UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2008
OR
For the transition period from to
Commission file number 1-10890
HORACE MANN EDUCATORS CORPORATION
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
1 Horace Mann Plaza, Springfield, Illinois 62715-0001
(Address of principal executive offices, including Zip Code)
Registrant’s Telephone Number, Including Area Code: 217-789-2500
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark the registrant’s filer status, as such terms are defined in Rule 12b-2 of the Act.
Indicate by check mark whether the registrant is a shell company as defined in Rule 12b-2 of the Act. Yes¨ No x
As of October 31, 2008, 39,061,788 shares of Common Stock, par value $0.001 per share, were outstanding, net of 21,813,196 shares of treasury stock.
FOR THE QUARTER ENDED SEPTEMBER 30, 2008
INDEX
PART I - FINANCIAL INFORMATION
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations and Comprehensive Income (Loss)
Consolidated Statements of Changes in Shareholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
PART II -
OTHER INFORMATION
SIGNATURES
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders
Horace Mann Educators Corporation:
We have reviewed the accompanying consolidated balance sheet of Horace Mann Educators Corporation and subsidiaries (the Company) as of September 30, 2008, the related consolidated statements of operations and comprehensive income (loss) for the three-month and nine-month periods ended September 30, 2008 and 2007, and the related consolidated statements of changes in shareholders’ equity and cash flows for the nine-month periods ended September 30, 2008 and 2007. These consolidated financial statements are the responsibility of the Company’s management.
We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of the Company as of December 31, 2007, and the related consolidated statements of operations and comprehensive income, changes in shareholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated February 28, 2008, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2007, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it was derived.
As discussed in Note 1 to the December 31, 2007 consolidated financial statements, the Company adopted American Institute of Certified Public Accountants (“AICPA”) Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts”, effective January 1, 2007. As discussed in Note 6 to the December 31, 2007 consolidated financial statements, the Company adopted FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No 109”, effective January 1, 2007.
Chicago, Illinois
November 7, 2008
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CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
Investments
Fixed maturities, available for sale, at fair value
Fixed maturities (amortized cost 2008, $3,829,472; 2007, $3,795,665)
Fixed maturity securities on loan (amortized cost 2008, $0; 2007, $74,599)
Total fixed maturities
Equity securities, available for sale, at fair value (amortized cost 2008, $81,608; 2007, $94,083)
Short-term and other investments
Short-term investments, loaned securities collateral
Total investments
Cash
Accrued investment income and premiums receivable
Deferred policy acquisition costs
Goodwill
Value of acquired insurance in force
Other assets
Separate Account (variable annuity) assets
Total assets
Policy liabilities
Fixed annuity contract liabilities
Interest-sensitive life contract liabilities
Unpaid claims and claim expenses
Future policy benefits
Unearned premiums
Total policy liabilities
Other policyholder funds
Liability for securities lending agreements
Other liabilities
Short-term debt
Long-term debt
Separate Account (variable annuity) liabilities
Total liabilities
Preferred stock, $0.001 par value, authorized 1,000,000 shares; none issued
Common stock, $0.001 par value, authorized 75,000,000 shares; issued, 2008, 60,874,984; 2007, 60,855,455
Additional paid-in capital
Retained earnings
Accumulated other comprehensive loss net of taxes:
Net unrealized gains and losses on fixed maturities and equity securities
Net funded status of pension and other postretirement benefit obligations
Treasury stock, at cost, 2008, 21,813,196 shares; 2007, 18,614,971 shares
Total shareholders’ equity
Total liabilities and shareholders’ equity
See accompanying Notes to Consolidated Financial Statements.
See accompanying Report of Independent Registered Public Accounting Firm.
2
CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME (LOSS) (UNAUDITED)
(Dollars in thousands, except per share data)
Revenues
Insurance premiums and contract charges earned
Net investment income
Net realized investment gains (losses)
Other income
Total revenues
Benefits, losses and expenses
Benefits, claims and settlement expenses
Interest credited
Policy acquisition expenses amortized
Operating expenses
Amortization of intangible assets
Interest expense
Total benefits, losses and expenses
Income (loss) before income taxes
Income tax expense (benefit)
Net income (loss)
Net income (loss) per share
Basic
Diluted
Weighted average number of shares and equivalent shares (in thousands)
Comprehensive income (loss)
Other comprehensive income (loss), net of taxes:
Change in net unrealized gains and losses on fixed maturities and equity securities
Change in net funded status of pension and other postretirement benefit obligations
Other comprehensive income (loss)
Total
3
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)
Common stock
Beginning balance
Options exercised, 2008, 0 shares; 2007, 183,227 shares
Conversion of Director Stock Plan units, 2008, 16,355 shares; 2007, 18,362 shares
Conversion of restricted stock units, 2008, 3,174 shares; 2007, 2,115 shares
Ending balance
Options exercised and conversion of Director Stock Plan units and restricted stock units
Share-based compensation expense
Cash dividends, $0.315 per share
Accumulated other comprehensive income (loss), net of taxes:
Treasury stock, at cost
Beginning balance, 2008, 18,614,971 shares; 2007, 17,503,371 shares
Purchase of 3,198,225 shares in 2008; 0 shares in 2007
Ending balance, 2008, 21,813,196 shares; 2007, 17,503,371 shares
Shareholders’ equity at end of period
4
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Cash flows - operating activities
Premiums collected
Policyholder benefits paid
Policy acquisition and other operating expenses paid
Federal income taxes paid
Investment income collected
Interest expense paid
Other
Net cash provided by operating activities
Cash flows - investing activities
Fixed maturities
Purchases
Sales
Maturities, paydowns, calls and redemptions
Net cash used in short-term and other investments
Net cash used in investing activities
Cash flows - financing activities
Dividends paid to shareholders
Purchase of treasury stock
Exercise of stock options
Repurchase of Senior Convertible Notes
Annuity contracts, variable and fixed
Deposits
Benefits and withdrawals
Net transfer to Separate Account (variable annuity) assets
Life policy accounts
Withdrawals and surrenders
Change in bank overdrafts
Net cash used in financing activities
Net increase (decrease) in cash
Cash at beginning of period
Cash at end of period
5
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
September 30, 2008 and 2007
Note 1 - Basis of Presentation
The accompanying unaudited consolidated financial statements of Horace Mann Educators Corporation (“HMEC”; and together with its subsidiaries, the “Company” or “Horace Mann”) have been prepared in accordance with United States (“U.S.”) generally accepted accounting principles (“GAAP”) and with the rules and regulations of the Securities and Exchange Commission (“SEC”), specifically Regulation S-X and the instructions to Form 10-Q. Certain information and note disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted. The Company believes that these consolidated financial statements contain all adjustments (consisting of normal recurring accruals) which are, in the opinion of management, necessary to present fairly the Company’s consolidated financial position as of September 30, 2008, the consolidated results of operations and comprehensive income (loss) for the three and nine months ended September 30, 2008 and 2007, and the consolidated changes in shareholders’ equity and cash flows for the nine months ended September 30, 2008 and 2007. The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect (1) the reported amounts of assets and liabilities, (2) disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and (3) the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The subsidiaries of HMEC market and underwrite tax-qualified retirement annuities and private passenger automobile, homeowners, and life insurance products, primarily to K-12 educators and other employees of public schools and their families. The Company’s principal operating subsidiaries are Horace Mann Life Insurance Company, Horace Mann Insurance Company, Teachers Insurance Company, Horace Mann Property & Casualty Insurance Company and Horace Mann Lloyds.
These consolidated financial statements should be read in conjunction with the consolidated financial statements and the related notes to consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
The results of operations for the three and nine months ended September 30, 2008 are not necessarily indicative of the results to be expected for the full year.
The Company has reclassified the presentation of certain prior period information to conform with the 2008 presentation.
Deferred Policy Acquisition Costs
Deferred policy acquisition costs for interest-sensitive life and investment contracts are adjusted for the impact on estimated future gross profits as if net unrealized investment gains and losses had been realized at the balance sheet date. The impact of this adjustment is included in net unrealized gains and losses within shareholders’ equity. Compared to December 31, 2007, the increase in deferred policy acquisition costs at September 30, 2008 primarily was due to the impact of this factor.
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Note 1 - Basis of Presentation-(Continued)
Adoption of SFAS No. 159
Effective January 1, 2008, the Company adopted Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS” or “FAS”) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115”. SFAS No. 159 permits all entities to choose to elect, at specified election dates, to measure eligible financial instruments, as defined in SFAS No. 159, at fair value. Changes in unrealized gains and losses on items for which the fair value option has been elected are reported in earnings at each subsequent reporting date and upfront costs and fees related to those items will be reported in earnings as incurred and not deferred. At adoption, for those financial assets and financial liabilities which management has elected to carry at fair value, an entity will report the effect of the first remeasurement to fair value as a cumulative-effect adjustment to the opening balance of retained earnings. The Company’s management did not elect to measure any additional eligible financial assets or financial liabilities at fair value and as a result, adoption of this SFAS did not have an effect on the results of operations or financial position of the Company.
Adoption of SFAS No. 157
Effective January 1, 2008, the Company adopted FASB SFAS No. 157, “Fair Value Measurements”. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. This pronouncement did not require any new fair value measurements and its adoption did not affect the results of operations or financial position of the Company. In February 2008, the FASB issued FASB Staff Position (“FSP”) No. FAS 157-2, “Effective Date of FASB Statement No. 157”, which defers the effective date of SFAS No. 157 for one year for nonfinancial assets and nonfinancial liabilities that are not disclosed at fair value in the consolidated financial statements on a recurring basis. The FSP did not defer the recognition and disclosure requirements for financial or nonfinancial assets and liabilities that are measured at least annually. In February 2008, the Company adopted FSP No. FAS 157-2, and pursuant to its provisions has delayed the application of SFAS No. 157 for fair value measurements used in the impairment testing of goodwill. In October 2008, the FASB issued FSP No. FAS 157-3, “Determining the Fair Value of a Financial Asset in a Market That Is Not Active”. FSP FAS No. 157-3 was effective upon issuance, and applies to periods for which financial statements have not been issued. The FSP’s guidance clarifies various application issues with respect to the objective of a fair value measurement, distressed transactions, relevance of observable data, and the use of management’s assumptions. The Company adopted FSP No. FAS 157-3 in the preparation of its September 30, 2008 financial statements; however, adoption did not have a material effect on the results of operations or financial position of the Company. The Company’s expanded disclosures as a result of SFAS No. 157 are included in “Note 4 — Fair Value Measurements”.
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Note 2 - Debt and Subsequent Event
Indebtedness outstanding was as follows:
Short-term debt:
Bank Credit Facility
Long-term debt:
6.05% Senior Notes, due June 15, 2015. Aggregate principal amount of $75,000 less unaccrued discount of $179 and $198 (6.1% imputed rate)
6.85% Senior Notes, due April 15, 2016. Aggregate principal amount of $125,000 less unaccrued discount of $288 and $317 (6.9% imputed rate)
The Bank Credit Facility, 6.05% Senior Notes due 2015 (“Senior Notes due 2015”) and 6.85% Senior Notes due 2016 (“Senior Notes due 2016”) are described in “Notes to Consolidated Financial Statements — Note 4 — Debt” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
Subsequent Event
On October 2, 2008, the Company borrowed $75,000 under its existing $125,000 Bank Credit Facility. Interest accrues at varying spreads relative to corporate or Eurodollar base rates and is payable monthly or quarterly depending on the applicable base rate (London Interbank Offered Rate (“LIBOR”) plus 0.6%, or 4.7%, from October 2, 2008 through January 2, 2009 at which point the interest rate will be subject to change based on the then current LIBOR). The Bank Credit Facility agreement provides for unsecured borrowings of up to $125,000 and expires on December 19, 2011.
In light of the recent illiquidity in the credit markets, the Company elected to make this borrowing at the holding company on October 2, 2008 to provide flexibility for future capital needs, including capital contributions to the Company’s insurance subsidiaries, if necessary.
8
Note 3 - Investments and Subsequent Event
Fixed Maturity Securities and Equity Securities
The following table presents the composition and value of the Company’s fixed maturity securities and equity securities portfolios by rating category. At September 30, 2008, 95% of these securities were investment grade, with an overall average quality rating of AA-. The Company has classified the entire fixed maturity securities and equity securities portfolios as available for sale, which are carried at fair value.
