Claim reserves, unlike policy reserves, are subject to revision as current claim experience and projections of future factors affecting claim experience change. In a reporting period, actual experience may deviate from the long-term assumptions used to determine the claim reserves. The Company reviews annually, or more frequently as appropriate, emerging experience to ensure that its claim reserves make adequate and reasonable provision for future benefits and expenses. This review includes the determination of a range of reasonable estimates within which the reserve must fall. The Company’s reserves for group and individual disability products include a provision for future payments other than legal expenses on all lawsuits for which the cause of action has already occurred. This includes known lawsuits and those yet to be filed. The reserve amount is the Company’s estimate of the payments on all such lawsuits based on past payments and expected future payments.
The Company expects that its net periodic benefit cost, which is calculated in accordance with SFAS 87, may substantially increase in 2003 due to the recent decline in the stock market and the general decline in overall corporate bond yields that are used to establish the discount rate for projecting the benefit obligation. Based on projections as of December 31, 2002, the Company estimates its net periodic benefit cost for 2003 will be in the range of $50.0 million to $60.0 million compared to a $2.8 million net periodic benefit cost for 2002.
Group life, accidental death and dismemberment, and long-term care reported operating income of $179.2 million in 2001 compared to $214.0 million in 2000. Included in 2001 operating income is additional benefit expense of $6.7 million related to the September 11, 2001 tragedy.
Group life submitted and paid incidence remained high in 2001, although the incidence rates during the last six months of the year were lower than the rates for the first half of 2001. The average paid claim size has also increased compared to the prior year, and waiver incidence continues to be above recent levels. The claim recovery rate on waiver claims has increased, somewhat mitigating the effect of the increase in waiver incidence.
Operating income for 2002 was $164.2 million compared to $161.1 million in 2001. The overall 2002 benefit ratio for this segment was slightly lower than 2001. The life and cancer product lines each reported a decrease in the benefit ratio compared to the prior year. Life paid claims, as well as the average claim size, declined in 2002 compared to 2001. The cancer block results benefited from the reinsurance transaction entered into during the fourth quarter of 2001, as previously discussed. The individual short-term disability product reported an increase in the benefit ratio, primarily due to an increase in claim incidence and average indemnity relative to 2001. The average claim duration also increased over the prior year. The segment reported increases in the commission and operating expense ratios for 2002 relative to 2001.
Investment activities are an integral part of the Company’s business, and profitability is significantly affected by investment results. Invested assets are segmented into portfolios that support the various product lines. Generally, the investment strategy for the portfolios is to match the effective asset cash flows and durations with related expected liability cash flows and durations to consistently meet the liability funding requirements of the Company’s business. The Company seeks to maximize investment income and total return and to assume credit risk in a prudent and selective manner, subject to constraints of quality, liquidity, diversification, and regulatory considerations. The Company’s overall investment philosophy is to invest in a portfolio of high quality assets that provide investment returns consistent with that assumed in the pricing of its insurance products. Assets are invested predominately in fixed maturity securities, and the portfolio is matched with liabilities so as to eliminate as much as possible the Company’s exposure to changes in the overall level of interest rates. The Company invests for the long term, with the weighted average duration of its liability portfolio approximately 8.52 years at December 31, 2002. The weighted average duration of the Company’s investment portfolio was 7.50 years at December 31, 2002, and the weighted average rating was A.
Below-investment-grade bonds are inherently more risky than investment-grade bonds since the risk of default by the issuer, by definition and as exhibited by bond rating, is higher. Also, the secondary market for certain below-investment-grade issues can be highly illiquid. The Company expects additional downgrades may occur during 2003 and that the Company may experience additional other than temporary impairments in 2003. However, the Company does not anticipate any liquidity problem caused by the investments in below-investment-grade securities, nor does it expect these investments to adversely affect its ability to hold its other investments to maturity.
The Company has an investment in a collateralized bond obligation asset trust in which it is also the investment manager of the underlying high-yield securities. This investment was reported at fair value with fixed maturity securities in the consolidated statements of financial condition. The fair value of this investment was derived from the fair value of the underlying assets. The fair value and amortized cost of this investment was $6.9 million and $30.9 million, respectively, at December 31, 2002, and $20.4 million and $46.0 million at December 31, 2001.
