Principal properties owned by Standard and used by the Company consist of two office buildings in downtown Portland, Oregon: the Standard Insurance Center, with approximately 457,000 square feet; and the Standard Plaza, with approximately 216,000 square feet. In addition, Standard leases 160,000 square feet of office space in a third office building, also located in downtown Portland, Oregon, and 60,000 square feet of offsite storage. All three of our business segments use the facilities described above. The Company also leases 56 offices under commitments of varying terms to support its sales and regional processing offices throughout the United States. Late in 2004, the Company acquired 72,000 square feet of office space in Hillsboro, Oregon. Two of our investment businesses are expected to move to the Hillsboro location in the first quarter of 2005. Management believes that the capacity and types of facilities are suitable and adequate. Management may evaluate additional square footage in 2005 to accommodate its increasing workforce. See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Summary of Significant Accounting Policies-Property and equipment, net.” See also Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Contingencies and Commitments.”
The following management assessment of the financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes thereto. See Item 8, “Financial Statements and Supplementary Data.” Our consolidated financial statements and certain disclosures made in this Form 10-K have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and require us to make estimates and assumptions that affect reported amounts of assets and liabilities and contingent assets and contingent liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during each reporting period. The estimates most susceptible to material changes due to significant judgment are identified as critical accounting policies. The results of these estimates are critical because they affect our profitability and may affect key indicators used to measure the Company’s performance. See “Critical Accounting Policies and Estimates.”
It has been our long-term objective to grow premiums in the range of 10% to 12% annually. Economic conditions, including low interest rates and limited job growth, together with the rising cost of medical premiums faced by our customers, negatively impacted our sales and premium growth in 2004. We believe that improving economic conditions will positively affect our results in 2005. Significant factors that are likely to influence our 2005 financial results when compared to 2004 include:
Strong sales and customer retention in the third and fourth quarters of 2004 will contribute to premium growth in 2005. The Company currently expects to achieve its long-term objective of 10% to 12% premium growth in 2005.
The Company expects the benefit ratio (ratio of benefits to policyholders including interest credited to premiums) for the Employee Benefits segment for 2005 to be lower than the average over the last few years due to expected increases in new investment interest rates and a potential $9 million release of reserves.
Revenues consist primarily of premiums and net investment income. Total revenues increased $82.9 million, or 4.0%, for 2004 compared to 2003, and $312.2 million, or 17.8%, for 2003 compared to 2002. Revenue growth for 2003 includes the effect of the reinsurance of a block of group disability and group life business from TIAA. Effective October 1, 2002, Standard entered into a reinsurance agreement with TIAA to assume TIAA’s group disability and group life insurance business. This business included approximately 1,800 group insurance contracts, representing 650,000 insured individuals. Standard paid a ceding commission of approximately $75 million and received approximately $705 million in assets and corresponding statutory liabilities.
Benefits to policyholders, including interest credited, increased $182.8 million, or 15.4% for 2003, compared to 2002 primarily related to our assumption of the TIAA block of business.
Claims experience can be volatile from quarter to quarter. For an additional discussion of factors affecting benefits to policyholders see “Business Segments”.
Commissions and bonuses primarily represent sales-based compensation, which varies depending on the product, the structure of the commission program and factors such as persistency and profitability of business. Commissions and bonuses increased $10.3 million, or 7.1%, for 2004 compared to 2003, and $11.5 million, or 8.7% for 2003 compared to 2002. Increases for both comparative periods were primarily due to renewals and sales in each of our segments.
We defer certain policy acquisition-related commissions and incentive payments, certain costs of policy issuance and underwriting, and certain printing costs related to obtaining new business and acquiring business through reinsurance agreements. These costs are then amortized into expenses
Three primary factors drive premium growth for the Employee Benefits segment:
Organic growth. The rate of growth in our in force block of business decreased in 2003 and 2004, compared to 2002, in part due to lower wage rate increases and slower employment growth, commensurate with current economic conditions.
While premiums for the Employee Benefits segment increased 3.7% for 2004 compared to 2003, benefits to policyholders decreased $14.8 million or 1.2% for the same comparative periods primarily due to favorable claims experience during 2004. The favorable claims experience resulted from a combination of lower incidence and duration across product lines and industries. In addition, we continued to experience favorable and sustained claims recovery patterns for Employee Benefits group long term disability insurance, and as a result of our on-going assessment of those recovery patterns, we released reserves, which decreased benefits to policyholders, totaling $12.0 million for 2004. If the favorable and sustained claims recovery patterns in our group long term disability insurance continue, we may release up to an additional $9 million of reserves in the first three quarters of 2005. Partially offsetting the release of $12.0 million of reserves for 2004 was a $9 million reserve established as a result of a pricing miscalculation on long term disability contracts with one large Employee Benefits customer.
