As of December 31, 2019, the Company owned its headquarters of approximately 225,000 square feet located at 1 Horace Mann Plaza in Springfield, Illinois. Also in Springfield, the Company owns and leases some smaller buildings at other locations. In addition, the Company leases office space in suburban Chicago, Illinois, suburban Dallas, Texas (approximately 114,000 of rentable square feet), suburban Raleigh, North Carolina, and Cherry Hill, New Jersey which are utilized by one or more of all five reporting segments, depending on the location. For more information on reporting segments, see Part I - Item 1, Reporting Segments. The Company believes its properties and facilities are suitable and adequate for current operations.
Statements made in the following discussion that are not historical in nature are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995 and are subject to known and unknown risks, uncertainties and other factors. HMEC is not under any obligation to (and expressly disclaims any such obligation to) update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. It is important to note that the Company’s actual results could differ materially from those projected in forward-looking statements due to a number of risks and uncertainties inherent in the Company's business. See Part I - Item 1A in this Annual Report on Form 10-K for additional information regarding risks and uncertainties.
On January 2, 2019, the Company acquired all of the equity interests in BCG which provides advisory and benefit plan record keeping services. BCG's results are reported in the Retirement segment.
This MD&A begins with the Company’s consolidated financial highlights followed by consolidated results of operations, an outlook for future performance, details about critical accounting estimates and the results of operations by segment.
For 2019, the Company's net income increased $166.1 million compared to 2018. The increase in net income was primarily due to recognition of a $106.9 million after tax realized investment gain in the second quarter of 2019 associated with an annuity reinsurance transaction. The impact from the realized investment gain was partially offset by a $28.0 million annuity goodwill impairment charge. Lower catastrophe costs of $49.0 million after tax in Property and Casualty as well as the addition of $18.0 million of net income from the Supplemental segment also contributed to the increase in consolidated net income. See Part II - Item 8, Notes 2, 6 and 7 of the Consolidated Financial Statements in this report for more information regarding Supplemental, the annuity reinsurance transaction and the goodwill impairment charge.
Net income in 2018 was negatively impacted by an elevated level of catastrophe costs of $90.1 million after tax while net income in 2017 benefited $99.0 million from the passage of the Tax Cuts and Jobs Act of 2017 (TCJA).
Excluding accreted investment income on the deposit asset on reinsurance, 2019 net investment income decreased $82.2 million compared to 2018, primarily due to a $2.1 billion reduction in invested assets from investments transferred under the annuity reinsurance transaction in the second quarter of 2019 as well as continued low rates on new investments and lower prepayment levels, partially offset by stronger returns on alternative investments. Investment yields continue to be impacted by the low interest rate environment of recent years. For 2018, net investment income reflected increased prepayment activity offset by a reduction in yields from a strategic decision to improve the quality of the portfolio. The annualized yield on the total investment portfolio for the past three years was:
The Company, from time to time, sells securities subsequent to a reporting date that were considered temporarily impaired at the reporting date. Such sales are due to issuer specific events occurring subsequent to the reporting date that result in a change in the Company's intent to hold an invested asset.
For 2019, 2018 and 2017, other income steadily rose due to increases in commissions from third-party vendor products, decreases in annuity premium bonuses and the inclusion of BCG brokerage fees in 2019.
For 2019, operating expenses increased $29.2 million compared to 2018, driven by the inclusion of NTA and BCG operations as well as $5.5 million of severance charges incurred in 2019 pertaining to expense reduction initiatives. The increase in operating expenses in 2018 was consistent with management's expectations as the Company incurred expenditures to support targeted strategies in product, distribution and infrastructure, which were intended to enhance the overall customer experience, increase sales, and support favorable policy retention and business cross-sale ratios. 2018 also included transaction costs of $5.1 million to acquire BCG and NTA.
Interest expense increased $2.6 million in 2019, primarily due to the Company utilizing its senior revolving credit facility in the third quarter of 2019 to partially fund the acquisition of NTA. Interest expense increased in 2018, primarily due to FHLB borrowings in the fourth quarter of 2017 as described further in Part II - Item 8, Note 10 of the Consolidated Financial Statements in this report.
The effective income tax rate on the Company's pretax income, including net investment gains (losses) was 22.0%, 6.2% and (91.1)% for the years ended December 31, 2019, 2018 and 2017, respectively. Income from investments in tax-exempt securities reduced the effective income tax rates by 2.3, 21.2 and 11.0 percentage points for 2019, 2018 and 2017, respectively. The goodwill impairment charge in the Retirement segment increased the effective income tax rate by 2.3 percentage points and the acquisitions of NTA and BCG increased the effective income tax rate by 0.1 percentage points at December 31, 2019. The TCJA reduced the 2017 effective tax rate by 111.6 percentage points from re-measuring the Company's deferred taxes to reflect the changes in tax rates included in the TCJA as of the date of enactment.
Within Property and Casualty, low to mid-single digit planned rate increases, as well as continued underwriting initiatives, are expected to maintain the underlying loss ratios* at levels comparable to 2019. The expense ratio is expected to improve slightly from the 2019 expense ratio of 26.9 points. As a result, the Property and Casualty full-year combined ratio is expected to be 95-97%, assuming catastrophe losses add approximately 7.5 points, similar to 2019. Net income for Property and Casualty is anticipated to be in the range of $55 million to $60 million.
Supplemental is anticipated to generate a pretax profit margin in the low to mid 20% range and net investment income should begin to benefit from portfolio repositioning. As a result, net income is anticipated to be between $28 million and $30 million.
Life is expected to generate net income between $14 million and $16 million, including a return to modeled mortality cost levels.
As described in Critical Accounting Estimates, certain of the Company's significant accounting measurements require the use of estimates and assumptions. As additional information becomes available, adjustments may be required. Those adjustments are charged or credited to income for the period in which the adjustments are made and may impact actual results compared to management's estimates above. Additionally, see Forward-looking Information in Part I - Item 1 and Part I - Item 1A of this Annual Report on Form 10-K concerning other important factors that could impact actual results. Management believes that a projection of net income is not appropriate on a forward-looking basis because it is not possible to provide a valid forecast of net investment gains (losses), which can vary substantially from one period to another and may have a significant impact on net income.
Valuation of hard-to-value fixed maturity securities, including evaluation of other-than-temporary impairments
Valuation of liabilities for property and casualty unpaid claims and claim expenses
Although variability is inherent in these accounting estimates, management believes the amounts provided are appropriate based upon the facts available during preparation of the consolidated financial statements.
The fair value of a fixed maturity security is the estimated amount at which the security could be exchanged in an orderly transaction between knowledgeable, unrelated and willing parties. The Company utilizes its investment managers and its custodian bank to obtain fair value prices from independent third-party valuation service providers, broker-dealer quotes, and model prices. Each month, the Company obtains fair value prices from its investment managers and custodian bank, each of which use a variety of independent, nationally recognized pricing sources to determine market valuations for fixed maturity securities. Differences in prices between the sources that the Company considers significant are researched and the Company utilizes the price that it considers most representative of an exit price. Typical inputs used by these pricing sources include, but are not
limited to, reported trades, bids, offers, benchmark yield curves, benchmarking of like securities, rating designations, sector groupings, issuer spreads, and/or estimated cash flows, prepayment and default speeds, among others. The Company's fixed maturity securities portfolio is primarily publicly traded, which allows for a high percentage of the portfolio to be priced through pricing services. Approximately 94.1% of the portfolio, based on fair value, was priced through pricing services or index priced using observable inputs as of December 31, 2019.
When OTTI is deemed to have occurred, the investment is written-down to fair value at the trade lot level and the credit-related loss portion is recognized as a net investment loss during the period. The amount of total OTTI related to non-credit factors for fixed maturity securities is recognized in other comprehensive income (OCI), net of applicable taxes, in which the Company has the intent to sell the security or if it is more likely than not the Company will be required to sell the security before the anticipated recovery of the amortized cost basis. Also, see Part II - Item 8, Note 1 of the Consolidated Financial Statements in this report.
The goodwill impairment test, as defined in GAAP, allows an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying value. If an entity determines it is more likely than not that the fair value of a reporting unit is less than its carrying value, then the entity performs a quantitative goodwill impairment test by comparing the fair value of a reporting unit to its carrying value for purposes of confirming and measuring an impairment.
