketed by UNUM including: TSAs, guaranteed investment contracts ("GICs"), deposit administration accounts ("DAs"), 401(k) plans, individual life and group medical insurance. For the years ended December 31, 1998, and 1997, the segment reported decreased pretax operating income as compared with the respective prior year. The decline in operating income in both periods was primarily the result of the sale of UNUM's TSA business in October 1996, as discussed in Item 8 Note 5 "Sale of Tax-Sheltered Annuity Business." For 1997, the decrease in TSA results was partially offset by favorable volatility in the run-off of certain other discontinued products. UNUM expects these blocks of business to continue to decline in size over several years and experience earnings volatility, reflecting their run-off nature.
In our opinion, the consolidated financial statements listed in the index appearing under Item 8 on page 27 present fairly, in all material respects, the financial position of UNUM Corporation and its subsidiaries at December 31, 1998, and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. In addition, in our opinion, the financial statement schedules listed in the index appearing under Item 14(a) on page 71 present fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedules are the responsibility of UNUM's management; our responsibility is to express an opinion on these financial statements and financial statement schedules based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes 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. We believe that our audits provide a reasonable basis for the opinion expressed above.
To better reflect the business of Duncanson & Holt Underwriters Ltd., as reported in the Special Risk Insurance segment, the results have been reflected on separate lines in UNUM's statements of income, balance sheets and statements of cash flows. Previously the operating results, financial position and cash flows were reported as net amounts in fees and other income and other assets. Prior year amounts have been reclassified for comparative purposes. Certain other 1997 and 1996 amounts have been reclassified in 1998 for comparative purposes.
o Fixed maturities available for sale (certain bonds and redeemable preferred stocks)--at fair value.
o Equity securities available for sale (common stocks and non-redeemable preferred stocks)--at fair value.
o Other long-term investments--at cost plus UNUM's equity in undistributed net earnings since acquisition.
If a decline in fair value of an invested asset is considered to be other than temporary or if a long-lived asset is deemed to be permanently impaired, the investment is reduced to its net realizable value and the reduction is accounted for as a realized investment loss.
UNUM discontinues the accrual of investment income on invested assets when it is determined that collectability is doubtful. UNUM recognizes investment income on impaired loans when the income is received.
Purchases and sales of short-term financial instruments are part of investing activities and not necessarily a part of the cash management program. Therefore, short-term financial instruments are classified as investments in the Consolidated Balance Sheets and are included as investing activities in the Consolidated Statements of Cash Flows.
The costs of acquiring new business that vary with and are related primarily to the production of new business have been deferred to the extent such costs are deemed recoverable from future profits. Such costs include commissions, certain costs of policy issue and underwriting and certain variable field office expenses.
Participating policies issued by the former Union Mutual Life Insurance Company ("Union Mutual") prior to its conversion to a stock life insurance company on November 14, 1986, will remain participating as long as they remain in force. A Participation Fund Account ("PFA") was established for the benefit of all Union Mutual's individual participating life and annuity policies and contracts.
The provision for income taxes includes amounts currently payable and deferred income taxes, which result from differences between financial reporting and tax bases of assets and liabilities and are measured using enacted tax rates and laws. A valuation allowance is established for deferred tax assets when it is more likely than not that an amount will not be realized.
Premium for UNUM's Lloyd's of London ("Lloyd's") business is based on participation in the individual syndicate underwriting years that generate premiums over a three-year period of time. UNUM has participated in the Lloyd's market for a number of years and uses its historical experience plus information obtained from its managing agents to estimate revenues, losses, expenses, and the related assets and liabilities. Additionally, an independent acturial review of the syndicates' open reserves is performed annually and management periodically reviews its estimates as information is received from the Lloyd's syndicates. Any resulting adjustment to the estimates is reflected in the current results.