Should reinvestment rates ultimately prove to be lower than provided for in the margin between the new money investment rate and the reserve discount rate, we could be required to increase reserves which would cause benefits to policyholders to increase. The duration of our invested assets is well matched to the duration of our liabilities in total. Our investments are generally not callable or have prepayment penalties. Based on these factors, we believe the current margin in our overall block of business between invested assets yield and weighted average reserve discount rate of 0.44% is adequate to cover potential reinvestment risk. See “Liquidity and Capital Resources.”
We expect the benefit ratio for the Employee Benefits segment for 2005 to be lower than the average over the past few years due to the effects of expected increases in new investment interest rates and the potential $9 million release of reserves. In the Employee Benefits segment, the benefit ratio can fluctuate widely from quarter to quarter.
Income before income taxes for the Individual Insurance segment was $34.0 million, $37.4 million, and $31.7 million for 2004, 2003, and 2002, respectively. The following table
Premiums for this segment can fluctuate from year to year due in part to an experience rated reinsurance agreement, entered into in 2002, on a block of disability policies related to the Minnesota Life reinsurance agreement. Reinsurance premiums under this agreement, which are recorded as an adjustment to premiums, reduced premiums by $6.2 million and $3.8 million for 2004 and 2003, respectively. If claims experience is consistent with our expectations, this reinsurance agreement is expected to reduce annual premiums by approximately $9 million and annual income before income taxes by approximately $1 million. As the block of business matures over a period of years, the annual effects on premiums and income before income taxes are expected to decrease.
We believe that the annual trend indicated by our past experience in the Individual Insurance segment is a reasonable indicator for the benefit ratio trend for that segment. We expect the volatility in the benefit ratio for this segment to continue, especially when measured on a quarterly basis.
Interest credited as a percentage of net investment income declined for 2004, compared to 2003 and 2002. The decreases correlate with the change in interest rates on invested assets as the investment margin becomes more significant relative to the total return on invested assets.
At December 31, 2004, StanCorp Mortgage Investors was servicing $2.95 billion in commercial mortgage loans for subsidiaries of StanCorp and $747.9 million for other institutional investors. Capitalized mortgage servicing rights associated with commercial loans serviced for other institutional investors were $2.1 million at December 31, 2004. We have specialized expertise in the origination and servicing of small fixed-rate commercial mortgage loans and have generated average annual growth in commercial mortgage loan originations of 40.5% in recent years.
examined. The actuarial models include those used to support the statutory Statement of Actuarial Opinion required annually by insurance regulators. According to presently accepted actuarial standards of practice, statutory reserves of Standard and related items at December 31, 2004 made adequate provision for the anticipated cash flows required to meet contractual obligations and related expenses, in light of the assets held.
The duration of our invested assets was well matched to the duration of our liabilities in total, approximating 4.9 and 5.8, respectively, at December 31, 2004. Generally, duration is a measure of the price sensitivity of assets or liabilities to changes in interest rates. For example, a duration of 5 indicates that a 1% change in interest rates would result in a change of approximately 5% in the economic value of the asset or liability. Our investments generally have prepayment penalties or are not callable. As a percentage of our fixed maturity investments, callable bonds were 1.87% at December 31, 2004.
The Company’s financial instruments are exposed to financial market volatility and potential disruptions in the market that may result in certain financial instruments becoming less valuable. Financial market volatility includes interest rate risk. The Company has analyzed the estimated loss in fair value of certain market sensitive financial assets held at December 31, 2004 and 2003, given a hypothetical 10% increase in interest rates, and related qualitative information on how the Company manages interest rate risk. The interest rate sensitivity analysis was based upon the Company’s fixed maturity securities and commercial mortgage loans held at December 31, 2004 and 2003. Interest rate sensitivity of the Company’s financial assets was measured assuming a parallel shift in interest rates. All security yields were increased by 10% of the year end 10-year U.S. Government Treasury bond yield, or 0.42% for both the 2004 and 2003 analyses. The change in fair value of each security was estimated as the change in the option adjusted value of each security. Option adjusted values were computed using Company payment models and provisions for the effects of possible future changes in interest rates. The analyses did not explicitly provide for the possibility of non-parallel shifts in the yield curve, which would involve discount rates for different maturities being increased by different amounts. The actual change in fair value of the Company’s financial assets can be significantly different from that estimated by the model. The hypothetical reduction in the fair value of the Company’s financial assets that resulted from the model was estimated to be $162 million and $154 million at December 31, 2004 and 2003, respectively.
Net cash provided by operations is net income adjusted for non-cash items and accruals. Net cash provided by operating activities was $404.8 million, $337.4 million, and $380.4 million for 2004, 2003, and 2002, respectively. Adjustments to reconcile net income to net cash provided by operating activities for 2002 included a $20.0 million federal tax refund due to changes in temporary differences associated with a change in tax return filing status in prior years.
The Company maintains a diversified investment portfolio consisting primarily of fixed maturity securities and fixed-rate commercial mortgage loans. Investing cash inflows consist primarily of the proceeds of investments sold, matured, or repaid. Investing cash outflows consist primarily of payments for investments acquired or originated.
represent approximately 40% of our investment portfolio in the future. Net cash used in investing activities for 2003 and 2002 included investments in fixed maturity securities related to proceeds from the TIAA business and approximately $200 million in proceeds received from the issuance of long term debt (see “-Financing Cash Flows”).