The process of evaluating goodwill for impairment requires management to make multiple judgments and assumptions to determine the fair value of each reporting unit, including discounted cash flow calculations, the level of the Company's own share price and assumptions that market participants would make in valuing each reporting unit. Fair value estimates are based primarily on an in-depth analysis of historical experience, projected future cash flows and relevant discount rates, which consider market participant inputs and the relative risk associated with the projected cash flows. Other assumptions include levels of economic capital, future business growth, earnings projections and assets under management for each reporting unit. Estimates of fair value are subject to assumptions that are sensitive to change and represent the Company's reasonable expectation regarding future developments. The Company also considers other valuation techniques such as peer company price-to-earnings and price-to-book multiples.
The Company accounts for VODA associated with the acquisition of BCG based on management's estimate of the present value of future business to be written by the existing distribution channel. VODA was $4.6 million as of December 31, 2019 and is being amortized based on the present value of future profits to be received. The Company estimates that it will recognize VODA amortization of $0.4 million in each of the years 2020 through 2024, respectively.
The Company accounts for the value of customer relationships based on the present value of expected profits from existing BCG customers in force at the date of acquisition. Customer relationships was $7.3 million as of December 31, 2019 and is being amortized based on the present value of future profits to be received. The Company estimates that it will recognize customer relationships amortization of $1.5 million in 2020, $1.2 million in 2021, $1.0 million in 2022, $0.9 million in 2023 and $0.7 million in 2024.
In the event actual experience differs significantly from assumptions or assumptions are significantly revised, the Company may be required to record a material charge or credit to current period amortization expense for the
The process by which these reserves are established requires reliance upon estimates based on known facts and on interpretations of circumstances, including the Company's experience with similar cases and historical trends involving claim payments and related patterns, pending levels of unpaid claims and product mix, as well as other factors including court decisions, economic conditions, public attitudes and medical costs. The Company calculates and records a single best estimate of the reserve (which is equal to the actuarial point estimate) as of each reporting date.
Reserves are re-estimated quarterly. Changes to reserves are recorded in the period in which development factor changes result in reserve re-estimates. A detailed discussion of the process utilized to estimate loss reserves, risk factors considered and the impact of adjustments recorded during recent years is included in Item 8., Note 8 of the Consolidated Financial Statements in this report. Due to the nature of the Company's personal lines business, the Company has no exposure to losses related to claims for toxic waste cleanup, other environmental remediation or asbestos-related illnesses other than claims under property insurance policies for environmentally related items such as mold.
Based on the Company's products and coverages, historical experience, and modeling of various actuarial methodologies used to develop reserve estimates, the Company estimates that the potential variability of the Property and Casualty loss reserves within a reasonable probability of other possible outcomes may be approximately plus or minus 6.0%, which equates to plus or minus approximately $13.0 million of net income based on net reserves as of December 31, 2019. Although this evaluation reflects the most likely outcomes, it is possible the final outcome may fall below or above these estimates.
The Company's liabilities for unpaid claims and claim expenses for Property and Casualty were as follows:
The facts and circumstances leading to the Company's re-estimate of reserves relate to revisions of the development factors used to predict how losses are likely to develop from the end of a reporting period until all claims have been paid. Re-estimates occur because actual loss amounts are different than those predicted by the estimated development factors used in prior reserve estimates. At December 31, 2019, the impact of a reserve re-estimation resulting in a 1.0% increase in net reserves would be a decrease of approximately $2.0 million in net income. A reserve re-estimation resulting in a 1.0% decrease in net reserves would increase net income by approximately $2.0 million.
Liabilities for future policy benefits on supplemental insurance policies are computed using the net level premium method and are based on assumptions as to future investment yields, morbidity, mortality, persistency, expenses and other assumptions based on the Company’s experience, including provisions for adverse deviation. Mortality, morbidity and lapse assumptions for all policies have been based on standard actuarial tables which are modified as appropriate to reflect the Company's own experience. In the event actual experience is worse than the assumptions, additional reserves may be required. This would result in recognition of a loss for the period in which the increase in reserves occurred.
Valuation of Assets Acquired and Liabilities Assumed under Purchase Accounting and Purchase Price Allocation
In accounting for the acquisitions of NTA and BCG, assets acquired and liabilities assumed were recognized based on estimated fair values as of the date of acquisition. The excess of the purchase price when compared to the fair value of the net tangible and identifiable intangible assets acquired was recognized as goodwill. A significant amount of judgment was involved in estimating the individual fair values of tangible assets, intangible assets, and other assets and liabilities. The Company used all available information to make these fair value determinations and engaged third-party consultants for valuation assistance. The fair value of assets and liabilities as of the acquisition date were estimated using a combination of approaches, including the income approach, which required the Company to project future cash flows and apply an appropriate discount rate; the cost approach, which required estimates of replacement costs and depreciation and obsolescence estimates; and the market approach. The estimates used in determining fair values were based on assumptions believed to be reasonable but which are inherently uncertain. Accordingly, actual results may differ materially from the projected results used to determine fair value.
The VOBA intangible asset represents the difference between the fair value of insurance contracts and insurance policy reserves measured in accordance with the Company's accounting policies for insurance contracts acquired. VOBA was based on an actuarial estimate of the present value of future distributable earnings for insurance in force on the acquisition date. The VODA intangible asset associated with the acquisition of NTA was based on an actuarial estimate of the present value of future business to be written by the existing distribution channel. The VODA intangible asset associated with the acquisition of BCG was based on management's estimate of the present value of future business to be written by the distribution channel. The value of agency relationships intangible asset represents the present value of the commission overrides retained by NTA. The aforementioned intangible assets were valued using the income approach. The trade names intangible asset represents the present value of future savings accruing to NTA and BCG by virtue of not having to pay royalties for the use of the trade names, valued using the relief from royalty method. The state licenses intangible asset represents the regulatory licenses held by NTA that were valued using the cost approach. The valuation of NTA's policy reserves represents the present value of future benefits and expenses associated with the policies, valued using the actuarial appraisal approach.
Consolidated financial results primarily reflect the operating results of four reporting segments as well as the corporate and other line. These segments are defined based on financial information management uses to evaluate performance and to determine the allocation of resources (see Part II - Item 8, Note 1 for a description of changes to the Company's reporting segments).
The determination of segment data is described in more detail in Part II - Item 8, Note 18 of the Consolidated Financial Statements in this report. The following sections provide analysis and discussion of results of operations for each of the reporting segments as well as investment results.
12.8 points of improvement in the Property and Casualty combined ratio for the year due to lower catastrophe losses
2018 core earnings reflected a significant level of catastrophe costs. The most significant catastrophe event in 2018 was the Camp Fire in California, which generated gross losses of $150.0 million, and, net losses after reinsurance of $37.9 million pretax. The Camp Fire in California was the largest single catastrophe event for the Company since Hurricane Katrina in 2005.
Rate actions were the primary factor for the slight increase in total premiums written* compared to 2018. For 2019, average approved rate changes were 4.8% for automobile and 3.5% for property.
Automobile premiums written* decreased $8.2 million compared to 2018. In 2019, the average written premium per policy and average earned premium per policy increased 4.1% and 5.3%, respectively, compared to 2018. In 2018, automobile premiums written increased $19.2 million compared to 2017. In 2018, the average written premium per policy and average earned premium per policy increased 6.9% and 6.8%, respectively, compared to 2017. Based on policies in force, the automobile 12 month retention rate for new and renewal policies was 81.1%, 81.9% and 83.0% at December 31, 2019, 2018 and 2017, respectively, with the decrease due to recent rate and underwriting actions. The number of educator policies has been stable relative to overall automobile policies over the past three years as educators represented 85.4%, 85.4% and 85.2% of the automobile policies in force as of December 31, 2019, 2018 and 2017, respectively.
Property and other premiums written* increased $9.8 million compared to 2018, as catastrophe reinstatement reinsurance premiums reduced premiums written by approximately $6.7 million in 2018. While the number of property policies in force has declined, the average written premium per policy and average earned premium per policy increased 6.2% and 5.4%, respectively, compared to 2018. In 2018, the average written premium per policy and average earned premium per policy increased 4.3% and 3.1%, respectively, compared to 2017. Based on policies in force, the property 12 month new and renewal policy retention rate was 87.1%, 88.0% and 87.6% at December 31, 2019, 2018 and 2017, respectively. The number of educator policies has been stable relative to overall property policies over the past three years as educators represented 82.4%, 82.2% and 82.1% of the property policies in force as of December 31, 2019, 2018 and 2017, respectively.