During fourth quarter 1997, certain reinsurance pools managed by UNUM's wholly-owned subsidiary, Duncanson & Holt Inc. ("D&H"), received new claim information from ceding insurance enterprises about certain older pool years and completed an analysis of recent claims experience deterioration. As a result of these factors, certain pools have strengthened claim reserves. The impact to UNUM in fourth quarter 1997 from these pool claim reserve increases was an $11.7 million reduction in fee income and a $6.7 million increase in benefits to policyholders reported in the Special Risk Insurance segment, reducing net income by $12.0 million in the Consolidated Statement of Income.
or transactions related to an entity's capital instruments. UNUM has reclassified financial statements for earlier years as required by FAS 130.
Effective January 1, 1998, UNUM adopted FAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which established standards for reporting information about operating segments. Generally, FAS 131 requires that financial information about operating segments be reported on the basis that is used internally for evaluating performance. UNUM has determined that its current segment reporting structure meets the requirements of FAS 131 and no restatement of financial information is needed. Additional segment information has been disclosed as required under FAS 131.
Effective January 1, 1998, UNUM adopted FAS No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits," which revised disclosure requirements for employers' pension and other retiree benefits. FAS 132 did not change the measurement or recognition of pension or other postretirement benefit plans. UNUM has restated disclosures for earlier years presented, as required under FAS 132.
Effective December 31, 1997, UNUM adopted FAS No. 129, "Disclosures of Information About Capital Structure," which consolidated disclosure requirements related to the type and nature of securities contained in an entity's capital structure. FAS 129 did not add to or change any of UNUM's disclosures.
In October 1998, the Accounting Standards Executive Committee ("AcSEC") issued SOP 98-7, "Deposit Accounting: Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk," which provides guidance on applying the deposit method of accounting to insurance and reinsurance contracts that do not transfer insurance risk. UNUM is required to adopt SOP 98-7 effective January 1, 2000. Previously issued financial statements should not be restated unless the SOP is adopted prior to the effective date and during an interim period. The adoption of SOP 98-7 is not expected to have a material impact on UNUM's results of operations, liquidity or financial position.
In December 1997, the AcSEC issued SOP 97-3, "Accounting by Insurance and Other Enterprises for Insurance-Related Assessments," which provides guidance on accounting for the recognition and measurement of liabilities for guaranty funds and other insurance-related assessments. UNUM is required to adopt SOP 97-3 effective January 1, 1999. Previously issued financial statements should not be restated unless the SOP is adopted prior to the effective date and during an interim period. The adoption of SOP 97-3 is not expected to have a material impact on UNUM's results of operations, liquidity or financial position.
NOTE 2. INVESTMENTS The following tables summarize the components of investment income, net realized investment gains (losses) and changes in unrealized gains (losses), net:
Equity Securities The fair values, which also represent carrying amounts, and the cost of equity securities available for sale were as follows at December 31, 1998:
Gross unrealized investment gains on equity securities available for sale totaled $10.5 million, $9.6 million, and $7.5 million at December 31, 1998, 1997 and 1996, respectively. Gross unrealized investment losses were not material at December 31, 1998, 1997 and 1996.
UNUM was committed at December 31, 1998, to purchase fixed maturities and other invested assets in the amount of $45.7 million.
Changes in the allowance for probable losses on mortgage loans and real estate held for sale were as follows:
Additions represent charges to net realized investment gains (losses) less recoveries, and deductions represent reserves released upon disposal or restructuring of the related asset.
revised if it is determined that future expected experience is worse than the reserve assumptions. Reserves for group insurance policies consist primarily of prepaid premiums. The interest rates used in the calculation of reserves for future policy benefits at December 31, 1998, and 1997, principally ranged from 4.5% to 9.5% and from 5.0% to 9.5%, respectively. Certain reserve calculations are based on variable interest rates within these ranges.
The interest rate used to discount the disability reserves is a composite of the yields on assets specifically identified with each block of business. The discount rate may decline further depending on the interest rate environment. UNUM periodically adjusts prices on both existing and new business in an effort to mitigate the impact of the current interest rate environment. See Note 17 "Proposed Merger with Provident and Combined Condensed Pro Forma Financial Statements (Unaudited)," for a discussion of potential impacts to reserve discount rates subsequent to the proposed merger.