Our fixed maturity securities totaled $4.41 billion at December 31, 2004. We believe that we maintain prudent diversification across industries, issuers, and maturities. The overall credit quality of our fixed maturity securities investment portfolio was A (Standard & Poor’s) as of December 31, 2004. The percentage of fixed maturity securities below investment-grade was well below industry averages at 3.9% and 3.5% at December 31, 2004 and 2003, respectively. Our corporate bond industry diversification targets are based on the Lehman Investment Grade Credit Index which is reasonably reflective of the mix of issuers broadly available in the market. We also target a specified level of government, agency and municipal securities in our portfolio for credit quality and additional liquidity.
At December 31, 2004, our commercial mortgage loan portfolio was diversified regionally as follows:
Under the laws of certain states, contamination of a property may give rise to a lien on the property to secure recovery of the costs of cleanup. In some states, such a lien has priority over the lien of an existing mortgage against such property. As a commercial mortgage lender, we customarily conduct environmental assessments prior to making
commercial mortgage loans secured by real estate and before taking title through foreclosure on real estate collateralizing delinquent commercial mortgage loans held by us. Based on our environmental assessments, we believe that any compliance costs associated with environmental laws and regulations or any remediation of affected properties would not have a material adverse effect on the Company’s business, financial position, results of operations or cash flows. However, we cannot provide assurance that material compliance costs will not be incurred by us, which could have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
StanCorp filed a $1.0 billion shelf registration statement with the SEC, which became effective on July 23, 2002, registering common stock, preferred stock, debt securities, and warrants. On September 25, 2002, we completed an initial public debt offering of $250.0 million of 6.875%, 10- year senior notes, pursuant to the shelf registration statement. The principal amount of the senior notes is payable at maturity and interest is payable semi-annually in April and October. Approximately $200 million was used to support payment of the $75 million ceding commission to TIAA to assume the block of business and to maintain Standard’s RBC ratio at our targeted level. The remaining proceeds were used to pay our annual dividend to shareholders, to fund a modest level of share repurchases and for general corporate purposes.
State insurance departments require insurance enterprises to maintain minimum levels of capital and surplus. Our target is generally to maintain capital at 265% to 275% of the company action level RBC, the minimum required by regulators to avoid remedial action by our insurance subsidiaries (this equates to 530% to 550% of the authorized control level RBC by our states of domicile). At December 31, 2004, our statutory capital (adjusted to exclude asset valuation reserves) was $1.02 billion, or 331% of the company action level RBC (which equates to 662% of the authorized control level RBC by our states of domicile).
In addition to maintaining targeted RBC, we seek to maintain excess capital of approximately 5% of consolidated equity excluding accumulated other comprehensive income, or approximately $60 million, as well as amounts sufficient to fund holding company operating expenses, interest on our
debt and our annual dividend to shareholders, totaling approximately $50 million annually. Maintaining capital above targeted levels provides timing flexibility should we wish to access capital markets to finance growth or acquisitions.
The level of excess capital we generate varies in relation to our levels of premium growth primarily due to initial reserve requirements, certain regulatory capital requirements based on premium, and certain acquisition costs associated with policy issuance. At higher levels of premium growth, we generate less excess capital. At very high levels of premium growth, we could generate the need for capital infusions into our insurance subsidiaries. At lower levels of premium growth, we generate more excess capital. Recently, with premium growth levels lower than our long-term objective, we have accumulated additional excess capital. If not utilized, excess capital could reduce return on average equity for 2005, as the rate of return available from the related investments could be less than we would expect to achieve if invested in businesses meeting our return objectives.
During 2004, Standard’s board of directors approved distributions to StanCorp to pay accrued interest and to make partial repayment of principal on the intercompany surplus note up to $155 million. At December 31, 2004, Standard had distributed a total of approximately $140 million related to that approval. The outstanding principal balance on the surplus note was $75 million at December 31, 2004. While the surplus note is outstanding, any distributions from Standard to StanCorp will be applied to the interest and outstanding principal on the surplus note. Standard paid dividends of $65.0 million to StanCorp in 2003.
There is no amount available for payment of dividends by The Standard Life Insurance Company of New York in 2005. There are no regulatory restrictions on dividends from non-insurance subsidiaries to StanCorp. StanCorp Mortgage Investors paid dividends of $10.0 million and $13.2 million to StanCorp for 2004 and 2003, respectively.
Standard & Poor’s, Moody’s Investors Service, Inc., Fitch, Inc., and A.M. Best Company provide debt ratings on our senior debentures. As of December 2004, ratings from these agencies were BBB+, Baa1, A-, and bbb+, respectively.
In January 2004, Standard & Poor’s raised its outlook on our ratings from stable to positive.