Rating (1)
Fixed maturity securities
AAA
AA
A
BBB
BB
B
CCC or lower
Not rated (3)
Equity securities
Not rated (4)
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Note 3 - Investments and Subsequent Event-(Continued)
The following table presents the distribution of the Company’s fixed maturity securities portfolio by estimated expected maturity. Estimated expected maturities differ from contractual maturities, reflecting assumptions regarding borrowers’ utilization of the right to call or prepay obligations with or without call or prepayment penalties. Estimated expected maturities consider broker dealer survey values and are verified for consistency with the interest rate and economic environments.
Due in 1 year or less
Due after 1 year through 5 years
Due after 5 years through 10 years
Due after 10 years through 20 years
Due after 20 years
The average option adjusted duration for the Company’s fixed maturity securities was 5.7 years at September 30, 2008 and 5.5 years at December 31, 2007.
In the nine months ended September 30, 2008, the Company recorded a total of $47,308 of impairment write-downs — $33,400 in the three months ended September 30, $11,170 in the three months ended June 30 and $2,738 in the three months ended March 31. In the first nine months of 2007, the Company recorded $2,604 of impairment write-downs, primarily in the second quarter, and these securities were subsequently sold in 2007. The third quarter 2008 write-downs included $23,706 related to fixed maturity security and preferred stock impairments for which the issuer’s ability to pay future interest and principal based upon contractual terms has been compromised — namely, Lehman Brothers Holdings, Inc., the Federal National Mortgage Association (“Fannie Mae”), the Federal Home Loan Mortgage Corporation (“Freddie Mac”), and American International Group, Inc. The remaining amount of write-downs — primarily of financial institution securities and high yield bonds — was primarily attributable to the Company no longer having the intent to hold the securities for a period of time necessary to recover the decline in value. The second quarter 2008 write-downs were primarily related to 2 collateralized debt obligation securities and 5 equity securities, including 4 financial industry preferred stock issues. The first quarter 2008 write-downs were primarily related to certain below investment grade securities, with $2,291 of the write-downs attributable to 6 securities of telecommunications and telecommunications-related media issuers, which at March 31, 2008 the Company no longer intended to hold until the value fully recovered. In addition, net realized losses in the nine months ended September 30, 2008 included $18,382 of realized other-than-temporary impairment losses, primarily on financial institution and below investment grade securities, that were disposed of during the period.
10
The following table presents the fair value and gross unrealized losses of fixed maturity securities and equity securities in an unrealized loss position at September 30, 2008 and December 31, 2007, respectively. The Company views the decrease in value of all of the securities with unrealized losses at September 30, 2008 — which was driven by spread widening, market illiquidity and changes in interest rates — as temporary, expects recovery in fair value in a reasonable timeframe, anticipates continued payments under the terms of the securities, and has the intent and ability to hold these securities until maturity or a recovery in fair value occurs. Therefore, no impairment of these securities was recorded at September 30, 2008.
As of September 30, 2008
U.S. government and federally sponsored agency obligations:
Mortgage-backed securities
Municipal bonds
Foreign government bonds
Corporate bonds
Other mortgage-backed securities
Totals
As of December 31, 2007
The Company’s investment portfolio includes no derivative financial instruments (futures, forwards, swaps, option contracts or other financial instruments with similar characteristics).
11
Subsequent to September 30, 2008, the credit and liquidity crisis in the U.S. and throughout the global financial system has resulted in a substantially increased level of volatility in the financial markets and the banking system. These and other economic events have had a significant adverse impact on the Company’s investment portfolio. As a result, at the time of this Quarterly Report on Form 10-Q, the Company’s investments have incurred a notable decline in fair value since September 30, 2008. The Company has continued to monitor this subsequent event activity and has concluded that the assessment of other-than-temporary impairments as of September 30, 2008 has not changed. Should this environment and similar events continue, such subsequent events could have an ongoing or potentially further significant impact on the Company’s investment portfolio.
Securities Lending
The Company loans fixed income securities to third parties, primarily major brokerage firms. Beginning in the third quarter of 2007, the Company reduced the amount of fixed income securities that it loans compared to previous levels and as of the time of this Quarterly Report on Form 10-Q, the Company’s securities lending program is suspended. As of September 30, 2008 and December 31, 2007, fixed maturity securities with a fair value of $0 and $74,658, respectively, were on loan. Loans of securities are required at all times to be secured by collateral from borrowers at least equal to 100% of the fair value of the securities loaned. The Company maintains effective control over the loaned securities and therefore reports them as Fixed Maturity Securities in the Consolidated Balance Sheets. Securities lending collateral is classified as short-term investments with a corresponding liability in the Company’s Consolidated Balance Sheets.
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Note 4 - Fair Value Measurements
Effective January 1, 2008, the Company adopted SFAS No. 157, which provides a framework for measuring fair value in accordance with GAAP. FSP No. FAS 157-2 defers the effective date of SFAS No. 157 for one year for nonfinancial assets and nonfinancial liabilities that are not disclosed at fair value in the consolidated financial statements on a recurring basis.
Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. SFAS No. 157 also establishes a fair value hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:
The following discussion describes the valuation methodologies used for financial assets measured at fair value. The techniques utilized in estimating the fair values are affected by the assumptions used, including discount rates and estimates of the amount and timing of future cash flows. Care should be exercised in deriving conclusions about the Company’s business, its value or financial position based on the fair value information of financial assets presented below.
13
Note 4 - Fair Value Measurements-(Continued)
Fair value estimates are made at a specific point in time, based on available market information and judgments about the financial asset, including estimates of timing, amount of expected future cash flows and the credit standing of the issuer. In some cases, the fair value estimates cannot be substantiated by comparison to independent markets. In addition, the disclosed fair value may not be realized in the immediate settlement of the financial asset. In addition, the disclosed fair values do not reflect any premium or discount that could result from offering for sale at one time an entire holding of a particular financial asset. Potential taxes and other expenses that would be incurred in an actual sale or settlement are not reflected in amounts disclosed.
Fair values for the Company’s fixed maturity securities are based on prices provided by its investment managers and its custodian bank. Both the investment managers and the custodian bank use a variety of pricing sources to determine market valuations. Each designate specific pricing services or indexes for each sector of the market based upon the provider’s expertise. Broker-dealers are also used to price certain types of securities. The broker-dealers’ valuation methodology is sometimes matrix-based, using indicative evaluation measures and adjustments for specific security characteristics and market sentiment. The Company analyzes market valuations received to verify reasonableness and to understand the key assumptions used and their sources. The Company’s fixed maturity securities portfolio is highly liquid, which allows for a high percentage of the portfolio to be priced through pricing services. Approximately 95% of the portfolio was priced through pricing services or index priced as of September 30, 2008. The remainder of the portfolio was priced by broker-dealers, which were generally Level 2 inputs.
Fair values of equity securities have been determined by the Company from observable market quotations, when available. Private placement securities and other equity securities where a public quotation is not available are valued by using broker quotes or through the use of internal models or analysis.
Short-term investments are comprised of short-term fixed income securities. Because of the nature of these assets, carrying amounts approximate fair values, which have been determined from public quotations, when available.
Separate Account assets represent variable annuity contract holder funds invested in various mutual funds. Fair values of these assets have been determined from public quotations.
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The following table presents the Company’s fair value hierarchy for those assets and liabilities measured at fair value on a recurring basis as of September 30, 2008. At September 30, 2008, Level 3 assets comprised approximately 0.01% of the Company’s total investment portfolio fair value.
Financial Assets
Short-term investments (1)
The following table presents a reconciliation for all Level 3 assets measured at fair value on a recurring basis for the period January 1, 2008 to September 30, 2008.
Beginning balance, January 1, 2008
Total net gains (losses) (unrealized)
Paydowns and maturities
Purchases, sales, issuances and settlements
Transfers in (out) of Level 3
Ending balance, September 30, 2008
For the period January 1, 2008 to September 30, 2008, there were no realized gains or losses included in earnings that were attributable to Level 3 assets still held at September 30, 2008.
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Note 5 - Share Repurchase Programs and Treasury Shares Held (Common Stock)
As disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, on September 12, 2007, the Company’s Board of Directors (“Board”) authorized a new share repurchase program allowing repurchases up to $50,000. The new share repurchase program authorized the repurchase of common shares in open market or privately negotiated transactions, from time to time, depending on market conditions.
From September 12, 2007 through December 31, 2007, the Company repurchased 1,111,600 shares of its common stock, or 2.6% of the outstanding shares on December 31, 2006, at an aggregate cost of $20,748, or an average cost of $18.66 per share, under its new share repurchase program. From January 1, 2008 through February 19, 2008, the Company completed the new program by repurchasing an additional 1,626,776 shares of its common stock, or 3.9% of the outstanding shares on December 31, 2007. In total, 2,738,376 shares were repurchased under the $50,000 program at an average cost of $18.28 per share. The repurchase of shares was financed through use of cash.
On March 7, 2008, the Board authorized an additional $25,000 share repurchase program allowing for repurchase of common shares in open market or privately negotiated transactions, from time to time, depending on market conditions (the “March 2008 Program”). As of June 30, 2008, the Company completed the March 2008 Program resulting in a total of 1,571,449 shares of its common stock repurchased under this program at an average cost of $15.93 per share. Shares repurchased under the March 2008 Program represented 3.7% of the outstanding shares on December 31, 2007. The repurchase of shares was financed through use of cash.
At September 30, 2008, the Company held 21,813,196 shares in treasury. As of June 30, 2008, the Company had completed its authorized share repurchase programs.
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Note 6 - Pension Plans and Other Postretirement Benefits
The Company has the following retirement plans: a defined contribution plan; a 401(k) plan; a defined benefit plan for employees hired on or before December 31, 1998; and certain employees participate in a supplemental defined contribution plan or a supplemental defined benefit plan or both. Additional information regarding the Company’s retirement plans is contained in “Notes to Consolidated Financial Statements — Note 9 — Pension Plans and Other Postretirement Benefits” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
The following table summarizes the components of net periodic pension cost recognized for the defined benefit plan and the supplemental defined benefit plans for the three and nine months ended September 30, 2008 and 2007.
Components of net periodic pension expense:
Service cost
Interest cost
Expected return on plan assets
Recognized net actuarial loss
Settlement loss
Net periodic pension expense
Consistent with disclosure in “Notes to Consolidated Financial Statements — Note 9 — Pension Plans and Other Postretirement Benefits” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, the Company expects to contribute approximately $1,100 to the supplemental defined benefit plans in 2008, of which $791 was contributed during the nine months ended September 30, 2008. There is no minimum funding requirement for the Company’s defined benefit pension plan in 2008. At the time of this Quarterly Report on Form 10-Q, and consistent with disclosure in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, the Company does not anticipate making a contribution to the defined benefit plan in 2008.
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Note 6 - Pension Plans and Other Postretirement Benefits-(Continued)
In addition to providing pension benefits, the Company also provides certain health care and life insurance benefits to retired employees, who meet the Plan’s eligibility requirements, and their eligible dependents. As described in “Notes to Consolidated Financial Statements — Note 9 — Pension Plans and Other Postretirement Benefits”, effective January 1, 2007, the Company eliminated the previous health care benefits for retirees 65 years of age and over and established a defined contribution plan with a Health Reimbursement Account (“HRA”) for each eligible retired participant. Funding of HRA accounts was approximately $740 for the nine months ended September 30, 2008. Also, the new plan does not provide life insurance benefits to individuals who retired after December 31, 1993. As a result of the changes in the plan for other postretirement benefits, the Company anticipates a reduction in its expenses of approximately $2,300 in 2008, $1,728 of which was recognized in the nine months ended September 30, 2008.
The following table summarizes the components of the net periodic benefit cost (gain) for postretirement benefits other than pension for the three and nine months ended September 30, 2008 and 2007.
Components of net periodic cost (gain):
Amortization of prior service cost
Recognized net actuarial gain
Net periodic benefit gain
Consistent with disclosure in “Notes to Consolidated Financial Statements — Note 9 — Pension Plans and Other Postretirement Benefits” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, the Company expects to contribute approximately $700 to the defined benefit postretirement benefit plans other than pensions in 2008, of which $348 was contributed during the nine months ended September 30, 2008.