The components of the unpaid claims and claims expenses incurred and related to prior years were as follows:
On October 1, 1996, UNUM America and First UNUM closed the sale of their respective TSA businesses to The Lincoln National Life Insurance Company and Lincoln Life & Annuity Company of New York ("Lincoln"), both subsidiaries of Lincoln National Corporation. The sale involved approximately 1,700 group contractholders and assets under management of approximately $3.3 billion. The contracts were initially reinsured on an indemnity basis. Upon consent of the TSA contractholders and participants, the contracts are considered reinsured on an assumption basis, legally releasing UNUM America and First UNUM from future contractual obligation to the respective contractholders and participants.
To effect the sale of the TSA business, UNUM transferred into a trust account held for the benefit of Lincoln approximately $2,690 million of assets. UNUM has recorded a deposit asset in its Consolidated Balance Sheet representing the assets which support the TSA contracts of those contractholders and participants that have not given consent for assumption reinsurance. At December 31, 1998, the deposit asset related to the TSA transaction was approximately $257 million.
The sale resulted in a deferred pretax gain of $80.8 million, of which $72.6 million was recognized in income during 1997, reported as fees and other income, in proportion to contractholder and participant consents for assumption reinsurance. Additionally, the results for the year ended December 31, 1997, included $47.0 million of net income and basic and diluted net income per common share of $0.34 and $0.33, respectively, related to the recognition of the deferred pretax gain. Through December 31, 1998, consent for assumption reinsurance has been provided by TSA contractholders and participants owning substantially all assets under management.
UNUM periodically monitors the financial condition, and in some cases holds substantial collateral as security in the form of funds, securities and/or letters of credit to mitigate credit risk from its reinsurers. At December 31, 1998, approximately 85% of the reinsurance receivable balance was due from five reinsurers. These reinsurers had a rating of A or better (Strong) from Standard & Poor's--a recognized insurance rating agency. Additionally, UNUM holds collateral in the form of securities comprising 53% of the balance.
The agreement is a finite reinsurance arrangement. Under the agreement, Centre Re has an obligation to absorb losses within a defined risk layer. UNUM retains the risk for all experience up to Centre Re's defined risk layer, or attachment point. Once the attachment point is reached, Centre Re assumes the risk for all experience up to a contractually defined risk limit. Any experience above Centre Re's defined risk limit reverts back to UNUM. As of December 31, 1998, the attachment point had not been reached.
The following discloses the various layers in the agreement at December 31, 1998:
The actual operating results of the non-cancellable ID block of business are accounted for under FAS No. 113 "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts." This reinsurance agreement transfers risk and is accounted for as reinsurance in accordance with the requirements of FAS 113 for reinsurance of long-duration contracts. The underlying operating results of the reinsured block are reflected in fees and other income and realized gains and losses from sales of assets are reflected as realized investment gains (losses) in UNUM's Consolidated Statements of Income.
UNUM has a deposit asset at December 31, 1998, of approximately $419 million reflected in the Consolidated Balance Sheet. The deposit asset is comprised of UNUM's experience layer and unrealized gains or losses on the marketable securities held in the trust. Unrealized gains or losses on marketable securities held in the trust and the related effects on claim reserves are reflected as unrealized gains or losses in the equity section of UNUM's Consolidated Balance Sheets.
States. The reinsurance fees due Centre Re are expenses that were not contemplated when reserves were strengthened in 1994. Since these fees would have caused the non-cancellable ID block of business to be in a loss situation, UNUM recognized a pretax charge of $49.7 million in the fourth quarter of 1996. The charge represented the present value of the anticipated minimum amount of fees to be paid to Centre Re under the agreement for a period of six years. UNUM has the right, but no obligation, to recapture the business after six years without penalty. UNUM paid $9.4 million in fees to Centre Re during 1998 and 1997.
For the years ended December 31, 1998, 1997 and 1996, recoveries recognized under reinsurance agreements offset benefits to policyholders by $376.3 million, $309.7 million and $90.8 million, respectively.
Charges of $6.0 million and $7.2 million were recorded in 1997 and 1996, respectively. The charge in 1997 was related to a management and field office reorganization within the North American reinsurance operations, and consisted of $4.0 million of lease exit costs, $1.4 million of severance related costs, and $0.6 million of abandoned assets. The charge in 1996 was related to the merger of Commercial Life Insurance Company ("Commercial Life") into UNUM America. As of December 31, 1998, a liability was no longer being carried in the Consolidated Balance Sheet for these charges.