In the normal course of business, the Company is involved in various legal actions and other state and federal proceedings. A number of actions or proceedings were pending as of December 31, 2004. In some instances, lawsuits include claims for punitive damages and similar types of relief in unspecified or substantial amounts, in addition to amounts for alleged contractual liability or other compensatory damages. In the opinion of management, the ultimate liability, if any, arising from the actions or proceedings is not expected to have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
Standard and The Standard Life Insurance Company of New York prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by their states of domicile. Prescribed statutory accounting practices include state laws, regulations, and general administrative rules, as well as the Statements of Statutory Accounting Practices (“SSAP”), set forth in publications of the NAIC.
Statutory net gains from insurance operations before federal income taxes were $275.8 million, $214.2 million, and $111.9 million for 2004, 2003, and 2002, respectively. Statutory capital, adjusted to exclude asset valuation reserves, totaled $1.02 billion and $930.4 million at December 31, 2004 and 2003, respectively.
On December 16, 2004, the FASB issued SFAS No.123R, Share Based Payment, which amends SFAS No.123 and SFAS No.95, Statement of Cash Flows, and requires compensation costs related to share-based payment transactions to be recognized in the financial statements. With limited exceptions, the amount of compensation cost will be measured based on the grant-date fair value of the equity or liability instruments issued. In addition, liability awards will be remeasured each reporting period. Compensation cost will be recognized over the period that an employee provides service in exchange for the reward. SFAS No.123R requires the expense of all unvested grants, including grants prior to 2003, to be reported in operating expense (the “modified prospective” method). Options with graded vesting will be expensed more rapidly. The use of the modified prospective method as of the July 1, 2005 effective date will result in additional pre-tax expense of approximately $0.7 million in 2005 and $0.6 million in 2006.
The Company’s investment portfolio includes fixed maturity securities. When the fair value of a fixed maturity security is below its amortized cost, and depending on the length of time the condition exists and the extent the fair market value is below amortized cost, additional analysis is performed to determine whether an impairment exists. The analysis considers the financial condition and near-term prospects of the issuer, as well as the value of any security we may have in the investment. Often, the information available to conduct these assessments is limited and rapidly changing, making estimates of fair value subject to judgment. If actual information or conditions are different than estimated, the extent of the impairment of the fixed maturity security may be different than previously estimated, which could have a material effect on our results of operations and financial condition.
Reserves represent amounts set aside today to pay future benefits and claims. Developing the estimates for reserves (and therefore the resulting impact on earnings) requires varying degrees of subjectivity and judgment, depending upon the nature of the reserve. For most of our reserves, the calculation methodology is prescribed by various accounting and actuarial standards, although judgment is required in the determination of assumptions to use in the calculation. We also hold reserves that lack a prescribed methodology but instead are determined by a formula that we have developed based on our own experience. Because this type of reserve requires a higher level of subjective judgment, we closely monitor its adequacy. Finally, a small amount of reserves is held based entirely upon subjective judgment. These reserves are generally set up as a result of unique circumstances that are not expected to continue far into the future and are released according to pre-established conditions and timelines. Because this type of reserve requires the highest level of subjective judgment, formal documentation of reasoning is required. Currently, these reserves represent less than 1% of total reserves held.
the amount of monthly benefit paid to the insured (less claim amounts recovered from reinsurers);
Certain costs related to obtaining new business and acquiring business through reinsurance agreements have been deferred to accomplish matching against related future premiums or gross profits, as appropriate. We normally defer certain acquisition related commissions and incentive payments, certain costs of policy issuance and underwriting, and certain printing costs. Assumptions used in developing DAC and amortization amounts each period include the amount of business in force, expected future persistency, withdrawals, interest rates and profitability. These assumptions are modified to reflect actual experience when appropriate. The amortization of DAC is charged to current earnings to the extent it is determined that future premiums or gross profits are not adequate to cover the remaining amounts deferred. DAC totaled $132.5 million and $100.0 million at December 31, 2004 and 2003, respectively.
DAC for group disability and group life insurance products are amortized in proportion to future premiums generally over five years. DAC for individual disability insurance products are amortized in proportion to future premiums over the life of the contract averaging 20 to 25 years with approximately 50% and 75% expected to be amortized by years 10 and 15, respectively. DAC for individual deferred annuities are amortized in proportion to expected gross profits generally over 30 years with approximately 50% to 90% expected to be amortized by years 5 and 15, respectively. DAC for group annuity products are amortized in proportion to expected gross profits over 10 years with approximately 30% expected to be amortized by year five.
VOBA primarily represents the discounted future profits of business assumed through reinsurance agreements. VOBA is amortized in proportion to future premiums or future profitability, as appropriate. If actual premiums or future profitability is inconsistent with our assumptions, we could be required to make adjustments to VOBA and related amortization. For the VOBA associated with the Minnesota Life block of business reinsured, the amortization period is up to 30 years. The amortization period of the intangible asset for the marketing agreement with Minnesota Life is 23 years. The VOBA associated with the TIAA transaction is comprised of two parts with differing amortization methods. The amortization periods are up to 10 years for VOBA that is amortized in proportion to premiums and up to 20 years for VOBA that is amortized in proportion to expected gross profits, although approximately 75% is expected to be amortized within 5 years, or by the end of 2007. VOBA totaled $86.3 million and $100.7 million at December 31, 2004 and 2003, respectively.