The Pension Protection Act of 2006
In the third quarter of 2006, the federal government enacted the Pension Protection Act of 2006 (the “Act”) which changes the manner in which pension funding is determined. The new rules are effective for funding beginning in 2008. Management does not expect the Act to have a material impact on the Company’s funding activity.
The Company’s funding policy for the defined benefit pension plan is to contribute amounts which are actuarially determined to provide the plan with sufficient assets to meet future benefit payments consistent with the funding requirements of federal laws and regulations. There is no minimum funding requirement for the defined benefit pension plan in 2008. The Company’s obligations have not changed as a result of these developments.
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Note 7 - Reinsurance
The Company recognizes the cost of reinsurance premiums over the contract periods for such premiums in proportion to the insurance protection provided. Amounts recoverable from reinsurers for unpaid claims and claim settlement expenses, including estimated amounts for unsettled claims, claims incurred but not reported and policy benefits, are estimated in a manner consistent with the insurance liability associated with the policy. The effects of reinsurance on premiums written and contract deposits; premiums and contract charges earned; and benefits, claims and settlement expenses were as follows:
Three months ended September 30, 2008
Premiums written and contract deposits
Premiums and contract charges earned
Three months ended September 30, 2007
Nine months ended September 30, 2008
Nine months ended September 30, 2007
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Note 8 - Segment Information
The Company conducts and manages its business through four segments. The three operating segments, representing the major lines of insurance business, are: property and casualty insurance, principally personal lines automobile and homeowners products; annuity products, principally individual, tax-qualified fixed and variable deposits; and life insurance. The Company does not allocate the impact of corporate level transactions to the insurance segments, consistent with the basis for management’s evaluation of the results of those segments, but classifies those items in the fourth segment, corporate and other. In addition to ongoing transactions such as debt service, realized investment gains and losses and certain public company expenses, within the past five years such items have included debt retirement costs/gains and restructuring charges. Summarized financial information for these segments is as follows:
Property and casualty
Annuity
Life
Corporate and other
Intersegment eliminations
Amortization of intangible assets, pretax (included in segment net income)
Assets
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Note 9 - Income Taxes
In the three months ended September 30, 2008, the Company established a valuation allowance of $11,590 against deferred tax assets related to realized and unrealized investment losses. In accordance with SFAS No. 109, “Accounting for Income Taxes”, the Company evaluates deferred income taxes quarterly to determine if a valuation allowance is appropriate. SFAS No. 109 requires that companies assess whether a valuation allowance should be established against deferred tax assets based on the consideration of all available evidence using a more-likely-than-not standard. As previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, a valuation allowance was not established in prior periods.
The Company believes that a valuation allowance is appropriate at September 30, 2008 for the deferred tax asset related to realized and unrealized investment losses due to financial market events and developments that occurred during the three months ended September 30, 2008. In assessing the realizability of all deferred tax assets, the Company considers whether it is more-likely-than-not that some or all of the deferred tax assets will not be realized. The realization of deferred tax assets depends on the generation of future taxable income of similar character during the periods in which the deferred tax assets are deductible. The Company considered the scheduled reversal of deferred tax liabilities (including available carryback periods), projected taxable income (capital gains), and tax-planning strategies in making this assessment. Based on the unavailability of unrealized or realized capital gains at September 30, 2008, the Company believes it is more-likely-than-not it will not realize all of the benefits of the deductible temporary differences related to realized and unrealized investment losses. Of the valuation allowance amount, $8,224 relates to losses realized on investments during the three months ended September 30, 2008, where it is not more-likely-than-not that the amounts due will be collected according to the contractual terms of the securities, specifically Lehman Brothers Holding, Inc., the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), and was recorded as a reduction to the Company’s tax benefit on realized investment losses. The remaining $3,366 of the valuation allowance relates primarily to unrealized investment losses on the Company’s perpetual preferred stock holdings and was recorded as a component of accumulated other comprehensive income in shareholders’ equity.
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Dollars in millions, except per share data)
Forward-looking Information
Statements made in the following discussion that state the Company’s or management’s intentions, hopes, beliefs, expectations or predictions of future events or the Company’s future financial performance are forward-looking statements and involve known and unknown risks, uncertainties and other factors. Horace Mann is not under any obligation to (and expressly disclaims any such obligation to) update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. It is important to note that the Company’s actual results could differ materially from those projected in forward-looking statements due to, among other risks and uncertainties inherent in the Company’s business, the following important factors:
Changes in the composition of the Company’s assets and liabilities which may result from occurrences such as acquisitions, divestitures, impairment in asset values or changes in estimates of insurance reserves.
Fluctuations in the fair value of securities in the Company’s investment portfolio and the related after-tax effect on the Company’s shareholders’ equity and total capital through either realized or unrealized investment losses, as well as the potential impact on the ability of the Company’s insurance subsidiaries to distribute cash to the holding company and/or need for the holding company to make capital contributions to the insurance subsidiaries. In addition, the impact of fluctuations in the financial markets on the Company’s defined benefit pension plan assets and the related after-tax effect on the Company’s operating expenses, shareholders’ equity and total capital.
The impact of fluctuations in the financial markets on the Company’s variable annuity fee revenues, valuations of deferred policy acquisition costs and value of acquired insurance in force, and the level of guaranteed minimum death benefit reserves.
The impact of fluctuations in the capital markets on the Company’s ability to refinance outstanding indebtedness or repurchase shares of the Company’s common stock.
Defaults on interest or dividend payments in the Company’s investment portfolio due to credit issues and the resulting impact on investment income.
Prevailing interest rate levels, including the impact of interest rates on (1) unrealized gains and losses in the Company’s investment portfolio and the related after-tax effect on the Company’s shareholders’ equity and total capital, (2) the book yield of the Company’s investment portfolio, (3) the Company’s ability to maintain appropriate interest rate spreads over the fixed rates guaranteed in the Company’s life and annuity products and (4) valuations of deferred policy acquisition costs and value of acquired insurance in force.
The cyclicality of the insurance industry and the related effects of changes in price competition and industry-wide underwriting results.
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The frequency and severity of catastrophes such as hurricanes, earthquakes, storms and wildfires and the ability of the Company to provide accurate estimates of ultimate catastrophe costs in its consolidated financial statements in light of such factors as: the proximity of the catastrophe occurrence date to the date of the consolidated financial statements; potential inflation of property repair costs in the affected area; the occurrence of multiple catastrophes in a geographic area over a relatively short period of time; the outcome of litigation which may be filed against the Company by policyholders, state attorneys general and other parties relative to loss coverage disputes and loss settlement payments; and the ability of state insurance facilities to assess participating insurers when financial deficits occur.
The Company’s risk exposure to catastrophe-prone areas. Based on full year 2007 property and casualty direct earned premiums, the Company’s ten largest states represented 57% of the segment total. Included in this top ten group are certain states which are considered more prone to catastrophe occurrences: Florida, California, North Carolina, Texas, Louisiana, South Carolina and Georgia.
The potential near-term, adverse impact of underwriting actions to mitigate the Company’s risk exposure to catastrophe-prone areas on premium, policy and earnings growth.
The ability of the Company to maintain a favorable catastrophe reinsurance program considering both availability and cost; and the collectibility of reinsurance receivables.
Adverse development of property and casualty loss and loss adjustment expense reserve experience and its impact on estimated claims and claim settlement expenses for losses occurring in prior years.
Adverse changes in business persistency, policyholder mortality and morbidity rates, interest spreads and market appreciation and the resulting impact on both estimated reserves and the valuations of deferred policy acquisition costs and value of acquired insurance in force.
Changes in insurance regulations, including (1) those affecting the ability of the Company’s insurance subsidiaries to distribute cash to the holding company and (2) those impacting the Company’s ability to profitably write property and casualty insurance policies in one or more states.
Changes in federal income tax laws and changes resulting from federal tax audits affecting corporate tax rates or taxable income.
Changes in federal and state laws and regulations, which affect the relative tax and other advantages of the Company’s life and annuity products to customers, including, but not limited to, changes in IRS regulations governing Section 403(b) plans.
The resolution of legal proceedings and related matters including the potential adverse impact on the Company’s reputation and charges against the Company’s earnings resulting from legal defense costs, a settlement agreement and/or an adverse finding or findings against the Company from the proceedings.
The Company’s ability to maintain favorable claims-paying ability, financial strength and debt ratings.
The Company’s ability to profitably expand its property and casualty business in highly competitive environments.
The competitive impact of the new Section 403(b) tax-qualified annuity regulations, including (1) their potential to lead plan sponsors to restrict the number of providers and (2) the possible entry into the 403(b) market of larger competitors experienced in 401(k) plans.
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The Company’s ability to develop and expand its agency operations, including its agent force and their licensed producers and support staff, as well as the Company’s ability to maintain and secure sponsorships by local, state and national education associations.
The Company’s dated and complex information systems, which are difficult to upgrade and more prone to error than advanced technology systems.
Disruptions of the general business climate, investments, capital markets and consumer attitudes caused by pandemics or geopolitical acts such as terrorism, war or other similar events.
Executive Summary
Horace Mann Educators Corporation (“HMEC”; and together with its subsidiaries, the “Company” or “Horace Mann”) is an insurance holding company. Through its subsidiaries, HMEC markets and underwrites personal lines of property and casualty insurance, retirement annuities and life insurance in the U.S. The Company markets its products primarily to K-12 educators and other employees of public schools and their families.
For the three months ended September 30, 2008, the Company had a net loss of $30.8 million, a decrease of $49.2 million compared to net income in the prior year, including a $37.2 million increase in after-tax net realized investment losses on securities and a $16.9 million increase in after-tax catastrophe costs. Consistent with industry experience, the current quarter reflected a significant level of hurricane and other weather-related catastrophe losses along with the continued adverse impacts of a challenging financial market environment and a slowing economy. The third quarter 2008 property and casualty segment net loss of $1.3 million was $11.7 million less than the prior year net income, reflecting a higher level of catastrophe losses partially offset by a higher amount of favorable prior years’ reserve development in the current period. Net income for the annuity segment increased $1.1 million compared to the third quarter of 2007, as current period improvements in the interest margin were partially offset by the adverse impact of the financial markets on the level of contract charges earned. For the third quarter of 2008, the valuation of annuity deferred policy acquisition costs had a net positive impact on earnings. Life segment net income for the quarter decreased $1.1 million, with growth in earned premiums and investment income more than offset by higher mortality costs.
For the nine months ended September 30, 2008, the Company’s net loss of $12.0 million represented a decrease of $76.8 million compared to net income reported for the prior year, including a $45.6 million reduction in after-tax net realized investment gains and losses. Catastrophe costs increased $30.1 million after tax and non-catastrophe weather-related losses also increased compared to the prior year. In addition, results in the current nine months were negatively impacted by a reduced level of favorable prior years’ property and casualty reserve development. Including all factors, the property and casualty combined ratio was 103.3% for the first nine months of 2008 compared to 91.8% for the same period in 2007. Annuity segment net income increased $0.7 million, or 5%, compared to the first nine months of 2007, as current period improvements in the interest margin were partially offset by the adverse impact of the financial market on the level of contract charges earned. Life segment net income decreased $0.5 million, or 4%, compared to a year earlier, reflecting growth in investment income offset by higher mortality costs.
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Premiums written and contract deposits declined 1% and 2%, compared to the three and nine months ended September 30, 2007, respectively, largely due to expected decreases in single premium annuity deposit receipts in 2008. For the nine months ended September 30, 2008, reduced costs associated with the Company’s property and casualty catastrophe reinsurance program represented a $4.7 million increase in premiums written compared to 2007. New automobile sales units in the current period were 6% less than the first nine months of 2007, with third quarter sales improving sequentially compared to the first and second quarters of 2008. The year-to-date sales decrease was somewhat offset by favorable policy retention, resulting in voluntary automobile policies in force equal to September 30, 2007. However, automobile policies of educators increased 3% compared to a year earlier. Annuity contract deposits for the three and nine months ended September 30, 2008 decreased 5% and 8%, respectively, compared to a year earlier, and life segment insurance premiums and contract deposits were comparable to the prior year.