At December 31, 1998, UNUM Corporation had a $500 million committed revolving credit facility that expires on October 1, 2001. UNUM's commercial paper program is supported by the revolving credit facility and is available for general liquidity needs, capital expansion, acquisitions and stock repurchase. The committed revolving credit facility contains certain covenants which, among other provisions, require maintenance of certain levels of stockholders' equity and limits on debt levels.
On December 15, 1998, UNUM issued $250 million notes due December 15, 2028, with interest payable semi-annually. The notes are redeemable, in whole or in part, at the option of UNUM at any time at or above par. UNUM used the net proceeds to repay short term-debt and for general corporate purposes.
On December 4, 1997, UNUM borrowed [British pound]100 million ($168.3 million) through a private placement with an investor in the United Kingdom. The borrowing has an expected term of 10 years. Upon issuance of the [British pound]100 million borrowing, UNUM entered into currency and interest rate swap agreements that converted the principal amount to U.S. dollars and the interest obligation on the debt from a pound sterling based fixed rate to a U.S. dollar fixed rate. The borrowing is callable by either party over the life of the agreement, under certain circumstances. UNUM anticipates the debt will be called in 1999. Therefore, UNUM is currently evaluating various financing alternatives and intends to substitute a debt instrument to match the maturity and terms of the interest rate swap agreement.
In the normal course of business, UNUM enters into letters of credit, primarily to satisfy capital requirements related to certain subsidiary transactions. UNUM had outstanding letters of credit of $149.7 million and $84.6 million at December 31, 1998, and 1997, respectively, which are not reflected in the Consolidated Balance Sheets.
Pension Plans In 1997, UNUM changed the measurement date for the valuation of its pension plan and postretirement benefit plan assets and actuarially determined obligations from December 31, to September 30. The change in measurement date had no effect on 1997 or prior years' net pension and periodic postretirement benefit costs.
UNUM provides certain health care and life insurance benefits for retired employees and covered dependents. The underlying plans are not currently funded. The cost of these plans was $4.5 million, $4.3 million and $10.3 million for the years ended December 31, 1998, 1997 and 1996, respectively. At December 31, 1998, and 1997, the liability associated with these plans was $85.8 million and $83.2 million, respectively.
Effective January 1, 1997, UNUM introduced a single retirement savings plan for all domestic employees. Dependent upon the employee's annual earnings, eligible employees may contribute up to 15% of their annual compensation, including incentive payouts. UNUM matches 100% of the employee's contribution up to 3% of the employee's compensation, plus 50% of the employee's contribution on the next 2% of the employee's compensation, to a maximum of 4% after eligibility requirements of one year of service is met. Employees become 100% vested immediately upon becoming eligible. Expense for the retirement savings plans amounted to $10.3 million, $9.6 million and $8.4 million in 1998, 1997 and 1996, respectively.
On March 14, 1997, UNUM's Board of Directors authorized a two-for-one common stock split, subject to shareholder approval of a proposal to increase the number of authorized shares of common stock. On May 9, 1997, UNUM's shareholders approved an increase in the number of authorized shares of common stock to 240 million from 120 million. The stock split was completed on June 2, 1997, through the distribution of one additional share for each share of stock already issued, to holders of record on May 19, 1997. Accordingly, all numbers of common shares and per common share data were restated to reflect the stock split. Par value of $10.0 million was transferred to common stock from additional paid-in capital in second quarter 1997.
Changes in the number of common shares outstanding were as follows:
Earnings Per Share Basic earnings per share ("EPS") is computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding. Diluted EPS is computed by dividing net income available to common stockholders by the weighted-average number of common shares outstanding while giving effect to all dilutive potential common shares outstanding.
The approximate number of shares used to calculate EPS was as follows:
Forfeiture rates are updated based on actual experience, and the cumulative adjustments made to the current year's pro forma amounts. Because some options vest over several years and additional awards generally are made each year, the pro forma amounts above may not be representative of the effects on net income for future years.
