Reducing the Company’s leverage by paying maturing debt of $227.0 million.
reassessment from other individuals whose claims were closed after January 1, 1997, and through December 31, 1999, subject to the same closure exceptions as the group receiving notice, and from claimants who dispute the category for closure if it affects their eligibility for reassessment. There will be ongoing oversight by the Company and lead state regulators of the reassessment process. The DOL may also participate in this monitoring of the reassessment process.
The final principal part of the settlement agreements addresses aspects of corporate governance which are intended to reflect today’s greater emphasis in this area and to help establish best practices for the industry. A regulatory compliance unit, reporting directly to a newly formed regulatory compliance committee of the board of directors, was created to monitor the reassessment process, compliance with market conduct regulations and ERISA requirements, as well as general claims handling compliance. The committee will be composed of five independent directors, including two directors with significant insurance industry or insurance regulatory experience.
on claim incidence and severity. Of this amount, approximately $64.0 million was established to reflect higher claim incidence expectations. Claim incidence in the second half of 2003 was 8.4 percent higher than the first half of the year and 5.8 percent above the second half of 2002. The Company’s January 2004 review indicated that claim incidence is expected to continue at an elevated level for several quarters as the Company believes that early indications of a recovering economy are not yet reflected in improved consumer confidence or job creation. Also included in the $140.0 million strengthening was approximately $76.0 million to reflect higher severity expectations driven primarily by a lengthening of claim duration expectations in those claims that have been open 36 months or longer. The $440.0 million reserve increase represented a 5.4 percent increase in total net group income protection reserves as of December 31, 2003, which totaled $8.186 billion prior to this increase.
(2) Equals the sum of “Policy and Contract Benefits”, “Reserves for Future Policy and Contract Benefits and Unearned Premiums”, and “Other Policyholders’ Funds” as reported in the consolidated statements of financial condition.
The Company’s review procedures include, but are not limited to, monthly meetings of certain members of the Company’s senior management personnel to review reports on the entire portfolio, identifying investments with changes in market value of five percent or more, investments with changes in rating either by external rating agencies or internal analysts, investments segmented by issuer, industry, and foreign exposure levels, and any other relevant investment information to help identify the Company’s exposure to possible credit losses.
Sales results shown in the preceding chart generally represent the annualized premium or annualized fee income on new sales expected to be received and reported as premium income or fee income during the next twelve months following or commencing in the initial quarter in which the sale is reported, depending on the effective date of the new sale. Sales do not correspond to premium income or fee income reported as revenue under GAAP because new annualized premiums measure current sales performance, while premium income and fee income are recognized when earned and reflect renewals and persistency of in force policies written in prior years as well as current new sales.
block of U.S. group long-term income protection business will be approximately 80 to 82 percent in 2005. Persistency for group short-term income protection is not expected to be materially different from the level of 2004.
Premium income grew as a result of new sales and continuing stable persistency of the existing block of business. The growth in net investment income in 2004 relative to the prior year was due to the growth in invested assets supporting this line of business.
Premium growth for 2004 relative to 2003 was attributable primarily to the United Kingdom operations and its acquisition of Sun Life, as previously discussed. Also contributing to the growth in premium income was sales growth in the brokerage voluntary lines.
The reinsurance pools and management operations reported revenue of $5.2 million in 2004, $15.5 million in 2003, and $30.0 million in 2002. During 2004, this line of business reported an operating loss of $7.5 million compared to operating losses of $7.1 million and $3.2 million in 2003 and 2002, respectively.
Included in these amounts are the Company’s operating results for its operation in Argentina, which produced operating revenue of $27.7 million, $18.1 million, and $18.4 million in 2004, 2003, and 2002, respectively, and operating income (losses) of $(6.2) million, $(13.4) million, and $0.1 million in each of those three years. As previously discussed, in conjunction with the restructuring of its Argentinean operation, the Company reduced its ownership position in this operation to 40 percent during the fourth quarter of 2004 and reported a before-tax loss of $4.7 million. During 2003, the Company recognized an impairment loss of $13.5 million related to this operation.
$12.0 million loss during the first quarter of 2004 on senior notes issued by a United Kingdom based engineering and manufacturing company engaged in the bus and automotive industry. The company experienced a rapid deterioration in business prospects at its main operating unit in late 2003 and early 2004, followed by the discovery of bookkeeping fraud at one of its business units. Both of these issues were discovered and disclosed to the company’s banks and note holders by outside financial consultants during the first quarter of 2004. The company filed for U.K. administration on March 31, 2004. The securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the third quarter of 2003. At the time of the impairment loss, these securities had been in an unrealized loss position for a period of greater than 180 days but less than 270 days. The circumstances of this impaired investment have no impact on other investments.
The following table is a distribution of the maturity dates for fixed maturity bonds in an unrealized loss position at December 31, 2004.
During the second quarter of 2004, the Company began utilizing a hedging strategy to lock in a reinvestment rate floor for the reinvestment of cash flows from renewals on policies with a one to two year minimum premium rate guarantee. Positions under this hedging program involved the purchase of options on forward interest rate swaps. As of December 31, 2004, the Company had $785.0 million notional amount of options open under this program.