Critical Accounting Policies
The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires the Company’s management to make estimates and assumptions based on information available at the time the consolidated financial statements are prepared. These estimates and assumptions affect the reported amounts of the Company’s consolidated assets, liabilities, shareholders’ equity and net income. Certain accounting estimates are particularly sensitive because of their significance to the Company’s consolidated financial statements and because of the possibility that subsequent events and available information may differ markedly from management’s judgements at the time the consolidated financial statements were prepared. Management has discussed with the Audit Committee the quality, not just the acceptability, of the Company’s accounting principles as applied in its financial reporting. The discussions generally included such matters as the consistency of the Company’s accounting policies and their application, and the clarity and completeness of the Company’s consolidated financial statements, which include related disclosures. For the Company, the areas most subject to significant management judgements include: liabilities for property and casualty claims and claim settlement expenses, liabilities for future policy benefits, deferred policy acquisition costs, value of acquired insurance in force for annuity and interest-sensitive life products, valuation of investments and valuation of assets and liabilities related to the defined benefit pension plan.
Liabilities for Property and Casualty Claims and Claim Settlement Expenses
Underwriting results of the property and casualty segment are significantly influenced by estimates of the Company’s ultimate liability for insured events. There is a high degree of uncertainty inherent in the estimates of ultimate losses underlying the liability for unpaid claims and claim settlement expenses. This inherent uncertainty is particularly significant for liability-related exposures due to the extended period, often many years, that transpires between a loss event, receipt of related claims data from policyholders and ultimate settlement of the claim. Reserves for property and casualty claims include provisions for payments to be made on reported claims (“case reserves”), claims incurred but not yet reported (“IBNR”) and associated settlement expenses (together, “loss reserves”). The process by which these reserves are established requires reliance upon estimates based on known facts and on interpretations of circumstances, including the Company’s experience with similar cases and historical trends involving claim payments and related patterns, pending levels of unpaid
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claims and product mix, as well as other factors including court decisions, economic conditions and public attitudes.
Reserves are reestimated quarterly. Changes to reserves are recorded in the period in which development factor changes result in reserve reestimates. Detailed discussion of the process utilized to estimate loss reserves, risk factors considered and the impact of adjustments recorded during recent years is included in “Notes to Consolidated Financial Statements — Note 3 — Property and Casualty Unpaid Claims and Claim Expenses” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. Due to the nature of the Company’s personal lines business, the Company has no exposure to claims for toxic waste cleanup, other environmental remediation or asbestos-related illnesses other than claims under homeowners insurance policies for environmentally related items such as mold.
Based on the Company’s products and coverages, historical experience, and modeling of various actuarial methodologies used to develop reserve estimates, the Company estimates that the potential variability of the property and casualty loss reserves within a reasonable probability of other possible outcomes may be approximately plus or minus 6%, which equates to plus or minus approximately $13 million of net income based on reserves as of September 30, 2008. Although this evaluation reflects the most likely outcomes, it is possible the final outcome may fall below or above these estimates.
There are a number of assumptions involved in the determination of the Company’s property and casualty loss reserves. Among the key factors affecting recorded loss reserves for both long-tail and short-tail related coverages, claim severity and claim frequency are of particular significance. Management estimates that a 2% change in claim severity or claim frequency for the most recent 36-month period is a reasonably likely scenario based on recent experience and would result in a change in the estimated loss reserves of between $6.0 million and $10.0 million for long-tail liability related exposures (automobile liability coverages) and between $3.0 million and $4.0 million for short-tail liability related exposures (homeowners and automobile physical damage coverages). Actual results may differ, depending on the magnitude and direction of the deviation.
The Company’s loss and loss adjustment expense actuarial analysis is discussed with management. As part of this discussion, the indicated point estimate of the IBNR loss reserve by line of business (coverage) is reviewed. The Company actuaries also discuss any indicated changes to the underlying assumptions used to calculate the indicated point estimate. Review of the variance between the indicated reserves from these changes in assumptions and the previously carried reserves takes place. After discussion of these analyses and all relevant risk factors, management determines whether the reserve balances require adjustment. The Company’s best estimate of loss reserves may change depending on a revision in the underlying assumptions.
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The Company’s liabilities for property and casualty unpaid claims and claim settlement expenses were as follows:
Automobile liability
Automobile other
Homeowners
All other
The facts and circumstances leading to the Company’s reestimate of reserves relate to revisions of the development factors used to predict how losses are likely to develop from the end of a reporting period until all claims have been paid. Reestimates occur because actual loss amounts are different than those predicted by the estimated development factors used in prior reserve estimates. At September 30, 2008, the impact of a reserve reestimation resulting in a 1% increase in net reserves would be a decrease of approximately $2 million in net income. A reserve reestimation resulting in a 1% decrease in net reserves would increase net income by approximately $2 million.
Favorable reserve reestimates increased net income for the nine months ended September 30, 2008 by approximately $7.4 million, primarily the result of favorable trends in voluntary automobile loss and loss adjustment expense emergence for accident years 2005 and prior. The lower than expected claims and expense emergence and resultant lower expected loss ratios caused the Company to lower its reserve estimate.
Information regarding the Company’s property and casualty claims and claims settlement expense reserve development table as of December 31, 2007 is located in “Business — Property and Casualty Segment — Property and Casualty Reserves” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
Liabilities for Future Policy Benefits
Liabilities for future benefits on life and annuity policies are established in amounts adequate to meet the estimated future obligations on policies in force. Liabilities for future policy benefits on certain life insurance policies are computed using the net level premium method and are based on assumptions as to future investment yield, mortality and withdrawals. Mortality and withdrawal assumptions for all policies have been based on actuarial tables which are consistent with the Company’s own experience. In the event actual experience is worse than the assumptions, additional reserves may be required. This would result in a charge to income for the period in which the increase in reserves occurred. Liabilities for future benefits on annuity contracts and certain long-duration life insurance contracts are carried at accumulated policyholder values without reduction for potential surrender or withdrawal charges.
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Deferred Policy Acquisition Costs and Value of Acquired Insurance in Force for Annuity and Interest-sensitive Life Products
Policy acquisition costs, consisting of commissions, policy issuance and other costs, which vary with and are primarily related to the production of business, are capitalized and amortized on a basis consistent with the type of insurance coverage. For all investment (annuity) contracts, acquisition costs, and also the value of annuity business acquired in the 1989 acquisition of the Company (“Annuity VIF”), are amortized over 20 years in proportion to estimated gross profits. Capitalized acquisition costs for interest-sensitive life contracts are also amortized over 20 years in proportion to estimated gross profits.
The most significant assumptions that are involved in the estimation of annuity gross profits include interest rate spreads, future financial market performance, business surrender/lapse rates, expenses and the impact of realized investment gains and losses. For the variable deposit portion of the annuity segment, the Company amortizes policy acquisition costs and the Annuity VIF utilizing a future financial market performance assumption of a 10% reversion to the mean approach with a 200 basis point corridor around the mean. At September 30, 2008, the ratio of capitalized annuity policy acquisition costs and the Annuity VIF asset to the total annuity accumulated cash value was approximately 5%.
In the event actual experience differs significantly from assumptions or assumptions are significantly revised, the Company may be required to record a material charge or credit to amortization expense for the period in which the adjustment is made. As noted above, there are key assumptions involved in the valuation of capitalized policy acquisition costs and the Annuity VIF. In terms of the sensitivity of this amortization to two of the more significant assumptions, assuming all other assumptions are met, (1) a 10 basis point deviation in the annual targeted interest rate spread assumption would currently impact amortization between $0.15 million and $0.25 million and (2) a 1% deviation from the targeted financial market performance for the underlying mutual funds of the Company’s variable annuities would currently impact amortization between $0.15 million and $0.25 million. These results may change depending on the magnitude and direction of the deviations but represent a range of reasonably likely experience for the noted assumptions. Detailed discussion of the impact of adjustments to the amortization of capitalized acquisition costs and Annuity VIF is included in “Results of Operations — Amortization of Policy Acquisition Expenses and Intangible Assets”.
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Valuation of Investments
Market valuations for the fixed maturity and equity securities portfolio are based on observable market quotations as well as prices provided by the Company’s custodian bank and its investment managers. Both the custodian bank and the investment managers use a variety of pricing sources to determine market valuations. Each designate specific pricing services or indexes for each sector of the market based upon the provider’s expertise. Broker-dealers are also used to price certain types of securities. The broker-dealers’ valuation methodology is sometimes matrix-based, using indicative evaluation measures and adjustments for specific security characteristics and market sentiment. The Company analyzes market valuations received to verify reasonableness and to understand the key assumptions used and their sources. The Company’s fixed maturity securities portfolio is highly liquid, which allows for a high percentage of the portfolio to be priced through pricing services. Approximately 95% of the portfolio was priced through pricing services or index priced as of September 30, 2008. The remainder of the portfolio was priced by broker-dealers.
The Company’s methodology of assessing other-than-temporary impairments is based on security-specific facts and circumstances as of the date of the reporting period. Based on these facts, if management believes it is probable that amounts due will not be collected according to the contractual terms of a debt security, or if the Company does not have the ability and intent to hold a debt or equity security with an unrealized loss until it matures or recovers in value, an other-than-temporary impairment is considered to have occurred. As a general rule, if the fair value of a debt security has fallen below 80% of book value, this security will be reviewed for an other-than-temporary impairment. Also as a general rule, if the fair value of an equity security has declined below cost, this security will be reviewed for an other-than-temporary impairment including an assessment of whether recovery in fair value is likely to occur within a reasonable period of time. Additionally, if events become known that call into question whether the security issuer has the ability to honor its contractual commitments, whether or not such security has been trading above an 80% fair value to book value relationship, such security holding will be evaluated to determine whether or not such security has suffered an other-than-temporary decline in value.
The Company reviews the fair value of all investments in its portfolio on a monthly basis to assess whether an other-than-temporary decline in value has occurred. These reviews, in conjunction with the Company’s investment managers’ monthly credit reports and relevant factors such as (1) the financial condition and near-term prospects of the issuer, (2) the length of time and extent to which the fair value has been less than amortized cost for fixed maturity securities or cost for equity securities, (3) the Company’s ability and intent to retain the investment long enough to allow for the anticipated recovery in fair value or until it matures, (4) the stock price trend of the issuer, (5) the market leadership position of the issuer, (6) the debt ratings of the issuer and (7) the cash flows of the issuer, are all considered in the impairment assessment. A write-down of an investment is recorded when a decline in the fair value of that investment is deemed to be other-than-temporary, with a realized investment loss charged to income for the period.
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With respect to fixed income securities involving securitized financial assets — primarily asset backed and commercial mortgage backed securities in the Company’s portfolio — which fall under the provisions of Emerging Issues Task Force (“EITF”) Issue No. 99-20, “Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests that Continue to be Held by a Transferor in Securitized Financial Assets”, all of the Company’s securitized financial assets fair values are determined by observable inputs. In addition, the Company’s credit analysis and/or analysis of the underlying collateral cash flows at September 30, 2008 indicated a very remote likelihood of default — even under severe stress testing.
The Company’s intent and ability to hold securities considers broad portfolio management objectives such as asset/liability duration management, issuer and industry segment exposures, interest rate views and the overall total return focus. In following these portfolio management objectives, changes in facts and circumstances that were present in past reporting periods may trigger a decision to sell securities that were held in prior reporting periods. The Company attempts to anticipate these types of changes and if a sale decision has been made on an impaired security and that security is not expected to recover prior to the expected time of sale, the security will be deemed other-than-temporarily impaired in the period that the sale decision was made and an other-than-temporary impairment loss will be recognized.
A decline in fair value below amortized cost is not assumed to be other-than-temporary for fixed maturity investments with unrealized losses due to changes in interest rates, spread widening or market illiquidity where there exists a reasonable expectation that fair value will recover in a reasonable timeframe versus historical cost and the Company has the intent and ability to hold the investment until maturity or a market recovery is realized. An other-than-temporary impairment loss will be recognized based upon all relevant facts and circumstances for each investment, as appropriate.
Valuation of Assets and Liabilities Related to the Defined Benefit Pension Plan
Effective April 1, 2002, participants stopped accruing benefits under the defined benefit pension plan but continue to retain the benefits they had accrued to that date.