Some of the statements contained in this MD&A, including those relating to our strategy and other statements that are predictive in nature, that depend on or refer to future events or conditions or that include words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates” and similar expressions, are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. These statements are not historical facts but instead represent only management’s expectations, estimates and projections regarding future events. Similarly, these statements are not guarantees of future performance and involve uncertainties that are difficult to predict, which may include, but are not limited to, the factors discussed below. As a provider of financial products and services, our results of operations may vary significantly in response to economic trends, interest rate changes, investment performance and claims experience. Caution should be used when extrapolating historical results or conditions to future periods.
adverse experience in delinquency rates or loss experience in our commercial mortgage loan portfolio;
Consolidated Statements of Changes in Shareholders’ Equity for the years ended December 31, 2004, 2003 and 2002
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of StanCorp Financial Group, Inc. and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 10, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
We were incorporated under the laws of Oregon as a parent holding company in 1998 and completed our initial public offering of common stock on April 21, 1999. We conduct business through our subsidiaries, including Standard Insurance Company (“Standard”); The Standard Life Insurance Company of New York; StanCorp Mortgage Investors, LLC (“StanCorp Mortgage Investors”); and StanCorp Investment Advisers, Inc. (“StanCorp Investment Advisers”). We are headquartered in Portland, Oregon and through our subsidiaries have the authority to underwrite insurance products in all 50 states.
Certain subsidiaries of StanCorp have interests in low income housing investments. Individually, the interests in these subsidiaries do not represent a significant subsidiary pursuant to the definition in Financial Accounting Standards Board (“FASB”) Interpretation No.46, “Consolidation of Variable Interest Entities,” nor do they meet the requirements for consolidation. The total equity investment in these interests approximated $19 million and $15 million at December 31, 2004 and 2003, respectively.
The consolidated financial statements include StanCorp and its subsidiaries. All significant intercompany balances and transactions have been eliminated. Certain 2003 and 2002 amounts have been reclassified to conform to the current presentation.
to amortized cost prior to the expected date of sale. Once an impairment charge has been recorded, we continue to review the other than temporarily impaired securities for further potential impairment on an on-going basis.
A permanent impairment is recognized on a security if its market value falls below 80% of its book value for 6 months or longer, or it is determined that the value will not recover. During the 6 month period, or as long as the holding is valued below 80% of its book value, the holding is watched for potential permanent impairment. At December 31, 2004, we held no issues that had market values below 80% of their book value.
The following table sets forth the major classifications of the Company’s property and equipment, and accumulated depreciation at December 31:
Property and equipment are stated at cost less accumulated depreciation. The Company provides for depreciation of property and equipment using the half year straight-line method over the estimated useful lives, which are generally 40 years for properties, and from three to ten years for equipment. Leasehold improvements are amortized over the estimated useful life of the asset, not to exceed the life of the lease. Depreciation expense for 2004, 2003, and 2002 was $12.5 million, $12.1 million and $11.6 million respectively. The Company reviews property and equipment for impairment when circumstances or events indicate the carrying amount of the asset may not be recoverable and recognizes a charge to earnings if an asset is impaired.
Non-affiliated tenants leased approximately 41.6%, 41.8%, and 44.1% of the home office properties at December 31, 2004, 2003, and 2002, respectively. Income from the leases is included in net investment income.
Benefits and expenses are matched with recognized premiums to result in recognition of profits over the life of the contracts. The match is accomplished by recording a provision for future policy benefits and unpaid claims and claim adjustment expenses. For most of our product lines, we establish and carry as a liability actuarially determined reserves that are calculated to meet our obligations for future policy benefits and claims. These reserves do not represent an exact calculation of our future benefit liabilities, but are instead estimates based on assumptions concerning a number of factors, including:
Premiums from group life and group and individual disability contracts are generally recognized as revenue monthly when due. Investment-type contract fee revenues consist of charges for policy administration and surrender charges assessed during the period. Charges related to services to be performed are deferred until earned. The amounts received in excess of premiums and fees are included in other policyholder funds in the consolidated balance sheets. Experience rated refunds (“ERRs”) are
computed in accordance with the terms of the contracts with certain group policyholders and are accounted for as an adjustment to premiums.