Supplemental contributed $18.0 million of net income during the second half of 2019. The pretax profit margin was 30.8% reflecting this business' focus on efficient operations and product mix. The non-cash impact from amortization of intangible assets recognized in connection with the purchase accounting of NTA reduced pretax net income by $6.6 million.
2019 net income decreased $46.5 million due to the impacts of the annuity reinsurance transaction coupled with a $28.0 million goodwill impairment charge triggered by the transaction. 2019 core earnings* decreased $18.5 million compared to 2018, reflecting the impact of the annuity reinsurance transaction which ceded $2.9 billion of fixed and variable reserves (see Part II - Item 8, Note 6 of the Consolidated Financial Statements for further details). 2019 results also include higher operating expenses from the inclusion of BCG.
2019 includes the results of BCG acquired on January 2, 2019.
2019 annuity contract deposits* increased $23.4 million compared to 2018, reflecting positive momentum in retirement initiatives and in engaging new households. Compared to 2018, variable and fixed annuity deposits increased $11.5 million and $11.9, respectively.
The Company actively manages its interest rate risk exposure, considering a variety of factors, including earned interest rates, credited interest rates and the relationship between the expected durations of assets and liabilities. Management estimates that over the next 12 months approximately $215.0 million of Retirement and Life combined investment portfolio and related investable cash flows will be reinvested at current market rates. As interest rates remain at low levels, borrowers may prepay or redeem the securities with greater frequency in order to borrow at lower market rates, which could increase investable cash flows and exacerbate the reinvestment risk.
As a general guideline, for a 100 basis point decline in the average reinvestment rate and based on the Company's existing policies and investment portfolio, the impact from investing in that lower interest rate environment could further reduce Retirement net investment income by approximately $2.1 million in year one and $6.3 million in year two, further reducing the annualized net interest spread by approximately 8 basis points and 22 basis points in the respective periods, compared to the current period annualized net interest spread. The Company could also consider potential changes in rates credited to policyholders, tempered by any restrictions on the ability to adjust policyholder rates due to minimum guaranteed crediting rates.
The expectation for future annualized net interest spreads is also an important component in the amortization of DAC. In terms of the sensitivity of this amortization to the annualized net interest spread, based on DAC as of December 31, 2019 and assuming all other assumptions are met, a 10 basis point deviation in the current year targeted interest rate spread assumption would impact amortization between $0.3 million and $0.4 million. This result may change depending on the magnitude and direction of any actual deviations but represents a range of reasonably likely experience for the noted assumption.
The Company will continue to be disciplined in executing strategies to mitigate the negative impact on profitability of a sustained low interest rate environment. However, the success of these strategies may be affected by the factors discussed in Part I - Item 1A and other factors within this report.
2019 net income and core earnings* decreased $1.2 million compared to 2018, reflecting lower net investment income and higher expenses partially offset by lower mortality costs. 2018 net income decreased $58.8 million compared to 2017, primarily due to the benefit of a $60.3 million from TCJA enacted in 2017.
2019 net income increased $127.2 million compared to 2018, primarily due to recognition of a $106.9 million after tax realized investment gain in the second quarter of 2019 associated with the annuity reinsurance transaction. 2019 core earnings* decreased $3.1 compared to 2018, driven by increased interest expense as the Company utilized its senior revolving credit facility on July 1, 2019 to partially fund the acquisition of NTA as well as acquisition costs associated with BCG and NTA. 2018 core earnings decreased compared to 2017, driven by transaction costs to acquire BCG and NTA of $4.0 million after tax.
For 2019, pretax net unrealized investment gains on securities were up $193.3 million compared to 2018, reflecting U.S. Treasury rates that declined 76 basis points and tighter credit spreads across most asset classes. For 2018, pretax net unrealized investment gains on securities were down $298.9 million compared to 2017, reflecting U.S. Treasury rates that rose 28 basis points and wider credit spreads across most asset classes.
The table below presents the Company's fixed maturity securities portfolio by major asset class, including the ten largest sectors of the Company's corporate bond holdings (based on fair value) as well as the Company's equity securities portfolio.
Ratings are as assigned primarily by S&P when available, with remaining ratings as assigned on an equivalent basis by Moody's or Fitch. Ratings for publicly traded securities are determined when the securities are acquired and are updated monthly to reflect any changes in ratings.
For 2019, net cash provided by operating activities decreased $73.3 million compared to 2018, primarily due to lower net investment income as a result of a $2.1 billion reduction of invested assets from investments transferred under the annuity reinsurance transaction in the second quarter of 2019.
HMEC's insurance subsidiaries maintain significant investments in fixed maturity securities to meet future contractual obligations to policyholders. In conjunction with its management of liquidity and other asset/liability management objectives, the Company, from time to time, will sell fixed maturity securities prior to maturity, and reinvest the proceeds into other investments with different interest rates, maturities or credit characteristics. Accordingly, the Company has classified the entire fixed maturity securities portfolio as available for sale.
Investing activities include the Company's acquisitions of NTA and BCG in 2019.
Financing activities include primarily payment of dividends, receipt and withdrawal of funds by annuity contractholders, issuances and repurchases of HMEC's common stock, fluctuations in book overdraft balances, and borrowings, repayments and repurchases related to debt facilities.
HMLIC, one of the Company's subsidiaries, operates under funding agreements with FHLB. In 2019, HMLIC received an additional $175.0 million from FHLB under funding agreements as well as repaid FHLB $305.0 million of principal. Advances under funding agreements are reported as Annuity Contracts: Variable, Fixed and FHLB Funding Agreements, Deposits and totaled $495.0 million as of December 31, 2019. For the year ended December 31, 2019, cash inflows from annuity contract deposits, excluding FHLB transactions, increased $23.4 million, or 5.3%, compared to 2018. Cash outflows from annuity contract benefits, withdrawals and net transfers to Separate Account (variable annuity) assets decreased $54.0 million, or 11.4%, compared to 2018.
The following table shows the Company's contractual obligations, as well as the projected timing of payments.
This information represents estimates of both the amounts to be paid to policyholders and the timing of such payments and is net of anticipated reinsurance recoveries.
This discussion addresses the following contractual obligations disclosed above: fixed annuities and fixed option of variable annuities, supplemental contracts and life insurance policies. Payment amounts reflect the Company's estimate of undiscounted cash flows related to these obligations and commitments. Balance sheet amounts were determined in accordance with GAAP, including the effect of discounting, and consequently in many cases differ significantly from the summation of undiscounted cash flows.
Amounts presented in the table above represent the estimated cash payments to be made to policyholders undiscounted by interest and including assumptions related to the receipt of future premiums and deposits, future interest credited, full and partial withdrawals, policy lapses, surrender charges, annuitization, mortality, morbidity, and other contingent events as appropriate to the respective product types. Additionally, coverage levels are assumed to remain unchanged from those provided under contracts in force at December 31, 2019. Separate Account (variable annuity) payments are not reflected due to the matched nature of these obligations and the fact that the contract owners maintain the investment risk on such deposits.
Additional information regarding net unrealized investment gains on securities in the Company's investment portfolio at December 31, 2019 is included in Part II - Item 7, Results of Operations by Segment for the Three Years Ended December 31, 2019 and Part II - Item 8, Note 3 of the Consolidated Financial Statements in this report.
On September 30, 2015, the Board authorized a share repurchase program allowing repurchases of up to $50.0 million of HMEC's common stock, par value $0.001 (Program). The Program authorizes the repurchase of common shares in open market or privately negotiated transactions, from time to time, depending on market conditions. The Program does not have an expiration date and may be limited or terminated at any time without notice. During 2019, the Company did not repurchase any shares of its common stock. In total and through December 31, 2019, 847,373 shares were repurchased under the Program at an average price of $32.16 per share. The repurchase of shares was funded through use of cash. As of December 31, 2019, $22.8 million remained authorized for future share repurchases under the Program.
In November 2015, the Company issued $250.0 million aggregate principal amount of Senior Notes, which will mature on December 1, 2025, at a discount resulting in an effective yield of 4.53%. Interest on the Senior Notes due 2025 is payable semi-annually. Detailed information regarding the redemption terms of the Senior Notes due 2025 is contained in Part II - Item 8, Note 10 of the Consolidated Financial Statements in this report. The Senior Notes due 2025 are traded in the open market (HMN 4.50).