The Company’s cost estimates for its defined benefit pension plan are determined annually based on assumptions which include the discount rate, expected return on plan assets, anticipated retirement rate and estimated lump sum distributions. A discount rate of 6.05% was used by the Company for estimating accumulated benefits under the plan at December 31, 2007, which was based on the average yield for long-term, high grade securities having maturities generally consistent with the defined benefit pension payout period. To set its discount rate, the Company looks to leading indicators, including the Citigroup Pension Discount Curve. The expected annual return on plan assets assumed by the Company at December 31, 2007 was 7.5%. The assumption for the long-term rate of return on plan assets was determined by considering actual investment experience during the lifetime of the plan, balanced with reasonable expectations of future growth considering the various classes of assets and percentage allocation for each asset class. Management believes that it has adopted reasonable assumptions for investment returns, discount rates and other key factors used in the estimation of pension costs and asset values.
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To the extent that actual experience differs from the Company’s assumptions, subsequent adjustments may be required, with the effects of those adjustments charged or credited to income and/or shareholders’ equity for the period in which the adjustments are made. Generally, a change of 50 basis points in the discount rate would inversely impact pension expense and accumulated other comprehensive income (“AOCI”) by approximately $0.1 million and $1.5 million, respectively. In addition, for every $1 million increase (decrease) in the value of pension plan assets, there is a comparable increase (decrease) in AOCI.
Results of Operations
Insurance Premiums and Contract Charges
Insurance Premiums Written and Contract Deposits
(Includes annuity and life contract deposits)
Property & casualty
Automobile and property (voluntary)
Involuntary and other property & casualty
Total property & casualty
Annuity deposits
Insurance Premiums and Contract Charges Earned
(Excludes annuity and life contract deposits)
For the three and nine months ended September 30, 2008, the Company’s premiums written and contract deposits decreased 1.2% and 2.0%, respectively, compared to the prior year, largely due to decreases in single premium annuity deposit receipts in 2008. The reduced costs associated with the Company’s property and casualty catastrophe reinsurance program, as described below, represented a $4.7 million increase to premiums for the nine months ended September 30, 2008. Voluntary property and casualty business represents policies sold through the Company’s marketing organization and issued under the Company’s underwriting guidelines. Involuntary property and casualty business consists of allocations of business from state mandatory insurance facilities and assigned risk business.
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The Company’s exclusive agent force totaled 690 at September 30, 2008, reflecting a decrease of 13.4% compared to 797 agents at September 30, 2007 and a decrease of 12.7% compared to 790 at December 31, 2007. Of the current period-end total, 161 agents were in their first 24 months with the Company, down 27.1% compared to September 30, 2007. The number of experienced agents in the agent force, 529, decreased 8.2% compared to a year earlier. In addition to agents, the Company’s total points of distribution include licensed producers who work with the agents. At September 30, 2008, there were 360 licensed producers, compared to 228 at September 30, 2007. Including these licensed producers, the Company’s total points of distribution increased to 1,050 at September 30, 2008, a growth of 2.4% compared to 12 months earlier. At the time of this Quarterly Report on Form 10-Q, management anticipates that over the next several quarters the agent count will continue to decline modestly during the Company’s transition to its new Agency Business Model, with an increase in total points of distribution resulting from the growing number of licensed producers supporting agents who adopt the new model.
In October 2006, the Company began the transition from a single-person agent operation to its new Agency Business Model, with agents in outside offices with support personnel and licensed producers, designed to remove capacity constraints and increase productivity. The first Agency Business School session was conducted in October 2006, beginning the formal roll-out of this model. From October 2006 through September 30, 2008, 213 of the agents at September 30, 2008 and all field sales management except those hired in recent months completed this training. See additional description in “Business — Corporate Strategy and Marketing — Exclusive Agency Force” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
For the first nine months of 2008, new automobile sales units were 6.1% less than for the same period a year earlier. New homeowners sales units decreased 9.4% compared to the first nine months of 2007. For the Company, as well as other personal lines property and casualty companies, new business levels have been impacted by the economy and the decreases in automobile and home sales. Annuity new business declined 9.0% compared to the first nine months of 2007, primarily due to an expected decline in single premium and rollover deposits, particularly from the independent agent distribution channel, somewhat mitigated by new business growth in the Company’s core scheduled deposit business from the Company’s exclusive agents. Life new business decreased 16.4% compared to the prior year, primarily reflecting reduced sales of partner company products. For the first nine months of 2008, total new business sales decreased 9.4% compared to a year earlier. In total, exclusive agent sales for the first nine months of 2008 decreased 4.6% compared to prior year, reflecting the lower number of agents in the current period. Average overall productivity per agent increased moderately compared to the first nine months of 2007. Average agent productivity is measured as new sales premiums from the exclusive agent force per the average number of exclusive agents for the period.
Total voluntary automobile and homeowners premium written increased 1.6%, or $6.3 million, in the first nine months of 2008, including the $4.7 million reduction in the cost of catastrophe reinsurance in the current year which reflected the elimination of the catastrophe aggregate reinsurance coverage as well as favorable pricing on the remaining coverages for 2008. The automobile average written premium per policy was comparable to a year earlier while the homeowners average premium increased in the current period compared to prior year, with the change in average premium for both lines adversely impacted by the improved quality of the books of business. At September 30, 2008, there were 535,000 voluntary
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automobile and 263,000 homeowners policies in force, for a total of 798,000 policies, compared to a total of 801,000 policies at both December 31, 2007 and September 30, 2007.
Based on policies in force, the voluntary automobile 6-month retention rate for new and renewal policies was 91.5% at September 30, 2008 compared to 91.4% at September 30, 2007. The property 12-month new and renewal policy retention rate was 88.7% at September 30, 2008 compared to 88.2% a year earlier. For the first nine months of 2008, approved rate increases for the Company’s automobile and homeowners business were minimal, similar to rate actions in 2007.
Voluntary automobile premium written increased 0.2% ($0.6 million) compared to the first nine months of 2007. In the first nine months of 2008, automobile policies in force, average written premium per policy and average earned premium per policy were comparable to the same period in 2007. Automobile policies in force at September 30, 2008 were equal to December 31, 2007 and September 30, 2007. Educator policies increased throughout the period.
Voluntary homeowners premium written increased 4.5% ($5.7 million) compared to the first nine months of 2007 including the lower amount of catastrophe reinsurance premiums described above. Homeowners average written premium per policy increased 3% compared to a year earlier, while average earned premium per policy increased 5%. Homeowners policies in force at September 30, 2008 decreased 3,000 compared to both December 31, 2007 and a year earlier, as growth in the number of educator policies was offset by expected reductions, primarily in non-educator policies, due to the Company’s risk mitigation programs, including actions in catastrophe-prone coastal areas. The Company continues to evaluate and implement actions to further mitigate its risk exposure in hurricane-prone areas. Such actions could include, but are not limited to, non-renewal of homeowners policies, restricted agent geographic placement, limitations on agent new business sales, further tightening of underwriting standards and increased utilization of third-party vendor marketing alliances.
The primary component of involuntary and other property and casualty earned premiums, which represented less than 2% of total property and casualty premiums for full year 2007, has been educator excess professional liability insurance purchased by the National Education Association (“NEA”) for all of its members. The NEA’s five-year contract to purchase this insurance from the Company expired on August 31, 2007 and represented approximately $8.6 million of premiums written in 2006, with 1/12, or approximately $0.7 million, of that premium earned each month during the September 2006 through August 2007 coverage period. The Company’s underwriting results from educator excess professional liability insurance have generally represented amounts which were not a material portion of net income for the Company or for the property and casualty segment. The other significant component of involuntary and other property and casualty premiums is automobile business assumed from state mandatory insurance facilities and this component decreased approximately $1.5 million compared to the first nine months of 2007.
Annuity deposits received decreased 7.9% for the nine months ended September 30, 2008 compared to the same period in 2007. In the first nine months of 2008, scheduled annuity deposits decreased 2.8% compared to the prior year while single premium and rollover deposits decreased 16.0%, impacted by the industry-wide effect on 403(b) transfers of the transition to the new Internal Revenue Service (“IRS”) Section 403(b) regulations and also the current year level of new single premium deposits from the independent agent distribution
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channel. In the first nine months of 2008, new deposits to variable accounts decreased 7.7%, or $8.6 million, and new deposits to fixed accounts decreased 8.1%, or $11.9 million, compared to the prior year. In addition to external contractholder deposits, annuity new deposits include contributions and transfers for the 401(k) group annuity contract by the Company’s employees.
The Company utilizes a nationwide network of independent agents who comprise a supplemental distribution channel for the Company’s 403(b) tax-qualified annuity products. The independent agent distribution channel included 1,012 authorized agents at September 30, 2008. During the first nine months of 2008, this channel generated $15.5 million in annualized new annuity sales for the Company compared to $27.2 million for the first nine months of 2007, with the decline primarily in single and rollover deposit business. The decrease in 2008 was anticipated as management continued to focus this channel on 403(b) and other tax-qualified business.
Total annuity accumulated cash value of $3.5 billion at September 30, 2008 decreased 5.6% compared to a year earlier, reflecting the increase from new deposits received and favorable retention more than offset by unfavorable financial market performance over the 12 months. At September 30, 2008, the number of annuity contracts outstanding of 168,000 increased 0.6%, or 1,000 contracts, compared to December 31, 2007 and increased 2.4%, or 4,000 contracts, compared to September 30, 2007.
Variable annuity accumulated balances were 21.4% lower at September 30, 2008 than at September 30, 2007, primarily reflecting financial market performance, and annuity segment contract charges earned decreased 15.9%, or $2.6 million, compared to the first nine months of 2007.
Life segment premiums and contract deposits increased 0.4%, or $0.3 million, compared to the first nine months of 2007. The ordinary life insurance in force lapse ratio was 5.5% for the 12 months ended September 30, 2008 compared to 5.6% for the 12 months ended September 30, 2007.
Net Investment Income
For the three months ended September 30, 2008, pretax investment income of $57.8 million increased 3.2%, or $1.8 million, (2.9%, or $1.1 million, after tax) compared to the same period in 2007. Pretax investment income of $172.2 million for the nine months ended September 30, 2008 increased 3.5%, or $5.9 million, (3.5%, or $4.0 million, after tax) compared to prior year. The increase reflected growth in the size of the average investment portfolio on an amortized cost basis and a modest increase in the portfolio yield. Average invested assets (excluding securities lending collateral) increased 2.3% over the prior 12 months. The average pretax yield on the investment portfolio was 5.53% (3.76% after tax) for the first nine months of 2008, compared to a pretax yield of 5.47% (3.72% after tax) a year earlier.
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Net Realized Investment Gains and Losses
For the three months ended September 30, 2008 and 2007, net realized investment losses (pretax) were $45.2 million and $0.5 million, respectively. Net realized investment losses (pretax) were $55.7 million for the first nine months of 2008 compared to net realized investment gains of $2.1 million in the prior year. The net gains and losses in both periods were realized from recording of impairment charges and ongoing investment portfolio management activity. In addition, the first nine months of 2008 and 2007 included $1.1 million and $0.2 million, respectively, of litigation proceeds on previously impaired WorldCom, Inc. debt securities.
In the first nine months of 2008, the Company recorded a total of $47.3 million of impairment write-downs — $33.4 million in the third quarter, $11.2 million in the second quarter and $2.7 million in the first quarter. In the first nine months of 2007, the Company recorded $2.6 million of impairment write-downs, primarily in the second quarter, and these securities were subsequently sold in 2007. The third quarter 2008 write-downs included approximately $23.7 million related to fixed maturity security and preferred stock impairments for which the issuer’s ability to pay future interest and principal based upon contractual terms has been compromised — namely, Lehman Brothers Holdings, Inc., the Federal National Mortgage Association (“Fannie Mae”), the Federal Home Loan Mortgage Corporation (“Freddie Mac”), and American International Group, Inc. The remaining amount of write-downs — primarily of financial institution securities and high yield bonds — was primarily attributable to the Company no longer having the intent to hold the securities for a period of time necessary to recover the decline in value. The second quarter 2008 write-downs were primarily related to 2 collateralized debt obligation securities and 5 equity securities, including 4 financial industry preferred stock issues. The first quarter 2008 write-downs were primarily related to certain below investment grade securities, with $2.3 million of the write-downs attributable to 6 securities of telecommunications and telecommunications-related media issuers, which at March 31, 2008 the Company no longer intended to hold until the value fully recovered. In addition, net realized losses in the first nine months of 2008 included $18.4 million of realized other-than-temporary impairment losses, primarily on financial institution and below investment grade securities that were disposed of during the period. Net realized investment losses in the first nine months of 2008 included additional realized losses of $2.7 million from sales of securities for which impairment charges were recorded in the second quarter of 2008, as well as gains of (1) $0.2 million from sales of securities for which impairment charges were recorded in the first quarter of 2008 and (2) $0.1 million from sales of securities for which impairment charges were recorded in 2007. Net realized investment gains in the first nine months of 2007 included $2.9 million from sales of securities for which impairment write-downs were recorded in 2002.
