(6) In 2003, the Financial Accounting Standards Board issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51. The Company adopted the provisions of FIN 46 in 2003, resulting in the elimination of the company-obligated mandatorily redeemable preferred securities of subsidiary trust holding solely junior subordinated debt securities of the company and an increase of $300.0 million in long-term debt.
- Strengthening its existing claim reserves for its group income protection business $300.0 million before tax to reflect the actual change in investment portfolio investment yield rates during 2003 and the expectation of lower future investment portfolio yield rates;
- Reducing its holdings in below-investment-grade securities from 10.4 percent of investments (on a carrying value basis) at year end 2002 to 7.8 percent at the end of 2003.
The discount rate is the interest rate at which future benefit cash flows are discounted to determine the current value of those cash flows. It is important since higher discount rates produce lower reserves. If the discount rate is higher than future investment returns, the Company’s reserves will not earn sufficient investment income to support future liabilities. In this case, the reserves will eventually be insufficient. Alternatively, if a discount rate is chosen that is too low relative to future investment results, the reserve, and thus the claim cost in the current period, will be overstated and profits will be accumulated in the reserves rather than released to current shareholders through earnings. The Company sets its discount rate assumptions very carefully in conjunction with the current and expected future investment income rate of the assets supporting the reserves. If the investment yield at which new investments are purchased is below or above the investment yield of the existing investment portfolio, it is likely that the discount rate on new claims will be established below or above the discount rate on existing claims. It is the Company’s intent to use a discount rate that provides some margin for adverse movement in the investment portfolio yield rate. Since policies may receive claim payments for a number of years, it is unlikely that the chosen discount rate assumption will prove to be accurate for any one policy; rather, the discount rate is chosen to apply to many claims with various characteristics of length and severity. The Company uses its experience and analysis of its existing claims and investment performance to determine the appropriate discount rate assumption. Actual claim reserves incurred in the calendar quarter are sensitive to the choice of discount rate. For example, a 25 basis point increase or decrease in the group long-term income protection claim discount rate would have changed a quarter’s incurred claim cost in 2003 by approximately $5.0 million.
The claim resolution rate is the rate of probability that a disability claim will close or change due to maximum benefits being paid under the policy, the recovery or death of the insured, or a change in status in any given period. It is important because it is used to estimate how long benefits will be paid for a claim. Estimated resolution rates that are set too high will result in reserves that are lower than they need to be to pay the claim benefits over time. A claim closes due to maximum benefits being paid if all of the contractual benefits under the policy have been paid. A claim also closes if the policyholder recovers from his or her disability and is no longer receiving disability benefit payments or if the policyholder dies in the period. A claim may change status during the period. For example, a policyholder receiving disability benefits may return to part time work, and the claim benefit may be reduced to reflect the change to partial disability. Establishing claim resolution assumptions is very complex and involves many factors, including the cause of disability, the policyholder’s age, the type of contractual benefits provided, etc. Claim resolution assumptions also vary by duration of disability and time since initially becoming disabled. The Company uses its extensive claim experience and analysis to develop its claim resolution assumptions. Claim resolution experience is studied over a number of years with more weight placed on the more recent experience. Claim resolution assumptions are established to represent the Company’s future resolution rate expectations. Due to the individual nature of each claim, it is unlikely that the claim resolution rate will be accurate for any particular claim. The Company establishes its claim resolution assumptions to apply as an average to its large base of active claims. In this manner, the assumed rates are much more accurate over the broad base of claims. Actual claim reserves incurred in the calendar quarter are sensitive to the choice of resolution rate. For example, a 100 basis point increase or decrease in the group long-term income protection claim resolution rate would have changed a quarter’s incurred claim cost in 2003 by approximately $3.0 million.
Effective December 31, 2003, the Company adopted the provisions of the Financial Accounting Standards Board Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51. FIN 46 expands upon ARB No. 51, Consolidated Financial Statements, to address financial accounting and reporting for certain entities in which a controlling financial interest cannot be identified based on an evaluation of voting interests.