The Incentive Plan also provides for granting to key officers restricted stock awards whose vesting is contingent upon UNUM achieving prescribed financial performance objectives, with the exception of 11,600 shares granted in 1996 and 10,000 shares granted in 1995, which will vest upon the grantee remaining in UNUM's employ for a specified period of time or a defined change in control. Plan participants are entitled to voting rights on their respective shares at grant. The compensation cost related to restricted stock grants was not material in 1998, 1997 and 1996.
The number of shares subject to issuance under the Incentive Plan cannot exceed 13.6 million, including both options and shares of restricted stock. At December 31, 1998, 1997 and 1996, 1,617,701 shares, 1,603,580 shares, and 1,385,036 shares, respectively, were available for grant under the Incentive Plan.
The number and weighted-average exercise price of exercisable shares as of December 31, 1998, 1997 and 1996, was 4,802,071 shares at $25.50 per share, 4,686,562 shares at $22.71 per share and 4,763,184 shares at $20.73 per share, respectively.
The following table summarizes information about stock options outstanding at December 31, 1998:
UNUM adopted a Shareholder Rights Plan on March 13, 1992. Under the Plan, each Right, under specific circumstances, entitles the holder to purchase one one-hundredth of a share of Series A Junior Participating Preferred Stock at a purchase price of $150. The Rights become exercisable at a specified time after (1) a person or group acquires 10% or more of UNUM Corporation common stock or (2) a tender or exchange offer for 10% or more of UNUM Corporation common stock. The Shareholder Rights Plan was amended in 1998 such that Provident, as a result of the merger and related transactions contemplated by the merger, will not be deemed to be an Acquiring Person as defined in the Rights Agreement. The Rights expire at the close of business on March 13, 2002, unless earlier redeemed by the Company under certain circumstances at a price of $0.01 per Right.
UNUM has not provided for a deferred tax liability of approximately $11 million that arose prior to 1984, which related to the policyholders' surplus accounts of UNUM's life insurance subsidiaries. Under current law, management believes the conditions under which such taxes would be paid to be remote.
UNUM's Consolidated Statements of Income for 1998, 1997 and 1996, included the following amounts of income subject to foreign taxation and the related foreign income tax expense:
Fixed Maturities Available for Sale: Fair values for fixed maturities are based on quoted market prices, where available. If quoted market prices are not available, fair values are estimated using values obtained from independent pricing services or, in the case of private placements, are estimated by discounting expected future cash flows using a current market rate applicable to the yield, credit quality and maturity of the investments.
Off-Balance Sheet Financial Instruments: Fair value for off-balance sheet financial instruments are based on current settlement values.
UNUM periodically uses options, futures, forward exchange contracts and interest rate swaps, which are common derivative financial instruments, to hedge certain risks associated with anticipated purchases and sales of investments, anticipated debt issuance and certain payments denominated in foreign currencies, primarily British pounds sterling, Canadian dollars and Japanese yen. These derivative financial instruments are used to protect UNUM from the effect of market fluctuations in interest and exchange rates between the contract date and the date on which the hedged transaction occurs. Additionally, UNUM uses swap agreements to convert foreign currency based debt instruments to U.S. dollars and to convert variable rate debt to a fixed rate.
In addition to the swap agreements discussed previously, UNUM had open interest rate futures contracts at December 31, 1998, with notional amounts of $111.0 million to hedge anticipated cash flows in 1999. These futures contracts had a related net unrealized loss of $0.3 million at December 31, 1998. Other than the swap agreements discussed previously, UNUM had no other open derivative financial instruments at December 31, 1997.
UNUM evaluates performance and allocates resources based on pretax operating income, which is defined as income (loss) before income taxes exclusive of realized investment gains (losses) and special items. Realized investment gains (losses) are excluded from management's evaluation of segment performance as management believes the volatility in gains and losses associated with the selling of invested assets in the financial markets is not representative of ongoing operations. Special items are excluded from management's evaluation of segment performance as management considers them as being not representative of ongoing operations and believes a discussion of the results on a pretax operating income basis provides a better understanding of the results of ongoing operations. The accounting polices of the operating segments are the same as those described in Note 1, "Summary of Significant Accounting Policies."