There were securities priced below 80% of book value at September 30, 2008 that were not impaired. The illiquidity in the marketplace, continued concern over economic weakness, continued write-offs related to mortgage and structured securities, distressed sellers in the marketplace and overall spread widening related to demand for increased risk premiums contributed to the decline in security valuations. Management views the decrease in value of all of these securities as temporary, anticipates continued payments under the terms of the securities and has the intent and ability to hold these securities until maturity or a recovery in fair value occurs.
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The table below presents the Company’s fixed maturity securities and equity securities portfolios as of September 30, 2008 by major asset class, including the ten largest sectors of the Company’s corporate bond holdings (based on fair value) and the sectors of the equity securities holdings. In the third quarter of 2008, the unprecedented uncertainty and volatility in the financial markets caused significant spread-widening and interest rate volatility, which had a significant adverse effect on the fair value of investments. The Company’s pretax net unrealized loss at September 30, 2008 was spread over numerous asset classes, and investment grade bonds, commercial mortgage-backed securities, and financial institution securities (both bonds and preferred stocks) were most impacted.
Fixed Maturity Securities
Energy
Banking and Finance
Utilities
Telecommunications
Health Care
Transportation
Insurance
Food and Beverage
Metal and Mining
Real estate
All Other Corporates (1)
Total corporate bonds
U.S. government and federally sponsored agencies
Government bonds
U.S.
Foreign
Collateralized debt obligations (2)
Asset-backed securities
Total fixed maturity securities
Equity Securities
Non-redeemable preferred stocks
U.S. federally sponsored agencies
Common stocks
Cable
Technology and other
Total equity securities
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At September 30, 2008, the Company’s diversified fixed maturity securities portfolio consisted of 1,553 investment positions, issued by 1,175 entities, and totaled approximately $3.6 billion in fair value. This portfolio was 95.1% investment grade, based on fair value, with an average quality rating of AA-.
At September 30, 2008, the Company had limited exposure to subprime and “Alt-A” mortgage loans. The Company had three subprime securities with a fair value of $4.4 million at September 30, 2008. The characteristics of the Company’s sub-prime securities include the following: low average Fair Isaac Credit Organization (“FICO”) score (less than 650), high weighted average coupon relative to other mortgage-backed and home equity securities of similar loan age and issue date, high prepayment penalties, and a high percentage of hybrid loans or negative amortizing loans. The “Alt-A” mortgage loan exposure was comprised of five securities with a total fair value of approximately $7.5 million, of which $4.9 million was vintage year 2004 and prior, with an unrealized loss of approximately $0.7 million at September 30, 2008. The characteristics of the Company’s “Alt-A” mortgage loans include the following: low average FICO score (less than 680), borrowers meet Fannie Mae and Freddie Mac standards for credit scores but might not meet standard guidelines for documentation requirements, property type, and debt ratio or loan-to-value ratio.
At September 30, 2008, the Company had $477.9 million fair value invested in municipal bonds, primarily in the portfolios of the property and casualty insurance subsidiaries, with an unrealized loss of $22.8 million. The overall credit quality of these securities was AA+, with approximately 63% of the value insured at September 30, 2008. This represents approximately 8% of the Company’s total investment portfolio that is guaranteed by the mono-line credit insurers. When selecting securities, the Company focuses primarily on the quality of the underlying security and does not place significant reliance on the additional insurance benefit. Excluding the effect of insurance, the credit quality of the underlying municipal bond portfolio was AA at September 30, 2008.
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At September 30, 2008, the fixed maturity securities and equity securities portfolio had $288.6 million pretax of gross unrealized losses related to 1,257 positions. The following table provides information regarding all fixed maturity securities and equity securities that had an unrealized loss at September 30, 2008, including the length of time that the securities have continuously been in an unrealized loss position.
Investment Positions With Unrealized Losses Segmented by
Quality and Period of Continuous Unrealized Loss
Investment grade
3 Months or less
4 through 6 months
7 through 9 months
10 through 12 months
13 through 24 months
25 through 36 months
37 through 48 months
Greater than 48 months
Non-investment grade
Not rated
Greater than 24 months
Non-investment grade, all 3 months or less
Not rated, all 3 months or less
Total fixed maturity securities and equity securities
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Of the investment positions (fixed maturity securities and equity securities) with unrealized losses, 146 were trading below 80% of book value at September 30, 2008 and the table below provides additional information regarding these securities. These positions were structured securities, investment grade bonds, preferred stock (both fixed maturity securities and equity securities in nature), and below investment grade bonds.
Investment Positions With Fair Value Below 80% of Amortized Cost
Segmented by Quality and Period of Continuous Valuation Below 80%
Greater than 12 months
3 months or less
Greater than 9 months
The 146 securities with fair values below 80% of book value at September 30, 2008 represented approximately 6% of the Company’s total investments at fair value. And, approximately 80% of those securities have been below 80% of book value for three months or less as of September 30, 2008. Of the total securities trading below 80% of book value, 68 securities had fair values less than 70% of book value, representing 2.3% of the Company’s total investments, with a pretax unrealized loss of $60.3 million.
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The Company views the decrease in value of all of the securities with unrealized losses at September 30, 2008 — which was driven by spread widening, market illiquidity and changes in interest rates — as temporary, expects recovery in fair value in a reasonable timeframe, anticipates continued payments under the terms of the securities including favorable underlying cash flows, and has the intent and ability to hold these securities until maturity or a recovery in fair value occurs. Therefore, no impairment of these securities was recorded at September 30, 2008. Future changes in circumstances related to these and other securities could require subsequent recognition of other-than-temporary impairment losses. The Company’s investment guidelines generally limit single corporate issuer concentrations to 1.0% of invested assets for “AA” or “AAA” rated securities, 0.75% of invested assets for “A” rated securities, 0.5% of invested assets for “BBB” rated securities, and 0.2% of invested assets for non-investment grade securities.
The following table provides information regarding the fixed maturity securities and equity securities that were trading below 80% of book value at December 31, 2007.
Greater than 6 months
Non-investment grade, all 3 Months or less
Not rated, all 4 through 6 months
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Benefits, Claims and Settlement Expenses
Property and casualty catastrophe losses, included above (1)
Property and Casualty Claims and Claim Expenses (“losses”)
Incurred claims and claim expenses:
Claims occurring in the current year
Decrease in estimated reserves for claims occurring in prior years (2)
Total claims and claim expenses incurred
Property and casualty loss ratio:
Effect of catastrophe costs, included above (1)
Three months ended
March 31
June 30
September 30
Total year-to-date
(Favorable)/unfavorable development of prior years’ reserves was recorded as follows:
For the three months ended September 30, 2008, the Company’s benefits, claims and settlement expenses of $131.2 million increased 20.8%, or $22.6 million, compared to the same period in 2007. This increase was due to the $25.9 million increase in catastrophe losses primarily resulting from Hurricanes Gustav and Ike. The current quarter incurred amount for catastrophes also included approximately $5 million related to reserve development for catastrophe activity in the second quarter of 2008. Property and casualty claims in the current quarter also reflected an increase in non-catastrophe weather-related losses.
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For the nine months ended September 30, 2008, the Company’s benefits, claims and settlement expenses increased compared to the prior year, including a significant increase in catastrophe losses — primarily from the third quarter hurricane losses and severe storm and tornado events in the second quarter, a smaller decrease in estimated reserves for property and casualty claims occurring in prior years, and unfavorable life mortality experience.
The current year-to-date favorable development of prior years’ property and casualty reserves of $11.4 million was the result of actual and remaining projected losses for prior years being below the level anticipated in the December 31, 2007 loss reserve estimate, primarily driven by favorable voluntary automobile loss and loss adjustment expense emergence for accident years 2005 and prior.
For the nine months ended September 30, 2008, the voluntary automobile loss ratio of 68.3% decreased by 1.2 percentage points compared to the same period a year earlier, including a 1.1 percentage point increase due to the higher level of catastrophe losses and a 0.9 percentage point decrease due to the higher level of favorable development of prior years’ reserves in the current period. The homeowners loss ratio of 105.4% for the nine months ended September 30, 2008 increased 44.2 percentage points compared to a year earlier, including an increase of 33.5 percentage points due to the higher level of catastrophe costs and an increase of 6.4 percentage points due to the lower level of favorable development of prior years’ reserves recorded in 2008. In 2008, in addition to the significant increase in catastrophe losses incurred in the second and third quarters, late-winter storms in some sections of the U.S. and heavy thunderstorms and tornadoes across the Southern U.S. contributed to higher than average first quarter catastrophic losses for the Company as well as the industry. For the nine months, catastrophe costs represented 47.3 percentage points of the homeowners loss ratio for the current period compared to 13.8 percentage points for the prior year. Also for the nine months, the current period homeowners loss ratio reflected an increase in non-catastrophe weather-related losses due to the more severe weather in 2008.
For the annuity segment, benefits in the first nine months of 2008 decreased $0.5 million compared to prior year. The Company’s guaranteed minimum death benefits (“GMDB”) reserve was $0.4 million at September 30, 2008, compared to less than $0.1 million at December 31, 2007 and $0.8 million at September 30, 2007.
For the life segment, benefits in the current nine months increased $3.8 million compared to a year earlier, primarily reflecting higher mortality costs.
Interest Credited to Policyholders
For the three months ended September 30, 2008, interest credited of $33.2 million increased 3.1%, or $1.0 million, compared to the same period in 2007, consistent with the percentage increase reflected for the nine months.
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Compared to the first nine months of 2007, the current period increase in annuity segment interest credited reflected a 4.7% increase in average accumulated fixed deposits, partially offset by an 8 basis point decline in the average annual interest rate credited to 4.26%. Life insurance interest credited increased as a result of the growth in interest-sensitive life insurance reserves.
The net interest spread on fixed annuity account value on deposit measures the difference between the rate of income earned on the underlying invested assets and the rate of interest which policyholders are credited on their account values. Fixed annuity crediting rates were lowered in recent years to reflect the decline in the rate of income on invested assets caused by lower investment rates on new and reinvested funds. The net interest spreads for the nine months ended September 30, 2008 and 2007 were 156 basis points and 141 basis points, respectively.
As of September 30, 2008, fixed annuity account values totaled $2.3 billion, including $2.0 billion of deferred annuities. Approximately 20% of the deferred annuity account values had minimum guaranteed interest rates of 3% or lower while approximately 70% of account values had minimum guaranteed rates of 4.5% or greater. For $1.7 billion of the deferred annuity account values, the credited interest rate was equal to the minimum guaranteed rate. The annuity net interest spread increased 15 basis points compared to the first nine months of 2007, due to improvements in the Company’s investment portfolio yield and continued decreases in average interest crediting rates.
Operating Expenses
For the first nine months of 2008, operating expenses decreased 2.5%, or $2.5 million, compared to the prior year, with $1.3 million of the decline recorded in the third quarter. The current year declines, for both the three and nine months, were attributable primarily to reductions in incentive compensation accruals which were partially offset by the impact of increased strategic investments in distribution and technology initiatives. The property and casualty expense ratio of 23.7% for the nine months ended September 30, 2008 decreased 0.4 percentage point compared to the prior year, reflecting the items above and the Company’s overall expense control discipline.
Amortization of Policy Acquisition Expenses and Intangible Assets
For the three months ended September 30, 2008, the combined amortization of policy acquisition expenses and intangible assets of $17.5 million decreased $2.1 million compared to the third quarter of 2007, primarily reflecting a decrease in the current quarter from the valuation of annuity deferred policy acquisition costs with the favorable impact of the investment losses recognized in the quarter more than offsetting the adverse impact of the financial markets on variable deposit fund performance. For the nine months ended September 30, 2008, the combined amortization of policy acquisition expenses and intangible assets was $60.1 million compared to $59.7 million recorded for the same period in the prior year, an increase of $0.4 million.