The Company’s exposure to non-current investments totaled $205.8 million at December 31, 2002, or 0.7 percent of invested assets excluding ceded policy loans. These non-current investments are fixed income securities and mortgage loans that became more than thirty days past due in principal and interest payments. Approximately $74.2 million of these investments had principal and interest payments past due for a period greater than one year.
covenants of the credit facilities since their inception, with the exception of the limitation on debt relative to the consolidated statutory earnings of the Company’s insurance subsidiaries, for which it received a waiver for the first, second, and fourth quarters of 2002 due to non-compliance. The Company’s statutory earnings improved during the second quarter and returned to historical levels in the third quarter of 2002, but the covenant stipulates that the most recent twelve month period be used for the statutory earnings test. On August 13, 2002, in connection with the waiver received for the second quarter, the credit facilities were amended to reflect adjusted required levels of consolidated statutory earnings in the calculation of this covenant through 2002 and adjusted required levels of the ratio of senior debt to consolidated statutory earnings through 2003. On March 4, 2003, the Company received a waiver for the limitation on debt relative to the consolidated statutory earnings of the Company’s insurance subsidiaries for the fourth quarter of 2002 to allow for the reporting effects of an intercompany reinsurance transaction.
In the fourth quarter of 2002 and subsequently, the rating agencies have downgraded the senior debt ratings of the Company and the financial strength ratings of the Company’s insurance subsidiaries. Currently, each of the rating agencies have the financial strength and senior debt ratings under review with negative implications. The table below reflects the debt ratings, as of the date of this filing, for the Company and the financial strength ratings for the U.S. domiciled insurance company subsidiaries.
The discount rate is an interest assumption used to convert the benefit payment stream to a present value. The discount rate was determined based on a review of long-term fixed income securities that receive one of the two highest ratings given by a recognized rating agency. In setting the assumption, the Company also has considered the change in the level of interest rates on these securities since the prior year end and the duration of the fixed income indices relative to the duration of the plans’ liabilities. Historically, the Company has used the Moody’s Aa corporate bond index as one of the primary benchmarks in selecting a discount rate. As of December 31, 2002, 2001, and 2000, this index was 6.52 percent, 7.08 percent, and 7.41 percent, respectively. The Company has estimated that the duration of the index is approximately 11 to 12 years. The majority of the obligations in the U.S. pension plans, however, are related to active and deferred vested employees, and duration, therefore, is significantly longer, at approximately 23 years. The Company therefore adjusted the Moody’s index upward by approximately 25 basis points to arrive at the discount rate assumption of 6.75 percent, 7.35 percent, and 7.60 percent as of December 31, 2002, 2001, and 2000, respectively. Between December 31, 2001 and 2002, the Moody’s Aa corporate bond index dropped by 56 basis points (from 7.08 percent to 6.52 percent). The decline in other Moody’s Aa indices (e.g., industrials and utilities) was comparable. Based on this analysis, the Company determined that the 60 basis point decline in the SFAS 87 and SFAS 106 discount rate, from 7.35 percent on December 31, 2001 to 6.75 percent on December 31, 2002, was reasonable. Lowering the discount rate by 0.5 percent would have increased the 2002 pension expense for the U.S. pension plans by $4.1 million and would be expected to result in an $8.5 million increase in the 2003 pension plan expense.
For 2003, the expected long-term rate of return assumption will be lowered to 8.50 percent, reflecting lower average expected returns for equities of about 9.25 percent annually. For the U.S. pension plans, the target asset allocation is 75 percent equities and 25 percent fixed income securities, and the actual asset allocation at December 31, 2002 was 73 percent equities and 27 percent fixed income securities. The equity securities are concentrated in large cap investments and subject to the investment return volatility experienced in the S&P 500. The Company uses a compound interest method in computing the rate of return on pension plan assets. The Company intends to review its pension investment policy during the first half of 2003 and will be rebalancing the asset mix following that review. Lowering the expected long-term rate of return on the plan assets by 0.5 percent would have increased the 2002 pension expense by approximately $2.3 million. For 2003, lowering the assumption by 0.5 percent would increase pension expense by approximately $1.8 million.
The Company’s subsidiaries had net operating loss carryforwards of approximately $496.0 million and capital loss carryforwards of $24.3 million as of December 31, 2002. The majority of the net operating loss carryforwards will begin to expire, if not utilized, in 2020. The capital loss carryforwards, if not utilized, will expire in 2006 and 2007.
Note 8 - Debt and Company-Obligated Mandatorily Redeemable Preferred Securities - Continued
A one percent increase or decrease in the assumed health care cost trend rate at December 31, 2002 and 2001 would have an insignificant impact on the net periodic postretirement benefit cost and postretirement benefit obligation.