In 2017, Horace Mann Insurance Company (HMIC) became a member of FHLB, which provides HMIC with access to collateralized borrowings and other FHLB products. As membership requires the ownership of membership stock, in June 2017, HMIC purchased common stock to meet the membership requirement. Any borrowing from the FHLB requires the purchase of FHLB activity-based common stock in an amount equal to 4.5% of the borrowing, or a lower percentage - such as 2.0% based on the Reduced Capitalization Advance Program. In 2017, HMIC purchased common stock to meet the activity-based requirement. In 2019, the Board authorized a maximum amount equal to 15% of net aggregate admitted assets less separate account assets of the insurance subsidiaries for FHLB borrowings. In the fourth quarter of 2017, the Company received $50.0 million in executed borrowings for HMIC. For the total $50.0 million received, $25.0 million matures on October 5, 2022 and $25.0 million matures on December 2, 2022. Interest on the borrowings accrues at an annual weighted average rate of 1.99% as of December 31, 2019. HMIC's FHLB borrowings of $50.0 million are included in Long-term debt on the Consolidated Balance Sheets.
All four agencies currently have assigned the same insurance financial strength ratings to the Company's Property and Casualty and the Company's Life insurance subsidiaries. Only A.M Best currently rates the Company's Supplemental segment's subsidiaries. Assigned ratings as of February 15, 2020 were as follows:
Note 8 - Property and Casualty Unpaid Claims and Claim Expenses
We have audited the accompanying consolidated balance sheets of Horace Mann Educators Corporation and subsidiaries (the Company) as of December 31, 2018 and 2019, the related consolidated statements of operations, comprehensive income (loss), changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2019, and the related notes and financial statement schedules I to IV and VI (collectively, the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2019 and 2018, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2019, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 1 to the consolidated financial statements, the Company changed its method of accounting for the change in fair value of equity investments effective January 1, 2018 due to the adoption of ASU No. 2016-01, Financial Instruments - Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities.
Assessment of the estimate of fair value for hard-to-value fixed maturity securities
hard-to-value. This includes securities that use both level II (observable) and level III (unobservable) inputs in the estimation of fair value. The Company estimates the fair value of hard-to-value fixed maturity securities, which includes securities that do not have market observable prices or that trade infrequently. The Company uses judgment to determine the appropriate inputs and assumptions used to estimate the fair value of these hard-to-value securities. The significant inputs and assumptions include benchmark yields, liquidity premium, estimated cash flows, and prepayment and default speeds. As of December 31, 2019, the estimated fair value of fixed maturity securities was $5,791.7 million.
Assessment of the estimate of property and casualty unpaid claims and claim expenses
The primary procedures we performed to address this critical audit matter included the following. We tested certain internal controls over the Company’s process for the development of the estimate of reserves, including controls over methods and assumptions used for the Company’s best estimate. We also involved an actuarial professional with specialized skills and knowledge, who assisted in:
Developing an independent estimate of the reserves for certain lines of business;
Assessment of the fair value of insurance contracts acquired in the National Teachers Association business combination
The primary procedures we performed to address this critical audit matter included the following. We tested certain internal controls over the Company’s acquisition-date valuation process to develop the key assumptions as well as the valuation methods and models used to estimate the fair value of the insurance contracts, consisting of VOBA and insurance policy reserves, and VODA.
Evaluating the valuation methods, models, and assumptions used to estimate the fair value of the insurance contracts, consisting of VOBA and insurance policy reserves, and VODA, in light of the generally accepted actuarial standards;
Comparing the Company’s discount rate, to a discount rate that was independently developed using publicly available market data for comparable entities; and
The subsidiaries of HMEC market and underwrite personal lines of property and casualty insurance products (primarily personal lines automobile and property insurance), supplemental insurance products (primarily heart, cancer, accident and limited supplemental disability coverages), retirement products (primarily tax-qualified annuities) and life insurance, primarily to K-12 teachers, administrators and other employees of public schools and their families. HMEC's principal operating subsidiaries are Horace Mann Life Insurance Company, Horace Mann Insurance Company, Teachers Insurance Company, Horace Mann Property & Casualty Insurance Company, Horace Mann Lloyds, National Teachers Associates Life Insurance Company and NTA Life Insurance Company of New York.
Cash reported on the Consolidated Balance Sheet at December 31, 2019 includes restricted cash in the amount of $0.3 million, representing funds held in segregated accounts for insurance premiums to be remitted to insurance companies on behalf of the Company’s customers or for the purpose of reimbursement to cafeteria plan participants.
The Company invests predominantly in fixed maturity securities. This category includes primarily bonds and notes, but also includes redeemable preferred stocks. These securities are classified as available for sale and carried at fair value, of which a portion represent securities that are hard-to-value.
An adjustment for net unrealized investment gains (losses) on all securities available for sale and carried at fair value, is recognized as a separate component of accumulated other comprehensive income (AOCI) within shareholders' equity, net of applicable deferred taxes and the related impact on DAC associated with annuity contracts and life insurance products with account values that would have occurred if the securities had been sold at their aggregate fair value and the proceeds reinvested at current yields.
Limited partnership interests include investments in commercial mortgage loans, infrastructure, corporate credit, private equity, real estate and other funds. All investments in limited partnership interests are accounted for in accordance with the equity method of accounting.
Investment income is recognized as earned. Investment income reflects amortization of premiums and accrual of discounts on an effective-yield basis.
Realized gains and losses arising from the disposal (recorded on a trade date basis) or impairment of securities are determined based upon specific identification of securities. The Company evaluates all investments in its portfolio for other-than-temporary declines in fair value as described in the following section.
The Company's methodology of assessing other-than-temporary impairments (OTTI) for fixed maturity securities is based on security-specific facts and circumstances as of the reporting date. Based on these facts, if (1) the Company has the intent to sell the security, (2) it is more likely than not the Company will be required to sell the security before the anticipated recovery of the amortized cost basis, or (3) management does not expect to recover the entire amortized cost basis of the security, OTTI is considered to have occurred. Additionally, if events become known that call into question whether the security issuer has the ability to honor its contractual commitments, such security holding will be evaluated to determine whether or not such security has suffered an other-than-temporary decline in fair value.
The Company has a policy and process to evaluate fixed maturity securities (at the cusip/issuer level) on a quarterly basis to assess whether there has been OTTI. These reviews, in conjunction with the Company's investment managers' monthly credit reports and relevant factors such as (1) the financial condition and near-term prospects of the issuer, (2) the length of time and extent to which the fair value has been less than the amortized cost basis (3) the Company's intent to sell a security or whether it is more likely than not the Company will be required to sell the security before the anticipated recovery of the amortized cost basis, (4) the market leadership position of the issuer, (5) the debt ratings of the issuer, and (6) the cash flows and liquidity of the issuer or the underlying cash flows for asset-backed securities, are all considered in the impairment assessment. When OTTI is deemed to have occurred, the investment is written-down to fair value at the trade lot level and the credit-related loss portion is recognized as a net investment loss during the period. The amount of total OTTI related to non-credit factors for fixed maturity securities is recognized in other comprehensive income (OCI), net of applicable taxes, in which the Company has the intent to sell the security or if it is more likely than not the Company will be required to sell the security before the anticipated recovery of the amortized cost basis.
Loan level characteristics such as issuer, FICO score, payment terms, level of documentation, property or residency type, and economic outlook are also utilized in financial models, along with historical performance, to estimate or measure the loan's propensity to default. Additionally, financial models take into account loan age, lease rollovers, rent volatilities, vacancy rates and exposure to refinancing as additional drivers of default. For transactions where loan level data is not available, financial models use a proxy that is based on the collateral characteristics. Loss severity is a function of multiple factors including, but not limited to, the unpaid balance, interest rate, mortgage insurance ratios, assessed property value at origination, change in property valuation and loan-to-value ratio at origination. Prepayment speeds, both actual and estimated, cost of capital rates and debt service ratios are also considered. The cash flows generated by the collateral securing these securities are then estimated with these default, loss severity and prepayment assumptions. These collateral cash flows are then utilized, along with consideration for the Company's position in the overall structure, to estimate the future cash flows associated with the residential or commercial mortgage-backed security held by the Company.
The Company's municipal bond portfolio consists primarily of revenue bonds, which present unique considerations in evaluating OTTI, but also includes general obligation bonds. The Company evaluates revenue bonds for OTTI based on guarantees associated with the repayment from revenues generated by the specified revenue-generating activity associated with the purpose of the bonds. Judgments regarding whether a municipal bond is other-than-temporarily impaired include analyzing the issuer's financial condition and whether there has been a decline in the overall financial condition of the issuer or its ability to service the specific security. Security credit ratings are reviewed with emphasis on the economy, finances, debt and management of the municipal issuer. Certain securities may be guaranteed by the mono - line credit insurers or other forms of guarantee.