Awards under the Company’s plans vest over periods ranging from one to four years. Therefore, the cost related to stock-based employee compensation included in the determination of net income for 2004 and prior years is less than that which would have been recognized if the fair value based method had been applied to all awards since the first options were granted in 1999. The following table sets forth the effect on net income and earnings per share if the fair value based method had been applied to all outstanding and unvested awards for the years ended December 31:
In November 2003, the FASB reached a partial consensus under Emerging Issue Task Force (“EITF”) 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF 03-1 required certain quantitative and qualitative disclosures for securities accounted for under SFAS No.115, Accounting for Certain Investments in Debt and Equity Securities, that are impaired at the balance sheet date but for which an other-than-temporary impairment has not been recognized. The portions of EITF 03-1 on which consensus was reached were effective for financial statements for fiscal years ending after December 15, 2003. Effective December 31, 2003, the required disclosures were included in the notes to consolidated financial statements. The portions of EITF 03-1 on which consensus was not reached are not yet final. EITF 03-1 provides more specific guidelines related to SFAS No.115 regarding when impairments need to be recognized through the income statement, as well as on the balance sheet. EITF 03-1 addresses whether a change in the interpretation of temporary impairments due to interest
rate and credit spread moves is appropriate. Under EITF 03-1, companies that do not have the ability and intent to hold an asset with unrealized losses until recovery of fair value would be required to impair the asset. Impaired losses would flow through net income and accretion on the impaired assets would be recognized in investment income in later periods. Currently, the FASB is considering whether a materiality threshold for recognizing impairment may be appropriate. The effective date for EITF 03-1 has been delayed until this determination is made. The Company is evaluating the potential financial statement effect of EITF 03-1.
On December 16, 2004, the FASB issued SFAS No.123R, Share Based Payment, which amends SFAS No.123 and SFAS No.95, Statement of Cash Flows, and requires compensation costs related to share-based payment transactions to be recognized in the financial statements. With limited exceptions, the amount of compensation cost will be measured based on the grant-date fair value of the equity or liability instruments issued. In addition, liability awards will be remeasured each reporting period. Compensation cost will be recognized over the period that an employee provides service in exchange for the reward. SFAS No.123R requires the expense of all unvested grants, including grants prior to 2003, to be reported in operating expense (the “modified prospective” method). The use of the modified prospective method as of the July 1, 2005 effective date will result in additional pre-tax expense of approximately $0.7 million in 2005 and $0.6 million in 2006.
Basic net income per common share was calculated based on the weighted-average number of common shares outstanding. Net income per diluted common share reflects the potential effects of restricted stock grants and exercises of outstanding options. The weighted-average common share and share equivalents outstanding used to compute the dilutive effect of common stock options outstanding were computed using the treasury stock method. The computation of dilutive weighted-average earnings per share does not include options with an option exercise price greater than the average market price because they are antidilutive (i.e., would increase earnings per share). For the years ended December 31, 2004, 2003, and 2002, antidilutive options were not material. Net income per diluted common share was calculated as follows, for the years ended December 31:
We operate through three segments: Employee Benefits, Individual Insurance, and Retirement Plans. Resources are allocated and performance is evaluated at the segment level. The Employee Benefits segment sells group disability and life insurance, group dental insurance, and AD&D insurance. The Individual Insurance segment sells disability insurance and fixed-rate annuities to individuals. The Retirement Plans segment offers full-service 401(k), 457, defined benefit, money purchase pension, and profit sharing plan products and services to small and medium sized employers.
The fair values of investment securities were based on quoted market prices, where available, or on values obtained from independent pricing services. The fair values of commercial mortgage loans were estimated using option adjusted valuation discount rates. The carrying values of policy loans approximate fair values. While potentially
Commercial mortgage loans in California account for 33.3% of our commercial mortgage loan portfolio at December 31, 2004. Due to this concentration, we are exposed to potential losses resulting from the risk of an economic downturn in California as well as to certain catastrophes, such as earthquakes, that may affect the region. Although we diversify our commercial mortgage loan portfolio within California by both location and type of property in an effort to reduce earthquake exposure, such diversification may not eliminate the risk of such losses. We do not require earthquake insurance for properties on which we make commercial mortgage loans, but do consider the potential for earthquake loss based upon seismic surveys and structural information specific to each property when new loans are underwritten.
Historically, the delinquency rate of our California-based commercial mortgage loans has been substantially below the industry average and consistent with our experience in other states. However, if economic conditions in California worsen, we could experience a higher delinquency rate on the portion of our commercial mortgage loan portfolio located in California, which could have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
The commercial mortgage loan valuation allowance is estimated based on evaluating known and inherent risks in the loan portfolio. The allowance is based on management’s analysis of factors including changes in the size and composition of the loan portfolio, actual loan loss experience, economic conditions, and individual loan analysis. A loan is considered impaired when it is probable that the Company will be unable to collect all amounts due, including principal and interest. Loan impairment is measured using discounted cash flows except when the current fair value, reduced by costs to sell, is determinable. Loans that are deemed uncollectible are written off against the allowance, and recoveries, if any, are credited to the allowance.