Adoption of FIN 46 also resulted in the de-consolidation of a trust that currently holds $300.0 million of junior subordinated debt securities of the Company and has issued a similar amount of mandatorily redeemable preferred securities. The impact of the de-consolidation was the elimination of the company-obligated mandatorily redeemable preferred securities of subsidiary trust holding solely junior subordinated debt securities of the company included in the consolidated statements of financial condition and an increase of $300.0 million in long-term debt. See Notes 1, 4, and 9 of the “Notes to Consolidated Financial Statements” contained herein in Item 8 for further discussion of FIN 46.
As discussed under “Cautionary Statement Regarding Forward-Looking Statements,” certain risks and uncertainties are inherent in the Company’s group income protection business. Components of claims experience, including, but not limited to, incidence levels and claims duration, may be worse than expected. Management monitors claims experience in group income protection and responds to changes by periodically adjusting prices, refining underwriting guidelines, changing product features, and strengthening risk management policies and procedures. The Company expects to price new business and re-price existing business, at contract renewal dates, in an attempt to mitigate the effect of these and other factors, including interest rates, on new claim liabilities. Given the competitive market conditions for the Company’s income protection products, it is uncertain whether pricing actions can entirely mitigate the effect.
For short-term income protection, the 2003 benefit ratio was higher than in 2002. Paid claim incidence was higher in 2003 than in 2002, but lower during the fourth quarter of 2003 relative to the second and third quarters of 2003. The average weekly indemnity and premium per life continued to increase as expected, but the growth in premium per life was greater than the growth in the average weekly indemnity compared to the growth level relationships experienced in 2002. The average claim duration for closed short-term income protection claims was higher than in 2002.
Positive effects on 2002 operating income for group income protection were increases in both premium income and net investment income and an improvement in the persistency rate on the overall block of group income protection business. Included in other income are ASO fees of $33.9 million for 2002 and $25.7 million for 2001.
Shown below are key performance indicators for individual income protection - recently issued.
Shown below are key performance indicators for individual income protection - closed block.
Premium income increased $68.8 million for 2003 compared to 2002, primarily due to new sales growth in previous periods. New annualized sales for long-term care were $70.9 million for 2003, compared to $87.2 million for the prior year and $75.5 million for 2001. Net investment income continues to increase due to the growth in invested assets supporting this line of business. Persistency in this line of business remains high and stable. Changes in the product offering during 2003 decreased the growth in individual long-term care sales relative to historical trends.
The Other operating segment includes results from products no longer actively marketed (with the exception of certain individual income products), including individual life and corporate-owned life insurance, reinsurance pools and management operations, group pension, health insurance, and individual annuities. It is expected that operating revenue and income in this segment will decline over time as these business lines wind down. Management expects to reinvest the capital supporting these lines of business in the future growth of the Income Protection, Life and Accident, and Colonial segments. The closed lines of business have been segregated for reporting and monitoring purposes.
As of December 31, 2003, the Company’s exposure to below-investment-grade fixed maturity securities was approximately 7.8 percent of the carrying value of invested assets excluding ceded policy loans and fixed maturity securities reported as discontinued operations, compared to 10.4 percent at the end of 2002. This asset class had increased during 2002 primarily from downgrades of existing securities that were previously investment-grade rather than the purchase of additional below-investment-grade securities. During the first quarter of 2003, the Company initiated a program to reduce its below-investment-grade fixed maturity securities holdings to comply with its investment policy regarding diversification and to better position the investment portfolio in today’s environment and reduce exposure to potential credit-related losses. The program was substantially complete at the end of the first quarter of 2003, with sales of approximately $760.9 million in market value and $758.6 million in book value. Gross gains of $23.1 million and gross losses of $20.8 million were recognized on the sale of these securities during the first quarter of 2003.
• $18.1 million loss during the first quarter of 2003 on securities issued by a Norwegian based energy services company engaged in offshore seismic surveying and floating production. The write-down represented 9.7 percent of the total write-downs for 2003. The write-down was taken after further analysis of available information indicated the company’s lack of near term liquidity and that overall industry conditions in the energy sector had negatively affected the operations more than previous analysis had indicated. The securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the third quarter of 2002. At the time of the write-down, these securities had been continuously in an unrealized loss position for a period of greater than three years. The circumstances of this impaired investment have no impact on other investments.