Net cash provided by operating activities was $747.0 million for the year ended December 31, 2004, as compared to $1,345.2 million and $1,786.7 million for the comparable periods of 2003 and 2002, respectively. Included in operating cash flows for 2004 is a cash disbursement of $707.4 million made in conjunction with the reinsurance of the Company’s individual income protection - closed block business. During 2003, by mutual consent the Company amended existing reinsurance contracts with one of its reinsurers to transform the contracts from coinsurance to modified coinsurance arrangements. Under the terms of those amendments, the Company, as the assuming reinsurer, transferred to the ceding reinsurer cash equal to the statutory disabled life reserves of approximately $286.2 million and established a corresponding receivable. The ceding reinsurer will retain the assets backing the statutory disabled life reserves and will credit interest at a 7.00 percent effective annual rate to the Company. This 2003 cash disbursement is included in cash flows from operations.
The Company is dependent upon payments from its subsidiaries to pay dividends to its stockholders, to pay its debt obligations, and to pay its expenses. These payments by the Company’s insurance and non-insurance subsidiaries may take the form of interest payments on amounts loaned to such subsidiaries by the Company, operating and investment management fees, and/or dividends. At December 31, 2004, the Company had outstanding from its insurance subsidiaries a $150.0 million surplus debenture due in 2006 with a weighted average interest rate during 2004 of 8.47 percent and a $100.0 million surplus debenture due in 2027 with a weighted average interest rate during 2004 of 8.25 percent. Semi-annual interest payments are conditional upon the approval by the insurance department of the applicable state of domicile.
Lowering the discount rate by 50 basis points would have increased the 2004 pension expense for the U.S. pension plans by $8.6 million and would be expected to result in a $10.0 million increase in the 2005 pension plan expense.
Pension expense was $11.6 million, $8.8 million, and $4.9 million in 2004, 2003, and 2002, respectively.
In our opinion, management’s assessment that UnumProvident Corporation and subsidiaries maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, UnumProvident Corporation and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the COSO criteria.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
Cash flow hedge. To the extent it is effective, changes in the fair value of the derivative are reported in other comprehensive income and reclassified into earnings in the same period or periods during which the hedged item affects earnings. The ineffective portion of the hedge, if any, is recognized in current earnings during the period of change in fair value. The gain or loss on the termination of an effective cash flow hedge is reported
Effective October 1, 2003, the Company adopted the provisions of Statement of Financial Accounting Standards No. 133 Implementation Issue B36 (DIG Issue B36), Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposure That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor Under Those Instruments. DIG Issue B36 addresses financial accounting and reporting for embedded derivatives in modified coinsurance contracts that incorporate credit risk exposure unrelated to the credit risk of the counterparty to the reinsurance contract and requires the bifurcation of any such derivative from the host reinsurance contract. The Company has two reinsurance contracts for which DIG Issue B36 is applicable. The adoption of DIG Issue B36 resulted in an increase in fixed maturity securities of $61.3 million to record the fair value of the embedded derivatives, a decrease of $116.1 million in miscellaneous assets, $18.4 million in reinsurance receivable, and $134.5 million in accumulated other comprehensive income (net unrealized gain on securities) to eliminate the previously reported adjustment to fair value of the marketable securities held in the trust and the related effects on claim reserves, and a $39.9 million cumulative effect of accounting principle change ($0.14 per common share, basic and assuming dilution), net of $21.4 million in tax. The adoption of DIG Issue B36 requires the change in the fair value of the embedded derivatives to be reported as a realized investment gain or loss during the period of change.
DIG Issue B36 Embedded Derivatives: Fair values are estimated using internal pricing models and represent the hypothetical value of the duration mismatch of assets and liabilities, interest rate risk, and third party credit risk embedded in certain reinsurance agreements entered into by the Company.
During 2004 and 2003, the Company entered into certain foreign currency forward contracts whereby the Company agreed to pay its counterparty a specific Canadian dollar denominated notional amount in exchange for a specific U.S. dollar denominated notional amount. These derivatives were identified as cash flow hedges and were used to eliminate the variability of functional currency cash flows associated with the proceeds from the sale of the Canadian branch. The Company terminated these currency forwards, for cash, at the time of the closing of the sale of the branch and recognized a gain of $2.4 million which was reported as a component of income (loss) from discontinued operations.
During the years ended December 31, 2004, 2003, and 2002, the Company recognized net gains of $29.1 million, $79.6 million, and $45.4 million, respectively, on the termination of cash flow hedges and reported $29.2 million, $79.1 million, and $42.1 million, respectively, in other comprehensive income and $(0.1) million, $0.5 million, and $3.3 million, respectively, as a component of realized investment gains and losses. The Company amortized $20.7 million of net deferred gains into net investment income during 2004, $17.3 million during 2003, and $12.4 million during 2002. The estimated amount of net deferred gains to be amortized into operating earnings during 2005 is $17.2 million. The notional amount of derivatives outstanding under the hedge programs was $4,795.9 million at December 31, 2004. For the year ended December 31, 2004, there was no material ineffectiveness related to the Company’s derivative holdings, and there was no component of the derivative instruments’ gain or loss excluded from the assessment of hedge effectiveness.
The Company also maintains a reserve for life insurance benefits payable to certain former retirees covered under the postretirement welfare plan. The expected return assumption for this reserve was 6.0 percent, which was based on full investment in fixed income securities with an average book yield of 6.72 percent and 7.25 percent for 2004 and 2003, respectively.
On November 30, 2004, the Massachusetts Attorney General issued a Civil Investigative Demand to Unum Life Insurance Company of America relative to the sale of group life insurance to employees of the Commonwealth of Massachusetts. The inquiry relates to bonus payments made to an insurance broker who was hired by the Commonwealth to oversee the bidding process related to this coverage. These bonus payments were later recouped by the Company in cooperation with the Group Insurance Commission of Massachusetts. The Company intends to fully cooperate with the Attorney General’s inquiry into the same matter.