There were no commercial mortgage loans foreclosed and transferred to real estate during 2004. Commercial mortgage loans foreclosed and transferred to real estate were $1.6 million for 2003. There was no charge against the valuation allowance for the foreclosure in 2003. At December 31, 2004, we had commercial mortgage loans totaling $7.5 million that were more than sixty days delinquent and in the process of foreclosure, most of which have been reinstated since year end. We do not anticipate losses on these mortgages should they proceed through foreclosure. There were no
Other policyholder funds at December 31, 2004, 2003, and 2002 included $954.9 million, $818.1 million, and $710.5 million, respectively, of employer-sponsored defined contribution and benefit plans funds, and $938.4 million, $776.5 million, and $655.5 million, respectively, of individual fixed-rate annuity funds.
StanCorp filed a $1.0 billion shelf registration statement with the SEC, which became effective on July 23, 2002, registering common stock, preferred stock, debt securities, and warrants. On September 25, 2002, we completed an initial public debt offering of $250.0 million of 6.875%, 10-year senior notes, pursuant to the shelf registration statement. The principal amount of the senior notes is payable at maturity and interest is payable semi-annually in April and October.
Prepaid benefit costs of $9.1 million, $15.1 million, and $7.1 million were recognized in the balance sheets at December 31, 2004, 2003, and 2002, respectively.
Equity securities in the employee pension plan portfolio totaled $74.3 million and $67.0 million at December 31, 2004 and 2003, respectively. The plan held no StanCorp securities as plan assets at December 31, 2004 and 2003.
Eligible executive officers, directors, agents, and group producers may participate in one of several non-qualified deferred compensation plans under which a portion of the deferred compensation is matched. The unfunded liability was $8.2 million and $8.0 million at December 31, 2004 and 2003, respectively.
Amounts recognized in the balance sheets at December 31 consisted of accrued benefit cost of $12.8 million, $11.8 million, and $10.6 million for 2004, 2003, and 2002, respectively.
The projected discounted cash flow obligation for the postretirement plan was $47.9 million and $47.3 million at December 31, 2004 and 2003, respectively.
The following table sets forth the Company’s target and actual weighted average asset allocations for the years ended December 31:
At December 31, 2004, the Company has contributed approximately $0.6 million to fund the postretirement benefit plan. The Company expects to make contributions of $0.9 million to its postretirement benefit plan in 2005.
In 2002, we adopted the 2002 Stock Incentive Plan. This plan authorizes the board of directors to grant eligible employees and certain related parties incentive or non-statutory stock options and restricted stock. The maximum number of shares of common stock that may be issued under this plan is 1.5 million. By the end of 2004, 538,465 shares, or options for shares had been issued under the 2002 plan. Employee options are subject to a four-year annual step-vesting schedule beginning one year after the date of grant. Directors’ options vest in one year.
The following tables set forth options outstanding and activity under the stock-based compensation plans for the years ended December 31:
The Company grants to certain key management employees restricted stock in which full ownership is not vested until the attainment of certain financial benchmarks (“performance” shares), or the completion of a specified period of employment with the Company (“retention” shares). Performance shares were first issued in 2000 and were released, subject to the attainment of financial goals, through 2004. A new grant of performance shares was made in 2004 to be released upon attainment of predetermined performance goals for years 2004 through 2006. The Company’s experience with performance shares was as follows for the years ended December 31:
The grant date fair value of the performance shares granted was $65.38 per share for the shares granted in 2004, and $50.74 per share for the shares granted in 2002. There were no performance shares granted in 2003.
The Company’s grants of retention shares were as follows for the years ended December 31:
In order to limit our losses from large exposures, we enter into reinsurance agreements with other insurance companies. During 2004, we reviewed our retention limits and, based on our current size and recent experience, increased our maximum retention limits for our group and individual disability and group life and AD&D contracts. Effective October 1, 2004, we increased our maximum retention limits per individual for group life and AD&D combined from $500,000 to $750,000. Our maximum retention for group disability insurance increased from $10,000 to $15,000 monthly benefit per individual. Except for certain policies in the block of business we assumed from Minnesota Life, our maximum retention increased generally from $3,500 to $5,000 monthly benefit per individual for individual disability policies with effective dates on or after October 1, 2004. On certain Minnesota Life business, we have a maximum retention of $6,000 monthly benefit per individual.
Standard is involved in a reinsurance and third party administration arrangement with The Northwestern Mutual Life Insurance Company (“Northwestern Mutual”) under which group long term and short term disability products are sold using Northwestern Mutual’s agency distribution system. Generally, Standard assumes 60% of the risk, and receives 60% of the premiums for the policies issued. Premiums assumed by Standard for the Northwestern Mutual business accounted for 3.5%, 3.5%, and 3.6% of the Company’s total premiums for 2004, 2003, and 2002, respectively. In addition to assuming risk, Standard provides product design, pricing, underwriting, legal support, claims management, and other administrative services under the arrangement. If Standard were to become unable to meet its obligations, Northwestern Mutual would retain the reinsured liabilities. Therefore, in accordance with an agreement with Northwestern Mutual, Standard established a trust for the benefit of Northwestern Mutual with the market value of assets in the trust equal to Northwestern Mutual’s reinsurance receivable from Standard. The market value of assets required to be maintained in the trust at December 31, 2004 was $200.1 million.