• $14.4 million loss during the first quarter of 2003, or 7.7 percent of the total write-downs for 2003, on securities issued by a United Kingdom electrical generation subsidiary of a U.S. based company. Although this industry’s operating environment in the U.K. weakened over the past few years due to competitive pricing pressures, the company had benefited from a favorable, long-term power sales agreement with a large, investment grade U.K. power customer. Depressed electricity prices in the merchant power market and operating problems at the company, as well as financial difficulties experienced by the company’s U.K. power customer, contributed to a weakened financial profile. In October 2002, the financial problems associated with the major U.K. customer resulted in the termination of the favorable power contract. The company made its December 2002 interest payments as scheduled. However, due to discussions that were initiated between the issuer and senior lenders in the first quarter of 2003 and the continued weakness in the U.K. power market, it was determined that this investment was other than temporarily impaired. The securities were investment-grade at the time of purchase but were downgraded to below-investment-grade in the fourth quarter of 2001. Prior to its write-down, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The Company also owns securities in the previously mentioned U.K. power customer of this issuer and previously recorded an impairment loss on those securities in the fourth quarter of 2002.
• $15.2 million loss during the first three quarters of 2003 on the sale of debt issued by a major domestic airline, representing 10.6 percent of the realized investment loss on sales of fixed maturity securities in 2003. The Company has systematically sold the securities during the first nine months of 2003 to substantially reduce its exposure to the airline. These securities had an investment-grade rating until the various issues were downgraded to below-investment-grade in the third quarter of 2001 and the first quarter of 2002. At the time of the initial sale, the investment had been in an unrealized loss position for a period of greater than one year but less than two years. The Company also took an other than temporary impairment charge of $0.3 million on the value of certain private, secured debt obligations of this issuer as part of a consensual restructuring proposal.
Fixed maturity securities at December 31, 2003, included $31.1 billion, or 99.6 percent, of bonds and $128.0 million, or 0.4 percent, of redeemable preferred stocks. The following table shows the fair value composition by internal industry classification of the fixed maturity bond portfolio and the associated unrealized gains and losses. The fixed maturity securities reported as discontinued operations are included within the industry classifications. The Company does not expect the exclusion of the securities transferred to the buyer of the Canadian branch to materially change the distribution by industry classification.
For those fixed maturity securities with an unrealized loss and on which the Company has not recorded an impairment write-down, the Company believes that the decline in fair value below amortized cost is temporary. The Company has the ability to hold its securities to the earlier of recovery or maturity and intends to hold all of its fixed maturity investments until maturity to meet its liability obligations. If information becomes available that changes the Company’s assessment as to whether the Company will receive contractual payments related to a fixed maturity security and the security is also not projected to recover in value, the related security is generally sold. The Company may also in certain circumstances sell a security because of industry or environmental issues, to extend the duration of the investment portfolio, in response to mergers between issuers or other events which result in positions in excess of the Company’s investment guidelines, and to take advantage of tender offers.
The following table is a distribution of the maturity dates for fixed maturity bonds in an unrealized loss position at December 31, 2003.
As of December 31, 2003, the Company held investment-grade and below-investment-grade securities with a gross unrealized loss of $10.0 million or greater, as follows:
Real estate was $25.9 million and $37.1 million at December 31, 2003 and 2002, 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, amounted to $4.9 million and $8.2 million at December 31, 2003 and 2002, respectively.
successful remarketing of the senior note element of the units, the Company will receive proceeds of approximately $575.0 million and will issue between 43.3 million and 52.9 million shares of common stock. See Note 9 of the “Notes to Consolidated Financial Statements” contained herein in Part II, Item 8 for further description of the units.
At December 31, 2003, the Company had capital commitments of $38.8 million to fund certain of its private placement fixed maturity securities. The funds are due upon satisfaction of contractual notice from the trustee or issuer. These amounts may or may not be funded during the term of the security.