Investment income and net realized investment gains and losses are allocated to the segments based on designation of ownership of assets identified to the products in each segment. Operating expenses are allocated to the segments based on direct association with a product whenever possible. If the expense cannot be readily associated with a particular product, the costs are allocated based on ratios of the relative time spent, extent of usage or varying volume of work performed for each segment.
UNUM's long-lived assets are not material to the total consolidated assets and are not presented by geographic region.
As previously discussed, management's evaluation of segment performance excludes realized investment gains (losses) and special items. The following describes or references the special items that reconcile total segment amounts to total consolidated amounts:
(a) See Note 7 "Business Restructuring and Other Charges." The $13.1 million charge in the Disability Insurance segment included an $11.7 million write-off of deferred acquisition costs. Additionally, $0.5 million of direct costs, primarily relocation expenses, were recognized during fourth quarter 1997.
(f) During third quarter 1996, actions related to the merger of Commercial Life into UNUM America resulted in a $10.1 million increase in operating expenses for Corporate.
The following unaudited pro forma combined condensed financial statements and explanatory notes are presented to show the impact on the historical financial positions and results of operations of UNUM and Provident of the planned merger under the "pooling of interests" method of accounting. The unaudited pro forma combined condensed financial statements combine the historical financial information of UNUM and Provident as of December 31, 1998, and for the years ended December 31, 1998, 1997 and 1996. The unaudited pro forma combined condensed statements of income give effect to the merger as if it had been completed at the beginning of the earliest period presented. The unaudited pro forma combined condensed balance sheet assumes the merger was completed on December 31, 1998.
The unaudited combined condensed pro forma financial statements as of December 31, 1998, and for each of the three years ended December 31, 1998, 1997 and 1996, are based on and derived from, and should be read in conjunction with the UNUM and Provident historical consolidated financial statements and related notes.
On the date the merger is completed or on an earlier date if required by generally accepted accounting principles, UNUMProvident will record an expense for merger related costs of approximately $210 million ($148 million net of income taxes). These costs include amounts for severance and related costs, early retirement, exit costs for duplicate facilities and asset impairments, and merger related costs such as investment banker, legal and accountant fees. The estimated merger related expenses represent management's best estimates based on available information at this time. Actual charges may differ from these estimates.
UNUM/Provident Unaudited Combined Condensed Pro Forma Consolidated Statements of Income (a)
(a) The above unaudited combined condensed pro forma consolidated statements of income reflect the combined results of the operations of UNUM and Provident for the periods presented. No adjustments have been made to arrive at net income available to common shareholders. The pro forma combined basic and diluted earnings per share for the respective periods presented are based on the combined weighted-average number of common and dilutive potential common shares and adjusted weighted-average shares of UNUM and Provident. The number of weighted-average common shares and adjusted weighted-average shares, including all dilutive potential common shares, reflect the reclassification of Provident common stock on a 0.73 to 1.0 basis and the conversion of each outstanding share of UNUM common stock into one share of UNUMProvident common stock in the merger.
UNUM Corporation and Provident Companies, Inc. Unaudited Combined Condensed Pro Forma Balance Sheet As of December 31, 1998
one dollar to ten cents, and the reclassification of Provident common stock on a 0.73 to 1.0 basis that results in 98.7 million shares issued to replace the 135.2 million shares of Provident common stock held by Provident stockholders on December 31, 1998, and the issuance to UNUM stockholders of 138.7 million shares of UNUMProvident common stock pursuant to the merger (calculated by multiplying the number of shares of UNUM common stock outstanding at December 31, 1998, of 138.7 million by the exchange ratio of 1.0 to 1.0 representing the number of shares UNUM stockholders will receive for each share of UNUM common stock they own immediately prior to consummation of the merger). The number of shares of UNUMProvident common stock that will be issued after completion of the merger will be based on the actual number of shares of UNUM common stock, and Provident common stock (after reclassification on a 0.73 to 1.0 basis) outstanding at the effective time of the merger.