During 2002, Standard formed a strategic marketing alliance with Ameritas Life Insurance Corp. (“Ameritas”) that offers Standard’s policyholders new and more flexible dental coverage options and access to Ameritas’ nationwide preferred provider organization panel of dentists. As part of this alliance, Standard and Ameritas entered into a reinsurance agreement that provides for approximately 15%
of the net dental premiums written by Standard and the risk associated with this premium, to be ceded to Ameritas.
The Terrorism Risk Insurance Act of 2002 (“TRIA”) provided for federal government assistance to property and casualty insurers in the event of material losses due to terrorist acts on behalf of a foreign person or foreign interest. In June 2004, TRIA was extended through the end of 2005. Group life insurance is not currently covered under TRIA. Group life insurance represents a significant portion of our revenues and income. Concentration of risk is inherent in the group life insurance products we offer and we have group life insurance exposure to certain customers in amounts significantly in excess of our catastrophe reinsurance coverage. Because of our concentration of risk, an occurrence of a significant catastrophe or a change in the on-going nature and availability of reinsurance and catastrophe reinsurance could have a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
Recoveries recognized under reinsurance agreements were $50.6 million, $50.3 million, and $42.4 million for 2004, 2003, and 2002, respectively. Amounts recoverable from reinsurers were $887.9 million and $871.9 million at December 31, 2004 and 2003, respectively. Of these amounts, $778.5 million and $777.5 million were from the reinsurance transaction with Protective Life Insurance Company (“Protective Life”) effective January 1, 2001. See “Note 14, Reinsurance of Blocks of Business.”
State insurance departments require insurance enterprises to adhere to minimum Risk-Based Capital (“RBC”) requirements promulgated by the NAIC. At December 31, 2004 and 2003, the insurance subsidiaries’ RBC levels were significantly in excess of that which would require corrective action by the insurance subsidiaries or regulatory agencies. The authorized control level RBC was $153.6 million and $145.6 million of statutory capital and surplus at December 31, 2004 and 2003, respectively. The current amount of distributions approved by the board of directors, based on excess capital at December 31, 2004, is $198 million. We anticipate seeking approval of a distribution from the Oregon Insurance Division during 2005.
The Company leases certain buildings and equipment under non-cancelable operating leases that expire in various years through 2013, with renewal options for periods ranging from one to nine years. Future minimum payments under the leases are 2005, $14.0 million; 2006, $11.6 million; 2007, $8.4 million; 2008, $6.4 million; 2009, $4.8 million and thereafter, $2.7 million. Total rent expense was $14.1 million, $12.2 million, and $13.9 million for the years ended December 31, 2004, 2003, and 2002, respectively.
The Company’s financing obligations generally include debts, lease payment obligations, and commitments to fund commercial mortgage loans. The remaining obligations reflect the long-term portion of other liabilities, excluding the Company’s obligations under our insurance and annuity product contracts. The following table summarizes the Company’s contractual obligations as of December 31, 2004:
In the normal course of business, the Company commits to fund commercial mortgage loans that generally have fixed expiration dates. At December 31, 2004, the Company had outstanding commitments to fund commercial mortgage loans with fixed interest rates ranging from 4.875% to 7.0%, totaling $186.0 million. These commitments generally have fixed expiration dates. A small percentage of commitments expire due to the borrower’s failure to deliver the requirements of the commitment by the expiration date. In these cases, the Company will retain the commitment fee and good faith deposit. Alternatively, if we terminate a commitment due to our disapproval, the commitment fee and deposit will be refunded to the borrower, less an administrative fee.
From time to time, the board of directors has authorized share repurchase programs. Share repurchases are to be effected in the open market or in negotiated transactions in compliance with the safe harbor provisions of Rule 10b-18 under regulations of the Securities Exchange Act of 1934. Execution of the share repurchase program is based upon management’s assessment of market conditions for its common stock and other potential growth opportunities. On November 8, 2004, the board of directors authorized a new share repurchase program of up to 1.5 million shares of StanCorp common stock. The new share repurchase program expires on December 31, 2005, and replaced the Company’s previous share repurchase program.
During 2004, we repurchased approximately 1.2 million shares of common stock at a total cost of $74.7 million for a volume weighted-average price of $63.38 per common share. At December 31, 2004, the Company had 1,453,600 shares remaining under its share repurchase program. Also during 2004, the Company acquired 26,749 shares of common stock from executive officers to cover tax liabilities resulting from the release of performance-based shares at a total cost of $1.8 million for a volume weighted-average price of $67.40 per common share.
During 2003, we repurchased 185,700 shares of common stock at a total cost of $9.3 million for a volume weighted-average price of $50.35 per common share. Also during 2003, the Company acquired 22,986 shares of common stock from executive officers to cover tax liabilities resulting from the release of performance-based shares at a total cost of $1.1 million for a volume weighted-average price of $47.76 per common share.