(5) The Company adopted the provisions of Statement of Financial Accounting Standards No. 133 Implementation 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, in 2003 and SFAS 142 in 2002.
The Company implemented the procedural and organizational changes outlined in the multistate settlement agreements and resulting from other process improvement initiatives. Implementation of the procedural and organizational changes temporarily reduced the operating effectiveness of the Company’s U.S. Brokerage claims management performance. Improving the claim management results was a major operational focus during 2005. Management assessed the causes of the lower than expected underlying performance and has been taking appropriate corrective actions. While progress was made during 2005 in improving operational effectiveness, the claims management results did not improve to the anticipated level. Management expects to restore the claim operational effectiveness during 2006 to reflect greater consistency in the timing of claim decisions, confirm management’s current belief concerning long-term expectations for recovery rates, and reflect any other more permanent effects of the changes, while maintaining the level of quality desired. To the extent that the operational improvement the Company has projected occurs at a slower rate, the Company may incur additional costs in its claim operations during 2006. See “Settlement of Multistate Market Conduct Examination” contained herein for further discussion of the multistate settlement agreements.
In addition to various regulatory agencies investigating issues relating to broker compensation and quoting practices, the Company has been named as a defendant, along with other insurers, in litigation brought by regulatory agencies or private parties in putative class actions making allegations arising out of broker compensation arrangements or quoting practices. For further information on the various lawsuits, see Note 15 of the “Notes to Consolidated Financial Statements” contained herein in Item 8.
In April 2003, the Company completed an analysis of its assumptions related to its U.S. Brokerage group long-term income protection claim reserves. Included in the analysis was a review of active claim reserves, incurred but not reported (IBNR) reserves, and claim reopen reserves. An active claim reserve is established for future benefit payments when a claim is incurred and reported to the Company. IBNR reserves are established on claims which are estimated to have been incurred but not yet reported to the Company. Claim reopen reserves are established for those claimants who have previously recovered but who are anticipated to return to disabled status under the same disability and within a specified period of time, as contractually allowed by the disability policy. The analysis was initiated based on lower claim resolution rates observed during the first quarter of 2003. The claim resolution rate is the rate of probability that a disability claimant will recover, die, or reach maximum benefit limits and no longer receive benefit payments from the Company. Generally, claim resolution rates vary by the age of the claimant at the time of disability, duration or length of time since the disability initially occurred, and claim diagnosis. The claim resolution rates for group long-term income protection during the first quarter of 2003 were below levels anticipated for reserves and were lower than those experienced in the full years 2002, 2001, and 2000. The analysis indicated not only a decrease in overall claim resolution rates, but also a change in claim resolution rates by claim duration. The analysis of emerging claim resolution rates and the reasons driving the changes resulted in a reduction in the Company’s long-term expectations with respect to claim resolution rates. The Company’s long-term expectations applied to all claims incurred regardless of the date of incurral. In addition, the Company reviewed the reserve discount rate, which is the interest rate at which future cash flows for benefits and expenses to be paid are discounted to determine the current value of those cash flows. The Company concluded at that time that a change in its discount rate assumptions was not warranted. Based on the April 2003 analysis, in the first quarter of 2003 the Company increased its U.S. Brokerage group long-term income protection claim reserves by $454.0 million before tax, or $295.1 million after tax, to reflect its current estimate of future benefit obligations. The active claim reserve for claims already reported to the Company and still in open claim status was increased by $516.0 million, the IBNR reserve was decreased by $23.0 million, and the reopen reserve was decreased by $39.0 million before tax. The first quarter 2003 change represented a 7.8 percent increase in total net U.S. Brokerage group income protection reserves as of March 31, 2003, which equaled $5.828 billion prior to this increase.
increase of $440.0 million before tax and $286.0 million after tax. Approximately $300.0 million of the reserve strengthening reflected implementation of a lower discount rate for the Company’s group income protection claim reserves. The discount rate was lowered to reflect the Company’s actual change in investment portfolio yield rates during 2003, the expectation of future investment portfolio yield rates, and the Company’s new discount rate management approach of maintaining a wider spread between its group income protection portfolio investment yield rate and its average discount rate. The Company’s new discount rate management approach is intended to better reflect the current investment environment and position the Company to be more responsive with discount rates on new incurred claims as changes to the investment environment emerge. Approximately $140.0 million of the reserve increase related to a strengthening of the morbidity assumptions to reflect the impact of the Company’s view of a continuing jobless economic recovery 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 6.6 percent increase in total net U.S. Brokerage group income protection reserves as of December 31, 2003, which totaled $6.674 billion prior to this increase.
Risk free interest rates of 4.35 percent for five-year maturities to 4.54 percent for 30-year maturities were derived from the current yield curve for U.S. Treasury Bonds with similar maturities.