investment objectives. Prior to December 31, 2003, these entities were accounted for as fixed maturity securities in the available for sale portfolio and carried at fair value which was derived from the fair value of the underlying assets. These entities are securitized asset trusts and contain specific financial instruments that do not include the Company’s common stock or debt. Three of these entities are trusts holding forward contracts to purchase unrelated equity securities. Each of these trusts also holds a defeasance swap contract for highly rated bonds to provide principal protection for the investments. The fair value of the underlying forward and swap contracts was $133.9 million at the time of transition to FIN 46, which was equivalent to the fair value at which they would have been reported as fixed maturity securities prior to the adoption of FIN 46. The fourth entity is a trust containing a highly rated bond for principal protection, unrelated equity securities, and several partnership equity investments. The Company contributed the bond and partnership investments into the trust at the time it was established. The purpose of this trust was to allow the Company to maintain its investment in the partnerships while at the same time protecting the principal of the investment. The fair values of the bond, equity securities, and partnerships were $61.8 million, $7.0 million, and $51.7 million, respectively, at the time of transition to FIN 46, which were equivalent to the fair values at which they would have been reported as fixed maturity securities. The adoption of FIN 46 had no impact on the fair value of total invested assets reported in the Company’s consolidated statements of financial condition.
Transition to the provisions of SFAS 142 required the Company to complete, within the year of adoption, impairment tests of goodwill existing at January 1, 2002, measured as of that date using a fair value approach. The Company had previously, prior to the adoption of SFAS 142, used undiscounted cash flows to determine if goodwill was recoverable. Goodwill impairment is deemed to occur if the net book value of a reporting unit exceeds its estimated fair value. The Company’s reporting units are generally operating segments, as defined in Note 14, or one level below the operating segment if that reporting unit constitutes a business. The Company completed the required transitional impairment tests and determined that the carrying value of its goodwill should be reduced $11.0 million. The charge, net of a $3.9 million tax benefit, was $7.1 million ($0.03 per common share, basic and assuming dilution) and is reported as a cumulative effect of accounting principle change in the consolidated statements of operations for the year ended December 31, 2002.
As previously discussed, during 2003 the Company entered into an agreement to sell its Canadian branch. The transaction is expected to close during the first half of 2004. The Canadian branch meets the accounting criteria for being reported as a discontinued operation in the consolidated financial statements and as such, its assets and liabilities are reported separately in the Company’s consolidated statements of financial condition. The Company will be retaining a portion of the Canadian branch fixed maturity bond portfolio according to the terms of the transaction. The specific bonds to be transferred have not yet been identified by the buyer, although the aggregate fair value of bonds to be transferred is approximately $1.1 billion, or 3.5 percent of the fair value of the Company’s total fixed maturity bond portfolio as of December 31, 2003. Because the specific investments to be transferred have not been identified, the disclosures in Note 4 will in some instances necessarily include the total Canadian investment portfolio, including those which will be transferred to the buyer when the transaction closes, with an appropriate disclosure noting that the information includes fixed maturity securities reported separately as discontinued operations in the consolidated statements of financial condition.
As discussed in Note 1, effective December 31, 2003, the Company adopted the provisions of FIN 46. The adoption of FIN 46 had no impact on the fair value of total invested assets reported in the Company’s consolidated statements of financial condition.
The majority of the net balances are related to disability claims with long-tail payouts on which interest earned on assets backing liabilities is an integral part of pricing and reserving. Interest accrued on prior year reserves has been calculated on the opening reserve balance less one-half year’s cash payments at the average reserve discount rate used by the Company during 2003, 2002, and 2001.
During 2001, the Company redeemed its $172.5 million par value 8.8% monthly income debt securities (junior subordinated debt), which were due in 2025 but callable at par in 2000 and thereafter. The early extinguishment of debt resulted in a fourth quarter of 2001 write-off of the remaining deferred debt cost of $4.5 million associated with the issuance of the securities.
The following table provides the components of the net periodic benefit cost (credit) and early retirement cost for the plans described above for the years ended December 31.
During 2003, the Company entered into an agreement to sell its wholly-owned subsidiary UNUM Japan Accident Insurance Co., Ltd. to Hitachi Capital Corporation (Hitachi). In conjunction with the sale, the Company entered into an agreement with Hitachi to reinsure certain existing income protection business. The transaction closed in January 2004.
Although the Company does not expect these regulatory examinations and investigations to affect materially its results of operations or financial position, they could result in, among other things, fines, changes in claims handling and other business practices, increases in policy liabilities, reopening certain closed or denied claims, injury to the Company’s reputation, negative publicity, and harm to the Company’s ability to sell or retain insurance policies. Determinations by regulatory authorities that the Company or its insurance subsidiaries have engaged in improper conduct also could adversely affect the Company’s defense of various lawsuits described herein. The indirect consequences from these regulatory examinations and investigations could have a material adverse effect on the Company.