Amortized policy acquisition expenses were $56.0 million for the first nine months of 2008 compared to $55.7 million for the same period in 2007. The September 30, 2008 valuation of annuity deferred policy acquisition costs resulted in a year-to-date decrease in amortization of $0.1 million, as the favorable impact of investment losses recognized in the
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nine months more than offset the adverse impact of financial market performance, compared to a $0.2 million decrease in amortization from a similar valuation at September 30, 2007. For the life segment, the September 30, 2008 valuation of deferred policy acquisition costs resulted in a $0.1 million year-to-date decrease in amortization compared to no change for the 2007 valuation. The remaining increase in amortized policy acquisition costs was due to scheduled amortization of capitalized costs.
Amortization of intangible assets was $4.1 million for the nine months ended September 30, 2008 and $4.0 million for the same period in 2007. The September 30, 2008 valuation of Annuity VIF resulted in no change in amortization compared to a $0.1 million increase at September 30, 2007.
Income Tax Expense (Benefit)
The effective income tax rate on the Company’s pretax loss in the current year and income in the prior year, including net realized investment gains and losses, was 10.4% and 29.5% for the nine months ended September 30, 2008 and 2007, respectively. Income from investments in tax-advantaged securities benefited the effective tax rate 40.0 percentage points for the nine months ended September 30, 2008 and reduced the effective income tax rate 6.1 percentage points for the nine months ended September 30, 2007. While the income from tax-advantaged securities decreased somewhat compared to a year earlier, the reduced level of taxable income in the current period resulted in this having a greater impact on the effective tax rate for 2008. The current period income tax (benefit) rate reflected an increase of 14.7 percentage points due to the establishment of a valuation allowance against deferred tax assets related to realized and unrealized investment losses at September 30, 2008. (See also “Notes to Consolidated Financial Statements — Note 9 — Income Taxes”.) The change in the effective income tax rate, from a tax of 22.6% for the six months ended June 30, 2008 to the current tax benefit rate, favorably impacted the income tax benefit for the three months ended September 30, 2008.
The Company records liabilities for uncertain tax filing positions where it is more-likely-than-not that the position will not be sustainable upon audit by taxing authorities. These liabilities are reevaluated routinely and are adjusted appropriately based upon changes in facts or law. The Company has no unrecorded liabilities from uncertain tax filing positions.
At September 30, 2008, the Company had income tax returns for the 2002 through 2007 tax years still open and subject to adjustment upon examination by taxing authorities. The Company is currently under examination by the Internal Revenue Service (“IRS”) for tax years 2002, 2004, 2005 and 2006. As of September 30, 2008, the IRS had proposed certain adjustments related to various deductions made in 2002, 2004, 2005 and 2006. Management is currently evaluating those proposed adjustments but does not anticipate the adjustments would result in a material change to the Company’s results of operations or financial position. The Company has recorded $5.6 million of uncertain tax position liabilities including interest related to all open tax years. Management believes that it is reasonably possible that uncertain tax position liabilities may decrease by approximately $3.4 million within the next 12 months as a result of the potential closing of the 2002, 2004, 2005 and 2006 tax years.
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Net Income (Loss)
For the nine months ended September 30, 2008, the Company’s net loss of $12.0 million represented a decrease of $76.8 million compared to net income reported for the prior year, including a $45.6 million reduction in after-tax realized investment gains and losses. Catastrophe costs increased $30.1 million after tax and non-catastrophe weather-related losses also increased compared to the prior year. In addition, results in the current nine months were negatively impacted by a reduced level of favorable prior years’ property and casualty reserve development. Including all factors, the property and casualty combined ratio was 103.3% for the first nine months of 2008 compared to 91.8% for the same period in 2007. Annuity segment net income increased $0.7 million, or 5%, compared to the first nine months of 2007, as current period improvements in the interest margin were partially offset by the adverse impact of the financial market on the level of contract charges earned. Life segment net income decreased $0.5 million, or 4%, compared to a year earlier, reflecting growth in investment income offset by higher mortality costs.
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Net income (loss) by segment and net income (loss) per share were as follows:
Analysis of net income (loss) by segment:
Corporate and other (1)
Effect of catastrophe costs, after tax, included above
Effect of realized investment gains (losses), after tax, included above
Diluted:
Weighted average number of shares and equivalent shares (in millions)
Property and casualty combined ratio:
Effect of catastrophe costs, included above
N.M. – Not meaningful.
For the current period, the changes in net income for the property and casualty, annuity and life segments are described above.
For the corporate and other segment, the current period increase in net loss compared to the first nine months of 2007 was due to net realized investment losses, compared to net realized investment gains in the first nine months of 2007.
Return on shareholders’ equity based on net income (loss) was 1% and 14% for the trailing 12 months ended September 30, 2008 and 2007, respectively.
At the time of this Quarterly Report on Form 10-Q, management estimates that 2008 full year net income before realized investment gains and losses will be within a range of $1.10 to $1.25 per diluted share. This projection incorporates results for the first nine months of 2008 — which included a significant level of property and casualty weather-related catastrophe costs, as well as the adverse impact of financial markets performance — and assumes an average amount of property and casualty catastrophe losses for the last three months of the year and a relatively flat performance in the financial markets from September 30, 2008 levels. The revised estimate also anticipates $0.05 per share of expenses related to the Company’s second quarter 2008 decision to consolidate its property and casualty field claims offices. As
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described in “Critical Accounting Policies”, certain of the Company’s significant accounting measurements require the use of estimates and assumptions. As additional information becomes available, adjustments may be required. Those adjustments are charged or credited to income for the period in which the adjustments are made and may impact actual results compared to management’s current estimate. A projection of net income including realized investment gains and losses is not accessible on a forward-looking basis because it is not possible to provide a reliable forecast of realized investment gains and losses, which can vary substantially from one period to another and may have a significant impact on net income.
Liquidity and Financial Resources
Off-Balance Sheet Arrangements
At September 30, 2008 and 2007, the Company did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As such, the Company is not exposed to any financing, liquidity, market or credit risk that could arise if the Company had engaged in such relationships.
Information regarding the Company’s investment portfolio, which is comprised primarily of investment grade, fixed income securities, is located in “Results of Operations — Net Realized Investment Gains and Losses” and in the “Notes to Consolidated Financial Statements — Note 3 — Investments”.
Cash Flow
The short-term liquidity requirements of the Company, within a 12-month operating cycle, are for the timely payment of claims and benefits to policyholders, operating expenses, interest payments and federal income taxes. Cash flow generated from operations has been, and is expected to be, adequate to meet the Company’s operating cash needs in the next 12 months. Cash flow in excess of operational needs has been used to fund business growth, retire short-term debt, pay dividends to shareholders and repurchase shares of the Company’s common stock. Long-term liquidity requirements, beyond one year, are principally for the payment of future insurance policy claims and benefits and retirement of long-term debt.
Operating Activities
As a holding company, HMEC conducts its principal operations in the personal lines segment of the property and casualty and life insurance industries through its subsidiaries. HMEC’s insurance subsidiaries generate cash flow from premium and investment income, generally well in excess of their immediate needs for policy obligations, operating expenses and other cash requirements. Cash provided by operating activities primarily reflects net cash generated by the insurance subsidiaries. For the first nine months of 2008, net cash provided by operating activities decreased compared to the same period in 2007, primarily reflecting an increase in the level of benefits/claims paid, including the impact of significant property and casualty catastrophe claims in the current period.
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Payment of principal and interest on debt, dividends to shareholders and parent company operating expenses are dependent upon the ability of the insurance subsidiaries to pay cash dividends or make other cash payments to HMEC, including tax payments pursuant to tax sharing agreements. Payments for the share repurchase programs also have this dependency. The insurance subsidiaries are subject to various regulatory restrictions which limit the amount of annual dividends or other distributions, including loans or cash advances, available to HMEC without prior approval of the insurance regulatory authorities. Dividends which may be paid by the insurance subsidiaries to HMEC during 2008 without prior approval are approximately $93 million, of which $64.5 million was paid during the nine months ended September 30, 2008. Although regulatory restrictions exist, dividend availability from subsidiaries has been, and is expected to be, adequate for HMEC’s capital needs.
Investing Activities
HMEC’s insurance subsidiaries maintain significant investments in fixed maturity securities to meet future contractual obligations to policyholders. In conjunction with its management of liquidity and other asset/liability management objectives, the Company, from time to time, will sell fixed maturity securities prior to maturity and reinvest the proceeds in other investments with different interest rates, maturities or credit characteristics. Accordingly, the Company has classified the entire fixed maturity securities and equity securities portfolios as “available for sale”.
Financing Activities
Financing activities include primarily payment of dividends, the receipt and withdrawal of funds by annuity contractholders, repurchases of the Company’s common stock, fluctuations in bank overdraft balances, and borrowings, repayments and repurchases related to its debt facilities.
The Company’s annuity business produced net positive cash flows in both the three and nine months ended September 30, 2008. For the nine months ended September 30, 2008, receipts from annuity contracts decreased $20.5 million, or 7.9%, compared to the same period in the prior year. Annuity contract benefits and withdrawals decreased $22.9 million, or 15.5%, compared to the prior year. Cash value retentions for variable and fixed annuity options were 92.7% and 93.3%, respectively, for the 12 month period ended September 30, 2008. Net transfers to variable annuity accumulated cash values decreased $55.7 million, or 51.8%, compared to the prior year.
During the first nine months of 2008, the Company repurchased 3,198,225 shares of its common stock, or 7.6% of the outstanding shares on December 31, 2007, at an aggregate cost of $54.3 million, or an average cost of $16.99 per share, under its stock repurchase programs, which are further described in “Notes to Consolidated Financial Statements — Note 5 — Share Repurchase Programs and Treasury Shares Held”. The repurchase of shares was financed through use of cash. As of June 30, 2008, the Company had completed its authorized share repurchase programs. See also “Liquidity and Financial Resources — Capital Resources”.
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Contractual Obligations
The annual disclosure of the Company’s contractual obligations was provided in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Financial Resources — Contractual Obligations” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. The Company’s contractual obligations at September 30, 2008 were not materially different than those at December 31, 2007. Discussion of the recent changes in the Company’s short-term debt obligations, including transactions that occurred subsequent to September 30, 2008, is included in “Capital Resources”. The table below identifies the future payments due on debt obligations that were outstanding as of October 2, 2008, including the borrowing under the Company’s Bank Credit Facility which occurred on October 2, 2008.
Short-Term Debt Obligations (2):
Bank Credit Facility (expires December 19, 2011)
Long-Term Debt Obligations (2):
Senior Notes Due June 15, 2015
Senior Notes Due April 15, 2016
Total debt obligations
Capital Resources
The Company has determined the amount of capital which is needed to adequately fund and support business growth, primarily based on risk-based capital formulas including those developed by the National Association of Insurance Commissioners (“NAIC”). Historically, the Company’s insurance subsidiaries have generated capital in excess of such needed capital. These excess amounts have been paid to HMEC through dividends. HMEC has then utilized these dividends and its access to the capital markets to service and retire long-term debt, pay dividends to its shareholders, fund growth initiatives, repurchase shares of its common stock and for other corporate purposes. Management anticipates that the Company’s sources of capital will continue to generate capital in excess of the needs for business growth, debt interest payments and shareholder dividends.
The total capital of the Company was $661.3 million at September 30, 2008, including $199.5 million of long-term debt and no short-term debt outstanding. Total debt represented 24.4% of total capital excluding unrealized investment gains and losses (30.2% including unrealized investment gains and losses) at September 30, 2008, which was below the Company’s long-term target of 25%.
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Shareholders’ equity was $461.8 million at September 30, 2008, including a net unrealized loss in the Company’s investment portfolio of $156.2 million after taxes and the related impact on deferred policy acquisition costs and the value of acquired insurance in force associated with annuity and interest-sensitive life policies. The market value of the Company’s common stock and the market value per share were $502.7 million and $12.87, respectively, at September 30, 2008. Book value per share was $11.82 at September 30, 2008 ($15.82 excluding investment fair value adjustments).
Additional information regarding the net unrealized loss in the Company’s investment portfolio at September 30, 2008 is included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations — Net Realized Investment Gains and Losses”.