Year Ended December 31, 2005 Compared with Year Ended December 31, 2004
Sales highlights for 2005 showing progress in achievement of the strategy of disciplined pricing and a balanced business mix through diversification include:
Growth in premium income during 2005 was attributable to sales growth and stable persistency. The benefit ratio for 2005 was consistent with the prior year, with decreases in the income protection and life lines of business offset by an increase in the cancer and critical illness line of business. Individual short-term income protection claim incidence decreased in 2005 compared to 2004, while the average claim duration for closed claims as well as the average indemnity was higher in 2005 relative to 2004. For accident and sickness products, which are included in the income protection line of business, the claim incidence rate decreased in 2005 relative to the prior year, but the average claim payment increased over that reported for 2004. The life line of business reported an increase in the number of paid claims in 2005 relative to 2004 and a decrease in the average claim payment. The cancer and critical illness line of business was unfavorably impacted by $3.5 million in benefit charges related to litigation.
Excluding the charges noted in (3) above and discussed more fully in the preceding significant transactions and events discussions for each applicable year, the Individual Income Protection - Closed Block segment would have reported operating income of $114.2 million in 2005 and $152.8 million in 2004.
The increase in the benefit ratio for 2004 relative to 2003, excluding the reserve charges in 2004 related to the restructuring of this block and the settlement of the multistate market conduct examination, was due to a decrease in the claim recovery rate relative to the level of 2003, offset somewhat by a decrease in claim incidence rates in 2004 relative to 2003 levels.
Real estate was $18.2 million and $27.4 million at December 31, 2005 and 2004, respectively. Investment real estate is carried at cost less accumulated depreciation. Real estate acquired through foreclosure is valued at fair value at the date of foreclosure and may be classified as investment real estate if it meets the Company’s investment criteria. If investment real estate is determined to be permanently impaired, the carrying amount of the asset is reduced to fair value. Occasionally, investment real estate is reclassified to real estate held for sale when it no longer meets the Company’s investment criteria. Real estate held for sale, which is valued net of a valuation allowance that reduces the carrying value to the lower of cost or fair value less estimated cost to sell, was $6.7 million at December 31, 2005 and $6.2 million at December 31, 2004.
mature but the need for it still exists. The notional amount of derivatives outstanding under the hedge programs was $4,606.5 million at December 31, 2005 and $4,795.9 million at December 31, 2004.
The Company’s policy benefits are primarily in the form of claim payments, and the Company therefore has minimal exposure to the policy withdrawal risk associated with deposit products such as individual life policies or annuities. The Company’s cash flows from operations could be negatively impacted by a decrease in demand for the Company’s insurance products or an increase in the incidence of new claims or the duration of existing claims.
The Company also has the ability to draw a dividend from its U.K. insurance subsidiary, Unum Limited. Such dividends are limited in amount, based on insurance company law in the U.K., which requires a minimum solvency margin. Approximately $240.3 million is available for the payment of dividends from Unum Limited during 2006.
At December 31, 2005 the Company had capital commitments of approximately $71.1 million to fund certain of its private placement fixed maturity securities and for commercial mortgage loan originations. The funds will be due upon satisfaction of contractual notice from the trustee or issuer of the private placement securities or at closing of the mortgage loans. The amounts may or may not be funded.
The Company did not repurchase any of its common stock during 2005.
Lowering the discount rate by 50 basis points would have increased the 2005 pension expense for the U.S. pension plans by $10.0 million and would be expected to result in a $10.7 million increase in the 2006 pension expense.
The Company has executed a series of cash flow hedges using forward contracts on credit spreads. Forward contracts on credit spreads are used to hedge fluctuations in the credit risk rate. A forward contract on credit spreads is an agreement in which the Company agrees with other parties to settle for cash, at a specified future date, the computed value of the change in credit spreads of a specific bond. The Company intends to purchase this specific bond at its current market value at the same time the forward contract is terminated. By entering into the forward contract, the Company is able to lock in the credit spread component of this specific bond’s purchase yield.
The notional amount of derivatives outstanding under the hedge programs was $4,606.5 million at December 31, 2005. For the year ended December 31, 2005, 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. Additionally, there were no gains or losses reclassified into earnings as a result of the discontinuance of cash flow hedges due to the improbability of the original forecasted transactions occurring as anticipated.
In November 2005, the Company issued 6.85% senior debentures due November 15, 2015 in a private offering and received net proceeds of $399.6 million.
The U.S. Brokerage segment includes the Company’s U.S. group income protection insurance, group life and accidental death and dismemberment products, and supplemental and voluntary lines of business, comprised of individual income protection - recently issued, group and individual long-term care, and brokerage voluntary workplace benefits products. These products are marketed through the Company’s field sales personnel who work in conjunction with independent brokers and consultants. The Company utilizes a distribution model for the sale of individual income protection and individual long-term care insurance products whereby independent brokers and consultants are provided direct access to a sales support center centrally located in the Company’s corporate offices.
Included in benefits and expenses is depreciation and amortization, including the 2004 impairment charges of $856.4 million related to the restructuring of the individual income protection - closed block business. These expenses by segment are as follows:
On May 7, 2003 the first of three identical putative securities class actions was filed in the Southern District of New York, which were later consolidated under the caption Azzolini v. CorTs Trust II for Provident Financial Trust, et al. This action alleges claims on behalf of a putative class of purchasers of UnumProvident Corporate-Backed Trust Securities (CorTs) certificates that were issued by certain underwriter defendants unaffiliated with the Company.