The Company's deferred policy acquisition costs (DAC) by reporting segment was as follows:
DAC for investment contracts and life insurance products with account values are adjusted for the impact on estimated future gross profits as if net unrealized investment gains (losses) on securities had been realized at the reporting date. This adjustment reduced DAC by $41.2 million and $17.9 million at December 31, 2019 and 2018, respectively. The after tax impact of this adjustment is included in AOCI (net unrealized investment gains (losses) on securities) within shareholders' equity.
DAC is reviewed for recoverability from future income, including net investment income, and costs that are deemed unrecoverable are expensed in the period in which the determination is made. No such costs were deemed unrecoverable during the years ended December 31, 2019, 2018 and 2017.
Trade names represents the present value of future savings accruing to NTA and BCG by virtue of not having to pay royalties for the use of the trade names, valued using the relief from royalty method. State licenses
represents the regulatory licenses held by NTA that were valued using the cost approach. Both trade names and state licenses are indefinite-lived intangibles that are not subject to amortization.
Goodwill represents the excess of the amounts paid to acquire a business over the fair value of its net assets at the date of acquisition. Goodwill is not amortized, but is tested for impairment at the reporting unit level at least annually or more frequently if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying amount. A reporting unit is defined as an operating segment or a business unit one level below an operating segment, if separate financial information is prepared and regularly reviewed by management at that level. The Company's reporting units, for which goodwill has been allocated, are equivalent to the Company's operating segments. Refer to Note 7 for the allocation of goodwill by reporting unit as of December 31, 2019.
The goodwill impairment test, as defined in GAAP, allows an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying value. If an entity determines it is more likely than not that the fair value of a reporting unit is less than its carrying value, then the entity performs a quantitative goodwill impairment test by comparing the fair value of a reporting unit to its carrying value for purposes of confirming and measuring an impairment. In the second quarter of 2019, the Company adopted guidance to eliminate Step 2 of the goodwill impairment test. Goodwill impairment is now the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. Any amount of goodwill determined to be impaired will be recognized as an expense in the period in which the impairment determination is made.
During each year from 2017 through 2019, the Company completed the required annual goodwill impairment testing. With exception to the goodwill impairment charge described in Note 7, no other goodwill impairment charges were necessary as a result of such assessments. The assessment of goodwill recoverability requires significant judgment and is subject to inherent uncertainty. The use of different assumptions, within a reasonable range, could cause the fair value to be below the carrying value. Subsequent goodwill assessments could result in impairment, particularly for any reporting unit with at-risk goodwill, due to the impact of a volatile financial market on earnings, discount rate assumptions, liquidity and market capitalization.
Separate Account assets represent variable annuity contractholder funds invested in various mutual funds. The Separate Account assets comprise actively traded mutual funds that have daily quoted net asset values that are readily determinable for identical assets that the Company can access. Net asset values for the actively traded mutual funds in which the Separate Account assets are invested are obtained daily from the fund managers. Separate Account liabilities are equal to the estimated fair value of Separate Account assets. The investment income, gains and losses of these accounts accrue directly to the contractholders and are not included in the operations of the Company. The activity of the Separate Accounts is not reflected in the Consolidated Statements of Operations except for (1) contract charges earned, (2) the activity related to contract guarantees, which are benefits on existing variable annuity contracts, and (3) the impact of financial market performance on the amortization of DAC. The Company's contract charges earned include fees charged to the Separate Accounts, including mortality charges, risk charges, policy administration fees, investment management fees and surrender charges.
Liabilities for future policy benefits on certain supplemental and life insurance policies are computed using the net level premium method including assumptions as to investment yields, mortality, morbidity, persistency, expenses and other assumptions based on the Company's experience, including a provision for adverse deviation. These assumptions are established at the time the policy is issued and are intended to estimate the experience for the period the policy benefits are payable. If experience is less favorable than the assumptions, additional liabilities may be established, resulting in recognition of a loss for that period.
The Company offers fixed indexed annuity (FIA) products with interest crediting strategies linked to the Standard & Poor's (S&P) 500 Index and the Dow Jones Industrial Average (DJIA). The Company purchases call options on the applicable indices as an investment to provide the income needed to fund the annual index credits on the indexed products. These products are deferred fixed annuities with a guaranteed minimum interest rate plus a contingent return based on equity market performance and are considered hybrid financial instruments under GAAP.
See Note 4 for more information regarding the determination of fair value for the FIA and IUL embedded derivatives and purchased call options.
of salvage and subrogation on unpaid Property and Casualty claims are deducted from the liability for unpaid claims. Due to the nature of the Company's personal lines business, the Company has no exposure to losses related to claims for toxic waste cleanup, other environmental remediation or asbestos-related illnesses other than claims under property insurance policies for environmentally related items such as mold.
In 2013, Horace Mann Life Insurance Company (HMLIC), and in 2019, NTA became members of FHLB, which provides both subsidiaries with access to collateralized borrowings and other FHLB products. Any borrowing from FHLB requires the purchase of FHLB activity-based common stock in an amount equal to 4.5% of the borrowing, or a lower percentage - such as 2.0% based on the Reduced Capitalization Advance Program. In 2019, HMEC's Board of Directors (Board) authorized a maximum amount equal to 15% of net aggregate admitted assets less separate account assets of the insurance subsidiaries for FHLB advances and funding agreements combined. In 2019, HMLIC received an additional $175.0 million from FHLB under funding agreements as well as repaid FHLB $305.0 million of principal. Outstanding advances under funding agreements are reported as Other policyholder funds in the Consolidated Balance Sheets and totaled $495.0 million as of December 31, 2019 of which $125.0 million matures on September 11, 2020, $20.0 million matures on November 15, 2023, $100.0 million matures on December 15, 2023, $50.0 million matures on January 12, 2024 and the remaining $200.0 million matures on January 16, 2026. Interest on the funding agreements accrues at an annual weighted average rate of 1.87% as of December 31, 2019.
If the Company determines that a reinsurance agreement does not expose the reinsurer to a reasonable possibility of a significant loss from insurance risk, the Company recognizes the reinsurance agreement using the deposit method of accounting. The assets transferred to the reinsurer as consideration paid is reported as a Deposit asset on reinsurance on the Company's Consolidated Balance Sheet. As amounts are received or paid or received, consistent with the underlying reinsured contracts, the Deposit asset on reinsurance is adjusted. The Deposit asset on reinsurance is accreted to the estimated ultimate cash flows using the interest method and the adjustment is reported as Net investment income. See Note 6 for further details.
Premiums and contract charges for life insurance contracts with account values and investment (annuity) contracts consist of charges for the cost of insurance, policy administration and withdrawals. Premiums for long-term traditional life and supplemental policies are recognized as revenues when due over the premium-paying
The Company grants stock options and both service-based and performance-based restricted common stock units (RSUs) to executive officers, other employees and Directors in an effort to attract and retain individuals while also aligning compensation with the interests of the Company's shareholders. Additional information regarding the Company's share-based compensation plans is contained in Note 13.
Stock options are accounted for under the fair value method of accounting using a Black-Scholes valuation model to measure stock option expense at the date of grant. The fair value of RSUs is measured at the market price of the Company's common stock on the date of grant, with the exception of market-based performance awards, for which the Company uses a Monte Carlo simulation model to determine fair value for purposes of measuring RSU expense. For the years ended December 31, 2019, 2018 and 2017, the Company recognized $1.2 million, $1.2 million, and $1.3 million, respectively, of stock option expense as a result of the vesting of stock options during the respective periods. For the years ended December 31, 2019, 2018 and 2017, the Company recognized $5.2 million, $6.6 million and $6.5 million, respectively, in RSU expense as a result of the performance and/or vesting of RSUs during the respective periods.
Total unrecognized compensation expense relating to RSUs outstanding as of December 31, 2019 was approximately $6.6 million. This amount will be recognized as expense over the remainder of the performance and/or vesting period, which is scheduled to be 2020 through 2022. Expense is reflected on a straight-line basis from the date of grant through the end of the performance and/or vesting period for the entire award. Forfeitures of unvested amounts due to terminations are recognized as a reduction to the related expenses.