In September 2007, HMEC’s Board of Directors (“Board”) authorized a new $50 million share repurchase program and ended the May 1999 authorization. The new program authorized the repurchase of common shares in open market or privately negotiated transactions, from time to time, depending on market conditions. By February 19, 2008, the Company had completed the $50.0 million authorized by the new program, resulting in a total of 2,738,376 shares repurchased under this program at an average cost of $18.28 per share. In March 2008, the Board authorized an additional $25.0 million share repurchase program allowing for repurchase of common shares in open market or privately negotiated transactions, from time to time, depending on market conditions (the “March 2008 Program”). As of June 30, 2008, the Company had completed the March 2008 Program, resulting in a total of 1,571,449 shares repurchased under this program at an average cost of $15.93 per share. As of June 30, 2008, the Company had completed all of its authorized share repurchase programs. See also “Notes to Consolidated Financial Statements — Note 5 — Share Repurchase Programs and Treasury Shares Held”.
As of September 30, 2008, the Company had outstanding $75.0 million aggregate principal amount of 6.05% Senior Notes (“Senior Notes due 2015”), which will mature on June 15, 2015, issued at a discount resulting in an effective yield of 6.1%. Interest on the Senior Notes due 2015 is payable semi-annually at a rate of 6.05%. Detailed information regarding the redemption terms of the Senior Notes due 2015 is contained in the “Notes to Consolidated Financial Statements — Note 4 — Debt” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
The Senior Notes due 2015 have an investment grade rating from S&P (BBB), Moody’s (Baa3), and A.M. Best Company, Inc. (“A.M. Best”) (bbb-). See also “Financial Ratings”. The Senior Notes due 2015 are traded in the open market (HMN 6.05).
As of September 30, 2008, the Company had outstanding $125.0 million aggregate principal amount of 6.85% Senior Notes (“Senior Notes due 2016”), which will mature on April 15, 2016, issued at a discount resulting in an effective yield of 6.893%. Interest on the Senior Notes due 2016 is payable semi-annually at a rate of 6.85%. Detailed information regarding the redemption terms of the Senior Notes due 2016 is contained in the “Notes to Consolidated Financial Statements — Note 4 — Debt” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
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The Senior Notes due 2016 have an investment grade rating from S&P (BBB), Moody’s (Baa3), and A.M. Best (bbb-). See also “Financial Ratings”. The Senior Notes due 2016 are traded in the open market (HMN 6.85).
As of September 30, 2008, the Company had no balance outstanding under its Bank Credit Facility. The Bank Credit Facility provides for unsecured borrowings of up to $125.0 million and expires on December 19, 2011. Interest accrues at varying spreads relative to corporate or Eurodollar base rates and is payable monthly or quarterly depending on the applicable base rate. The unused portion of the Bank Credit Facility is subject to a variable commitment fee, which was 0.125% on an annual basis at September 30, 2008.
On October 2, 2008, the Company borrowed $75.0 million under its existing $125.0 million Bank Credit Facility. Interest accrues at the London Interbank Offered Rate (“LIBOR”) plus 0.6%, or 4.7%, from October 2, 2008 through January 2, 2009 at which point the interest rate will be subject to change based on the then current LIBOR. In light of the recent illiquidity in the credit markets, the Company elected to make this borrowing at the holding company on October 2, 2008 to provide flexibility for future capital needs, including capital contributions to the Company’s insurance subsidiaries, if necessary, to maintain capital and operating ratios at a level consistent with the insurance subsidiaries’ financial strength ratings as of September 30, 2008. As of the date of this Quarterly Report on Form 10-Q, no capital contributions had been made to the insurance subsidiaries.
To provide additional capital management flexibility, the Company filed a “universal shelf” registration on Form S-3 with the SEC in December 2003. The registration statement, which registers the offer and sale by the Company from time to time of up to $300 million of various securities, which may include debt securities, preferred stock, common stock and/or depositary shares, was declared effective on December 30, 2003. Unless fully utilized or withdrawn by the Company earlier, this registration statement will remain effective through December 1, 2008. The $75.0 million face amount of Senior Notes due 2015 and $125.0 million face amount of Senior Notes due 2016 were issued utilizing this registration statement. No other securities associated with the registration statement have been issued as of the date of this Quarterly Report on Form 10-Q.
Total shareholder dividends were $12.9 million for the nine months ended September 30, 2008. In March, May and September 2008, the Board of Directors announced regular quarterly dividends of $0.105 per share.
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Information regarding the reinsurance program for the Company’s property and casualty segment is located in “Business — Property and Casualty Segment — Property and Casualty Reinsurance” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. All components of the Company’s property and casualty reinsurance program remain consistent with the Form 10-K disclosure, with the exception of the Florida Hurricane and Catastrophe Fund (“FHCF”) coverage. As previously disclosed, through June 1, 2008, the Company’s predominant insurance subsidiary for property and casualty business written in Florida reinsured 90% of hurricane losses in that state above an estimated retention of $14.7 million up to $87.2 million with the FHCF. The FHCF contract is a one-year contract. Effective June 1, 2008, the new contract with the FHCF reinsures 90% of hurricane losses in Florida above an estimated retention of $15.1 million up to $84.9 million, based on the FHCF’s financial resources. These limits reflect the Company’s purchase of both mandatory coverage and the Temporary Increase in Coverage Limit (“TICL”) option and resulted in changes to attachment points under the Company’s primary reinsurance contract for hurricane losses occurring in Florida. Additional coverage made available by the FHCF to the industry in future contract periods could increase the likelihood of assessments in periods following significant hurricane losses.
Information regarding the reinsurance program for the Company’s life segment is located in “Business — Life Segment” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
Financial Ratings
The Company’s principal insurance subsidiaries are rated by S&P, Moody’s and A.M. Best. These rating agencies have also assigned ratings to the Company’s long-term debt securities.
Assigned ratings as of October 31, 2008 were unchanged from the disclosure in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. On October 9, 2008, S&P affirmed the Company’s ratings and revised its outlook for those ratings from stable to negative citing the relatively high catastrophe frequency in the property and casualty industry, as well as general credit and equity market deterioration. On September 17, 2008, Moody’s affirmed the Company’s ratings and the outlook for those ratings. Assigned ratings as of October 31, 2008 were as follows (the insurance financial strength ratings for the Company’s property and casualty insurance subsidiaries and the Company’s principal life insurance subsidiary are the same):
As of October 31, 2008
S&P (1)
Moody’s (1)
A.M. Best
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Market Value Risk
Market value risk, the Company’s primary market risk exposure, is the risk that the Company’s invested assets will decrease in value. This decrease in value may be due to (1) a change in the yields realized on the Company’s assets and prevailing market yields for similar assets, (2) an unfavorable change in the liquidity of the investment, (3) an unfavorable change in the financial prospects of the issuer of the investment, or (4) a downgrade in the credit rating of the issuer of the investment. See also “Results of Operations — Net Realized Investment Gains and Losses”.
Significant changes in interest rates expose the Company to the risk of experiencing losses or earning a reduced level of income based on the difference between the interest rates earned on the Company’s investments and the credited interest rates on the Company’s insurance liabilities. See also “Results of Operations — Interest Credited to Policyholders”.
The Company seeks to manage its market value risk by coordinating the projected cash inflows of assets with the projected cash outflows of liabilities. For all its assets and liabilities, the Company seeks to maintain reasonable durations, consistent with the maximization of income without sacrificing investment quality, while providing for liquidity and diversification. The investment risk associated with variable annuity deposits and the underlying mutual funds is assumed by those contractholders, and not by the Company. Certain fees that the Company earns from variable annuity deposits are based on the market value of the funds deposited.
More detailed descriptions of the Company’s exposure to market value risks and the management of those risks is presented in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Market Value Risk” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
Recent Accounting Changes
SFAS No. 163
In May 2008, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS” or “FAS”) No. 163, “Accounting for Financial Guarantee Insurance Contracts – an interpretation of FASB Statement No. 60”. SFAS No. 163 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. This statement applies to financial guarantee insurance and reinsurance contracts, including the recognition and measurement of premium revenue and claim liabilities. Management believes this pronouncement will not have a material effect on the results of operations or financial position of the Company.
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SFAS No. 162
In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles”. SFAS No. 162 will be effective 60 days following the Securities and Exchange Commission’s approval of the Public Company Accounting Oversight Board’s related amendments to remove the generally accepted accounting principles in the United States (“GAAP”) hierarchy from auditing standards. SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principals used in the preparation of financial statements of nongovernmental entities that are presented in conformity with GAAP. Management believes the adoption of this pronouncement will not have a material effect on the results of operations or financial position of the Company.
FSP APB 14-1
In May 2008, the FASB issued FASB Staff Position (“FSP”) Accounting Principles Board (“APB”) 14-1, “Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement)”. FSP APB 14-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. This FSP requires issuers of convertible debt instruments that may be settled in cash upon conversion to separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods. Management is currently assessing the impact of this FSP, but anticipates that its adoption will not have a material effect on the results of operations or financial position of the Company.
FSP FAS 142-3
In April 2008, the FASB issued FSP FAS 142-3, “Determination of the Useful Life of Intangible Assets”. FSP FAS 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. This FSP requires companies estimating the useful life of a recognized intangible asset to consider their historical experience in renewing or extending similar arrangements or, in the absence of historical experience, to consider assumptions that market participants would use about renewal or extension as adjusted for SFAS No. 142, “Goodwill and Other Intangible Assets”. Management anticipates that adoption of this FSP will not have a material effect on the results of operations or financial position of the Company.
FSP FAS 140-3
In February 2008, the FASB amended SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities – a replacement of FASB Statement No. 125”, through issuance of FSP FAS 140-3, “Accounting for Transfers of Financial Assets and Repurchase Financing Transactions”. FSP FAS 140-3 is effective for financial statements issued for fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. This FSP presumes that an initial transfer of a financial asset and a repurchase financing are considered part of the same arrangement unless four conditions are all met. Transactions that meet all four criteria will be accounted for separately from repurchase financings. Management is currently assessing the impact of this FSP but anticipates that its adoption will not have a material effect on the results of operations or financial position of the Company.
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Other Matters
Proposal for Federal Regulation Option
In March 2008, the United States Treasury Department issued a report, “Blueprint for Financial Regulatory Reform”, including recommendations to improve regulatory oversight of the financial services sector. The report includes a proposal that would establish a federal insurance regulatory structure and allow individual insurance companies the option of obtaining a federal charter, similar to the current dual-chartering system for banking. Congress also has pending proposals regarding optional federal chartering of insurance companies and other various insurance-related matters which have been subject to congressional hearings in 2008. Management will continue to monitor these proposals and the potential impact on the Company, insurers of similar size and the insurance industry as a whole.
Ariel Capital Management, LLC, HMEC’s largest shareholder with 15.3% of the common shares outstanding per their SEC filing on Schedule 13G as of June 30, 2008, is the investment adviser for two of the mutual funds under the Company’s variable annuity contracts.
Item 3: Quantitative and Qualitative Disclosures About Market Risk
The information required by Item 305 of Regulation S-K is contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Market Value Risk” contained in this Quarterly Report on Form 10-Q.
Item 4: Controls and Procedures
Management’s Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
Under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company conducted an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as such term is defined in Rule 13a-15(e) of the Securities Exchange Act of 1934 as amended (the “Exchange Act”), as of September 30, 2008 pursuant to Rule 13a-15(b) of the Exchange Act. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) that is required to be included in the Company’s periodic Securities and Exchange Commission filings. No significant deficiencies or material weaknesses in the Company’s disclosure controls and procedures were identified in the evaluation and therefore, no corrective actions were taken. There were no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation.
Changes in Internal Control Over Financial Reporting
There were no changes in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
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PART II: OTHER INFORMATION
Item 1A: Risk Factors
At the time of this Quarterly Report on Form 10-Q, management believes there are no material changes from the risk factors as previously disclosed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.
Item 4: Submission of Matters to a Vote of Security Holders
None.
Item 5: Other Information
The Company is not aware of any information required to be disclosed in a report on Form 8-K during the three months ended September 30, 2008 which has not been filed with the SEC.
Item 6: Exhibits
Exhibit No.
Description
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
/s/ Louis G. Lower II
/s/ Peter H. Heckman
Executive Vice President
and Chief Financial Officer
/s/ Bret A. Conklin
Senior Vice President
and Controller
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EXHIBITS
To
For the Quarter Ended September 30, 2008
VOLUME 1 OF 1
The following items are filed as Exhibits to Horace Mann Educators Corporation’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2008. Management contracts and compensatory plans are indicated by an asterisk (*).
EXHIBIT INDEX