For the period ended December 31, 2017, deferred taxes attributable to net unrealized investment gains (losses) on fixed maturity and equity securities and Defined benefit plans were re-measured as a result of the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA). ASC 740, Income Taxes, requires that the income tax effect from the deferred tax re-measurement be reflected in the Company’s income tax expense, even if the deferred taxes being re-measured were originally established through AOCI. The mismatch between deferred taxes established in AOCI at 35% and re-measuring these same deferred taxes at 21% through income tax expense results in stranded deferred taxes in AOCI. On February 14, 2018, the Financial Accounting Standards Board (FASB) issued accounting guidance that permits recognition of a reclassification adjustment between AOCI and Retained earnings for stranded deferred tax amounts related to the reduced corporate tax rate enacted under the TCJA. As permitted under its provisions, the Company early adopted the accounting guidance effective for the quarterly period that ended December 31, 2017 and has elected to reclassify the stranded deferred tax amounts. The impact from early adoption resulted in an increase to AOCI and a reduction to Retained earnings of approximately $47.9 million; representing the stranded deferred tax liabilities of $50.0 million and $(2.1) million for net unrealized investment gains (losses) on fixed maturity and equity securities and Defined benefit plans, respectively.
The Company adopted guidance on January 1, 2018 that resulted in reclassifying $15.0 million of after tax net unrealized gains on equity securities from AOCI to Retained earnings.
Comparative information for elements that are not required to be reclassified in their entirety to net income in the same reporting period is located in Note 3.
Effective for the quarter ended March 31, 2019, the Company adopted guidance for leases and elected to utilize a cumulative-effect adjustment to the opening balance of retained earnings. Accordingly, the Company’s reporting for the comparative periods prior to adoption continues to be presented in the financial statements in accordance with previous lease accounting guidance. The Company elected to apply all practical expedients in the guidance for transition for leases in effect at adoption, including using hindsight to determine the lease term of existing leases, the option to not reassess whether an existing contract is a lease or contains a lease and whether the lease is an operating or finance lease. The adoption of the guidance resulted in the Company recognizing a $14.5 million lease liability equal to the present value of lease payments and a $13.9 million right-of-use (ROU) asset, which is the corresponding lease liability adjusted for qualifying accrued lease payments. The lease liability and ROU asset are reported in Other liabilities and Other assets on the Consolidated Balance Sheets. The impact of these changes at adoption had no impact on net income or shareholders' equity.
Effective for the quarter ended June 30, 2019, the Company adopted guidance to simplify the accounting for goodwill impairment. Adoption of this guidance removed Step 2 of the goodwill impairment test, which required a hypothetical purchase price allocation. Goodwill impairment is now the amount by which a reporting unit's carrying value exceeds its fair value, not to exceed the carrying amount of goodwill.
entities, the guidance is effective for annual reporting periods beginning after December 15, 2021, including interim periods within those years. With regards to the liability for future policy benefits and DAC, the guidance applies to contracts in force as of the beginning of the earliest period presented and may be applied retrospectively. With regards to MRBs, the guidance is to be applied retrospectively at the beginning of the earliest period presented. Early adoption is permitted. Management is evaluating the impact this guidance will have on the results of operations and financial position of the Company.
During the fourth quarter of 2019, the Company finalized its estimates of the fair value of NTA assets acquired and liabilities assumed, including, but not limited to, intangible assets, policy reserves, certain tax-related balances and certain investments. In accordance with Accounting Standards Codification (ASC) 805, Business Combinations, changes to the preliminary estimates and allocation as a result of events or conditions as of the acquisition date have been reported in the Company's consolidated financial statements as adjustments to the assets acquired and liabilities assumed. Such adjustments were insignificant. The Company has allocated all of the goodwill associated with the NTA acquisition to the Supplemental segment. The factors that contributed to recognition of goodwill include synergies from economies of scale within underwriting operations, acquiring a talented workforce and cost savings opportunities.
Intangible assets consist of the value of business acquired, value of distribution acquired, agency relationships, trade names and state licenses. The intangible assets that are amortizable have a total weighted average useful life of 23 years. See Note 7 for further information.
The amount of goodwill that is expected to be deductible for federal income tax purposes is $17.9 million.
The following unaudited pro forma information presents the Company's results of operations as if the acquisition of NTA occurred on January 1, 2018. The adjustments to arrive at the unaudited pro forma information below includes, among other things, adjustments for lost investment income on the cash used to fund the acquisition, amortization of an estimated fair value adjustment on NTA's policy reserves, amortization of acquired intangible assets, interest expense on debt incurred to finance the acquisition and exclusion of certain transaction costs attributable to the acquisition as such costs are considered non-recurring.
The unaudited pro forma financial information is not necessarily indicative of the consolidated results of operations that might have been achieved had the transaction in fact occurred at the beginning of the periods presented, nor does the information project results for any future period. The unaudited pro forma information does not include the impact of any future cost savings or synergies that may be achieved as a result of the acquisition.
The components of net investment income for the following periods were:
Net investment gains realized on fixed maturity securities include a $135.3 million realized investment gain associated with a transfer of investments to a reinsurer as consideration paid during the second quarter of 2019 in connection with the reinsurance of a $2.9 billion block of in force fixed and variable annuity business. See Notes 6 and 17 for further information.
The Company, from time to time, sells invested assets subsequent to the reporting date that were considered temporarily impaired at the reporting date. Such sales are due to issuer specific events occurring subsequent to the reporting date that result in a change in the Company's intent or ability to hold an invested asset. The types of events that may result in a sale include significant changes in the economic facts and circumstances related to the invested asset, significant unforeseen changes in liquidity needs, or changes in the Company's investment strategy.
The following table presents the fair value and gross unrealized losses securities in an unrealized loss position at December 31, 2019 and 2018, respectively. The Company views the decrease in fair value of all of the securities with unrealized losses at December 31, 2019 - which was driven largely by increasing interest rates, spread widening, financial market illiquidity and/or market volatility from the date of acquisition - as temporary. As of December 31, 2019, the Company has not made the decision to sell and it is not more likely than not the Company will be required to sell fixed maturity securities with unrealized losses before recovery of the amortized cost basis. Therefore, it was determined that the unrealized losses on the securities presented in the table below were not other-than-temporarily impaired as of December 31, 2019.
The following table summarizes the cumulative amounts related to the Company's credit loss component of OTTI losses on fixed maturity securities held as of December 31, 2019 and 2018 that the Company did not intend to sell as of those dates, and it was not more likely than not that the Company would be required to sell the securities before the anticipated recovery of the amortized cost basis, for which the non-credit portions of OTTI losses were recognized in OCI:
Effective January 1, 2018, with the adoption of new accounting guidance for recognition and measurement of financial instruments, available for sale equity securities were reclassified to equity securities at fair value and the related net unrealized gains were reclassified from AOCI to Retained earnings.
At December 31, 2019 and 2018, fixed maturity securities with a fair value of $26.0 million and $17.7 million, respectively, were on deposit with governmental agencies as required by law in various states in which the insurance subsidiaries of the Company conduct business. In addition, at December 31, 2019 and 2018, fixed maturity securities with a fair value of $594.2 million and $740.0 million, respectively, were on deposit with FHLB as collateral for amounts subject to funding agreements, advances and borrowings that were equal to $545.0 million and $675.0 million at the respective dates. The deposited securities are included in Fixed maturity securities on the Company's Consolidated Balance Sheets.
Unadjusted observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for the assets or liabilities. Level 2 assets and liabilities include fixed maturity securities (1) with quoted prices that are traded less frequently than exchange-traded instruments or (2) values based on discounted cash flows with observable inputs. This category generally includes certain U.S. Government and agency mortgage-backed securities, non-agency structured securities, corporate fixed maturity securities, preferred stocks, derivatives and embedded derivatives.
Fair value estimates are made at a specific point in time, based on available market information and judgments about the financial asset or financial liability, including estimates of both the timing and amount of expected future cash flows and the credit standing of the issuer. In some cases, fair value estimates cannot be substantiated by comparison to independent markets. In addition, the disclosed fair value may not be realized in the immediate settlement of the financial asset or financial liability. The disclosed fair values do not reflect any premium or discount that could result from offering for sale at one time an entire holding of a particular financial asset or financial liability. In periods of market disruption, the ability to observe prices and inputs may be reduced for many instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2 or from Level 2 to Level 3. Potential taxes and other expenses that would be incurred in an actual sale or settlement are not reflected in amounts disclosed.
The fair value of a fixed maturity security is the estimated amount at which the security could be exchanged in an orderly transaction between knowledgeable, unrelated and willing parties. The Company utilizes its investment managers and its custodian bank to obtain fair value prices from independent third-party valuation service providers, broker-dealer quotes, and model prices. Each month, the Company obtains fair value prices from its investment managers and custodian bank, each of which use a variety of independent, nationally recognized pricing sources to determine market valuations for fixed maturity securities. Differences in prices between the sources that the Company considers significant are researched and the Company utilizes the price that it considers most representative of an exit price. Typical inputs used by these pricing sources include, but are not limited to, reported trades, bids, offers, benchmark yield curves, benchmarking of like securities, rating designations, sector groupings, issuer spreads, and/or estimated cash flows, prepayment and default speeds, among others. The Company's fixed maturity securities portfolio is primarily publicly traded, which allows for a high percentage of the portfolio to be priced through pricing services. Approximately 94.1% and 90.7% of the portfolio, based on fair value, was priced through pricing services or index priced as of December 31, 2019 and 2018, respectively. The remainder of the portfolio was priced by broker-dealers or pricing models. When non-binding broker-dealer quotes can be corroborated by comparison to other vendor quotes, pricing models or analyses, the securities are generally classified as Level 2, otherwise they are classified as Level 3. There were no significant changes to the valuation process during 2019.
To determine the fair value of equity securities, the Company utilizes its investment managers and its custodian bank to obtain fair value prices from independent third-party valuation service providers. Each month, the Company obtains fair value prices from its investment managers and custodian bank, each of which use a variety of independent, nationally recognized pricing sources to determine market valuations for equity securities.
Short-term fixed maturity securities - Because of the nature of these assets, carrying amounts generally approximate fair values.
Derivatives, all call options - Fair values are based on the amount of cash expected to be received to settle each derivative on the reporting date. These amounts are obtained from each of the counterparties using industry accepted valuation models and observable inputs. Significant inputs include contractual terms, underlying index prices, market volatilities, interest rates and dividend yields.
The Company did not have any transfers between Levels 1 and 2 during 2019 and 2018. The following tables present reconciliations for the periods indicated for all Level 3 assets and liabilities measured at fair value on a recurring basis.
Includes U.S. Government and federally sponsored agency obligations for mortgage-backed securities and other mortgage-backed securities.
Transfers into and out of Level 3 during the years ended December 31, 2019 and 2018 were attributable to changes in the availability of observable market information for individual fixed maturity securities and short-term investments. The Company's policy is to recognize transfers into and transfers out of the levels as having occurred at the end of the reporting period in which the transfers were determined.
At December 31, 2019, the Company realized a loss of $1.1 million on Level 3 securities. At December 31, 2018 the Company realized a loss of $0.5 million on Level 3 securities. For the years ended December 31, 2019 and 2018, a realized loss of $12.6 million and a realized gain of $7.5 million, respectively, were included in earnings that were attributable to the changes in the fair value of Level 3 liabilities (embedded derivatives) still held.
The notional amount and fair value of call options by counterparty and each counterparty's long-term credit ratings were as follows:
The Company reinsured a $2.9 billion block of in force fixed and variable annuity business with a minimum crediting rate of 4.5%. This represented approximately 50% of the Company’s in force fixed annuity account balances. The arrangement contains investment guidelines and a trust to help meet the Company’s risk management objectives.
The annuity reinsurance transaction was effective April 1, 2019. Under the agreement, approximately $2.2 billion of fixed annuity reserves were reinsured on a coinsurance basis for consideration of approximately $2.3 billion which resulted in recognition of an after tax realized investment gain of $106.9 million. The separate account assets and liabilities of approximately $0.7 billion were reinsured on a modified coinsurance basis and thus, remain on the Company's consolidated financial statements, but the related results of operations are fully reinsured.
The Company determined that the reinsurance agreement does not expose the reinsurer to a reasonable possibility of a significant loss from insurance risk. Therefore, the Company recognizes the reinsurance agreement using the deposit method of accounting. The assets transferred to the reinsurer as consideration paid is reported as a Deposit asset on reinsurance on the Company's Consolidated Balance Sheet. As amounts are received or paid, consistent with the underlying reinsured contracts, the Deposit asset on reinsurance is adjusted. The Deposit asset on reinsurance is accreted to the estimated ultimate cash flows using the interest method and the adjustment is reported as Net investment income.
The Company conducts impairment testing for goodwill at least annually, or more often if events, changes or circumstances indicate that the carrying amount may not be recoverable. See Note 1 for further description of impairment testing.
The annuity reinsurance transaction described in Note 6 triggered a requirement to evaluate the goodwill associated with the annuity business of the Retirement reporting unit. For the evaluation, the fair value of the Retirement reporting unit was measured using a discounted cash flow method. The carrying value exceeded the fair value, resulting in a $28.0 million non-cash goodwill impairment charge during the second quarter of 2019. In the second quarter of 2019, the Company adopted guidance to eliminate Step 2 of the goodwill impairment test and as such, the goodwill impairment charge represented the entire balance of the goodwill associated with the annuity business of the Retirement reporting unit. The goodwill impairment charge was reported as Other expense - goodwill impairment in the Consolidated Statement of Operations.
As of December 31, 2019, the outstanding amounts of definite-lived intangible assets subject to amortization are attributable to the acquisitions of BCG and NTA during 2019. The acquisition of BCG resulted in initial recognition of definite-lived intangible assets subject to amortization in the amount of $14.1 million and the acquisition of NTA resulted in initial recognition of definite-lived intangible assets subject to amortization in the amount of $160.4 million. As of December 31, 2019 the outstanding amounts of definite-lived intangible assets subject to amortization were as follows:
Indefinite-lived intangible assets (not subject to amortization) as of December 31, 2019 were as follows:
NOTE 8 - Property and Casualty Unpaid Claims and Claim Expenses
Shows the amounts by which the Company decreased its reserves in each of the periods indicated for claims occurring in previous periods to reflect subsequent information on such claims and changes in their projected final settlement costs. Also refer to the paragraphs below for additional information regarding the reserve development recorded in 2019, 2018 and 2017.
Benefits, claims and settlement expenses as reported in the Consolidated Statements of Operations also include amounts for Supplemental, Retirement and Life of $109.5 million, $89.9 million, and $86.0 million for the years ended December 31, 2019, 2018 and 2017, respectively, in addition to Property and Casualty amounts.
Numerous risk factors will affect more than one product line. One of these factors is changes in claim department practices, including claim closure rates, number of claims closed without payment, the use of third-party claim adjusters and the level of needed case reserve estimated by the adjuster. Other risk factors include changes in claim frequency, changes in claim severity, regulatory and legislative actions, court actions, changes in economic conditions and trends (e.g., medical costs, labor rates and the cost of materials), the occurrence of unusually large or frequent catastrophic loss events, timeliness of claim reporting, the state in which the claim occurred and degree of claimant fraud. The extent of the impact of a risk factor will also vary by coverages within
An accident year refers to classifying claims based on the year in which the claims occurred. For estimating short-tail coverage reserves (e.g., homeowners and automobile physical damage), which comprise approximately 20.0% of the Company's total loss reserves as of December 31, 2019, the primary actuarial technique utilized is the development of paid loss dollars due to the relatively quick claim settlement period. As it relates to estimating long-tail coverage reserves (primarily related to automobile liability), which comprise approximately 80.0% of the Company's total loss reserves as of December 31, 2019, the primary actuarial technique utilized is the development of reported loss dollars due to the relatively long claim settlement period.
See tables on the following pages of Note 8 for details of the average annual percentage payout of incurred claims by age, also referred to as a history of claims duration and tables illustrating the incurred and paid claims development information by accident year on a net basis for the lines of Homeowners, Auto Liability, and Auto Physical Damage, which represents 99.0% of the Company's incurred losses for 2019.
Net favorable development of total reserves for Property and Casualty claims occurring in prior years was $7.5 million in 2019, $0.3 million in 2018 and $2.7 million in 2017. In 2019, the favorable development was predominantly the result of favorable severity trends in Auto for accident year 2018. In 2018, the favorable development was predominantly the result of favorable severity trends in property for accident years 2016 and prior. In 2017, the favorable development was predominantly the result of favorable severity trends in property for accident years 2015 and prior.
The Company completes a detailed study of Property and Casualty reserves based on information available at the end of each quarter and year. Trends of reported losses (paid amounts and case reserves on claims reported to the Company) for each accident year are reviewed and ultimate loss costs for those accident years are estimated. The Company engages an independent property and casualty actuarial consulting firm to prepare an independent study of the Company's Property and Casualty reserves at December 31st of each year. The result of the independent actuarial study at December 31, 2019 was consistent with management's analysis and selected estimates and did not result in any adjustments to the Company's Property and Casualty reserves recognized.
The information about incurred and paid claims development for the years ended December 31, 2010 to 2018 is presented as unaudited supplementary information.
This line includes Supplemental, Retirement and Life reserves as included in the Consolidated Balance Sheet.
The Company's catastrophe losses incurred of approximately $52.0 million, $107.3 million and $61.8 million for the years ended December 31, 2019, 2018 and 2017, respectively. For 2019, catastrophe losses were impacted by winter storm events in the first part of the year, wind/hail/tornado events in spring and summer months as well as losses from several storms in the latter part of the year.
This measure is not based on accounting principles generally accepted in the U.S. (non-GAAP). An explanation of this non-GAAP measure is contained in the Glossary of Selected Terms included as an exhibit in the Company's reports filed with the SEC.
There were no losses from uncollectible reinsurance recoverables in the three years ended December 31, 2019. Past due reinsurance recoverables as of December 31, 2019 were not material.
For liability coverages, in 2019, the Company reinsured each loss above a retention of $1.0 million with coverage up to $5.0 million on a per occurrence basis and $20.0 million in a clash event. (A clash cover is a reinsurance casualty excess contract requiring two or more casualty coverages or policies issued by the Company to be involved in the same loss occurrence for coverage to apply.) For property coverages, in 2019, the Company
On June 21, 2019, the Company, as borrower, replaced its current line of credit with a new five-year Credit Agreement (Bank Credit Facility). The new Bank Credit Facility increased the amount available on this senior revolving credit facility to $225.0 million from $150.0 million. PNC Capital Markets, LLC and JPMorgan Chase Bank, N.A. served as joint leads on the new agreement, with The Northern Trust Company, U.S. Bank National Association, KeyBank National Association, Comerica Bank and Illinois National Bank participating in the syndicate. Terms and conditions of the new Bank Credit Facility are substantially consistent with the prior agreement, with an interest rate based on LIBOR plus 115 basis points.
On July 1, 2019, the Company utilized the senior revolving credit facility to partially fund the acquisition of NTA. As of December 31, 2019, the amount outstanding on the senior revolving credit facility was $135.0 million. The unused portion of the Bank Credit Facility is subject to a variable commitment fee, which was 0.15% on an annual basis at December 31, 2019.
The Company evaluated sources and character of income, including historical earnings, loss carryback potential, taxable income from future reversals of existing taxable temporary differences, future taxable income exclusive of reversing temporary differences, and taxable income from prudent and feasible tax planning strategies. Although realization of deferred tax assets is not assured, the Company believes it is more likely than not that gross deferred tax assets will be fully realized and that a valuation allowance with respect to the realization of the total gross deferred tax assets was not necessary as of December 31, 2019 and 2018.
At December 31, 2019, the Company had available the following carryforwards or credits.
HMEC and its subsidiaries file a consolidated federal income tax return. The federal income tax sharing agreements between HMEC and its subsidiaries, as approved by the Board, provide that tax on income is charged to each subsidiary as if it were filing a separate tax return with the limitation that each subsidiary will receive the benefit of any losses or tax credits to the extent utilized in the consolidated tax return. Intercompany balances are settled quarterly with a final settlement after filing the consolidated federal income tax return with the IRS. National Teachers Associates Life Insurance Company and NTA Life Insurance Company of New York are not included in the consolidated federal income tax return and will file separate federal income tax returns until they are eligible to participate in the consolidated federal income tax return. This is expected to occur in 2025.
The Company has various operating lease agreements, primarily for real estate offices. Such leases have remaining lease terms of 1 year to 6 years, some of which may include options to extend certain leases for up to an additional 25 years.
During 2017, the Company repurchased 48,440 shares of its common stock, or 0.1% of the shares outstanding as of December 31, 2016, at an aggregate cost of $1.7 million, or an average price of $34.28 per share. During 2018, the Company repurchased 129,112 shares of its common stock, or 0.3% of the shares outstanding as of December 31, 2017, at an aggregate cost of $5.1 million, or an average price of $39.41 per share. During 2019, the Company did not repurchase any shares of its common stock. In total and through December 31, 2019, 2,977,162 shares were repurchased under the Program at an average price of $25.94 per share. The repurchase of shares was funded through use of cash. As of December 31, 2019, $22.8 million remained authorized for future share repurchases under the Program.
At December 31, 2019, the Company held 24,850,484 shares in treasury.
Deferred compensation for Directors is in the form of CSUs, which represent an equal number of common shares to be issued in the future. The outstanding units of Directors serving on the Board accrue dividends at the same rate as dividends paid to HMEC's shareholders. These dividends are reinvested into additional CSUs.
Deferred compensation for employees is in the form of CSUs, which represent an equal number of common shares to be issued in the future. Distributions of employee deferred compensation are allowed to be either in common shares or cash. Through December 31, 2019, all distributions have been in cash. The outstanding units accrue dividends at the same rate as dividends paid to HMEC's shareholders. These dividends are reinvested into additional CSUs.
The weighted average exercise prices of vested and exercisable options as of December 31, 2018 and 2017 were $31.42 and $27.12, respectively.
As of December 31, 2019, based on a closing stock price of $43.66 per share, the aggregate intrinsic (in-the-money) values of vested options and all options outstanding were $3.3 million and $5.3 million, respectively.
HMEC relies largely on dividends from its insurance subsidiaries to meet its obligations for payment of principal and interest on debt, dividends to shareholders and parent company operating expenses, including tax payments pursuant to tax sharing agreements. Payments for share repurchase programs also have this dependency. HMEC's insurance subsidiaries are subject to various regulatory restrictions which limit the amount of annual dividends or other distributions, including loans or cash advances, available to HMEC without prior approval of the insurance regulatory authorities. As a result, HMEC may not be able to receive dividends from such subsidiaries at times and in amounts necessary to pay desired dividends to shareholders. The maximum amount of dividends that may be paid in 2020 from all of HMEC's insurance subsidiaries without prior regulatory approval is $105.3 million, excluding the impact and timing of prior year dividends.
The Company sponsors two qualified and three non-qualified retirement plans. Substantially all employees participate in the 401(k) plan. Both the qualified defined benefit plan and the two non-qualified supplemental defined benefit plans have been frozen since 2002. All participants in the frozen plans are 100% vested in their accrued benefit and all non-qualified supplemental defined benefit plan participants are receiving payments. Certain employees participate in a non-qualified defined contribution plan.
The Company's policy for the frozen defined benefit plan is to contribute to the plan amounts which are actuarially determined to provide sufficient funding to meet future benefit payments as defined by federal laws and regulations.
The discount rates at December 31, 2019 were based on the average yield for long-term, high-grade securities available during the benefit payout period. To set its discount rate, the Company looks to leading indicators, including the Mercer Above Mean Yield Curve.
As of December 31, 2006, upon discontinuation of retiree medical benefits, Health Reimbursement Accounts (HRAs) were established for eligible participants and totaled $7.3 million. As of December 31, 2019, the balance of the previously established HRAs was $1.4 million. Funding of HRAs was $0.1 million, $0.1 million and $0.1 million for the years ended December 31, 2019, 2018 and 2017, respectively.
Non-cash investing activities include $2.1 billion of investments transferred to a reinsurer as consideration paid during the second quarter of 2019 in connection with the Company's reinsurance of a $2.9 billion block of in force fixed and variable annuity business. See Note 6 for further information.
Non-cash investing activities in respect to modifications or exchanges of fixed maturity securities as well as paid-in-kind activity for policy loans were insignificant for the years ended December 31, 2019, 2018 and 2017, respectively.
The Company conducts and manages its business through five segments. See Note 1 for a description of the Company's reporting segments that changed effective in the third quarter of 2019. The four operating segments, representing the major lines of insurance business, are Property and Casualty (primarily personal lines of automobile and property insurance products), the newly created Supplemental (primarily heart, cancer, accident and limited short-term supplemental disability coverages), Retirement (primarily tax-qualified fixed and variable annuities) and Life (life insurance). The Company does not allocate the impact of corporate-level transactions to these operating segments, consistent with the basis for management's evaluation of the results of those segments, but classifies those items in the fifth segment, Corporate and Other. In addition to ongoing transactions such as corporate debt service, net investment gains (losses) and certain public company expenses, such items also have included corporate debt retirement costs, when applicable.