UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20549
FORM 10-Q
Quarterly report pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2005.
Commission file number 1-11834
UnumProvident 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 FOUNTAIN SQUARE
CHATTANOOGA, TENNESSEE 37402
(Address of principal executive offices)
423.294.1011
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
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 whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes x No ¨
Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes ¨ No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
Outstanding at September 30, 2005
TABLE OF CONTENTS
Cautionary Statement Regarding Forward-Looking Statements
1.
Financial Statements (Unaudited):
Condensed Consolidated Statements of Financial Condition at September 30, 2005 and December 31, 2004
Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2005 and 2004
Condensed Consolidated Statements of Stockholders’ Equity for the nine months ended September 30, 2005 and 2004
Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004
Notes to Condensed Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
3.
Quantitative and Qualitative Disclosures about Market Risk
4.
Controls and Procedures
Legal Proceedings
6.
Exhibits
Signatures
The Private Securities Litigation Reform Act of 1995 (the Act) provides a “safe-harbor” for forward-looking statements which are identified as such and are accompanied by the identification of important factors that could cause actual results to differ materially from the forward-looking statements. For these statements, UnumProvident Corporation, together with its subsidiaries, unless the context implies otherwise (the Company), claims the protection afforded by the safe harbor in the Act. Certain information contained in this discussion, or in any other written or oral statements made by the Company, is or may be considered as forward-looking. Examples of disclosures that contain such information include, among others, sales estimates, income projections, and reserves and related assumptions. Forward-looking statements are those not based on historical information, but rather relate to future operations, strategies, financial results, or other developments and speak only as of the date made. These statements may be made directly in this document or may be made part of this document by reference to other documents filed with the Securities and Exchange Commission by the Company, which is known as “incorporation by reference.” You can find many of these statements by looking for words such as “will,” “may,” “should,” “could,” “believes,” “expects,” “anticipates,” “estimates,” “intends,” “projects,” “goals,” “objectives,” or similar expressions in this document or in documents incorporated herein.
These forward-looking statements are subject to numerous assumptions, risks, and uncertainties, many of which are beyond the Company’s control. Factors that may cause actual results to differ materially from those contemplated by the forward-looking statements include, among others, the following factors:
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For further discussion of risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, see “Risk Factors” contained in Part I of the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2004.
All subsequent written and oral forward-looking statements attributable to the Company or any person acting on its behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. The Company does not undertake any obligation to release publicly any revisions to such forward-looking statements to reflect events or circumstances after the date of this document or to reflect the occurrence of unanticipated events.
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PART I
ITEM 1. FINANCIAL STATEMENTS
CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
UnumProvident Corporation and Subsidiaries
Fixed Maturity Securities - at fair value
Equity Securities
Mortgage Loans
Real Estate
Policy Loans
Other Long-term Investments
Short-term Investments
Cash and Bank Deposits
Accounts and Premiums Receivable
Reinsurance Receivable
Accrued Investment Income
Deferred Policy Acquisition Costs
Value of Business Acquired
Goodwill
Other Assets
Separate Account Assets
See notes to condensed consolidated financial statements.
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CONDENSED CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION - Continued
Policy and Contract Benefits
Reserves for Future Policy and Contract Benefits
Unearned Premiums
Other Policyholders’ Funds
Current Income Tax
Deferred Income Tax
Short-term Debt
Long-term Debt
Other Liabilities
Separate Account Liabilities
Common Stock, $0.10 par
Authorized: 725,000,000 shares
Issued: 299,970,342 and 298,497,008 shares
Additional Paid-in Capital
Accumulated Other Comprehensive Income
Retained Earnings
Treasury Stock - at cost: 1,951,095 shares
Deferred Compensation
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CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Premium Income
Net Investment Income
Net Realized Investment Gain (Loss)
Other Income
Benefits and Change in Reserves for Future Benefits
Commissions
Interest and Debt Expense
Deferral of Policy Acquisition Costs
Amortization of Deferred Policy Acquisition Costs
Amortization of Value of Business Acquired
Impairment of Intangible Assets
Compensation Expense
Other Operating Expenses
Loss Before Income Tax
Income Tax Benefit
Basic
Income (Loss) from Continuing Operations
Net Income (Loss)
Assuming Dilution
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CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (UNAUDITED)
Comprehensive Loss, Net of Tax
Net Loss
Change in Net Unrealized Gain on Securities
Change in Net Gain on Cash Flow Hedges
Change in Foreign Currency Translation Adjustment
Total Comprehensive Loss
Issuance of Equity Security Units
Common Stock Activity
Dividends to Stockholders
Comprehensive Income, Net of Tax
Net Income
Total Comprehensive Income
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Adjustments to Reconcile Net Income (Loss) to Net Cash Provided by Operating Activities
Policy Acquisition Costs Capitalized
Amortization and Depreciation
Net Realized Investment (Gain) Loss
Insurance Reserves and Liabilities
Income Tax
Cash Transferred to Reinsurer for Individual Income Protection - Closed Block Restructuring Transaction
Other
Proceeds from Sales of Investments
Proceeds from Maturities of Investments
Purchase of Investments
Net Sales (Purchases) of Short-term Investments
Acquisition of Business
Disposition of Business
Deposits to Policyholder Accounts
Maturities and Benefit Payments from Policyholder Accounts
Net Short-term Debt Repayments
Issuance of Long-term Debt
Issuance of Common Stock
Dividends Paid to Stockholders
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
September 30, 2005
Note 1 - Basis of Presentation
The accompanying condensed consolidated financial statements of UnumProvident Corporation and subsidiaries (the Company) have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals, the impairment of intangible assets as discussed in Note 4, and the reserve strengthening as discussed in Note 5) considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ended September 30, 2005, are not necessarily indicative of the results that may be expected for the year ended December 31, 2005. Certain prior year amounts have been reclassified to conform to current year presentation.
During 2004, the Company completed the sale of its Canadian branch. Financial results for the Canadian branch are reported as discontinued operations in the condensed consolidated financial statements, and except where noted, the information presented in the notes to condensed consolidated financial statements excludes the Canadian branch. See Note 3 for further discussion of the Company’s discontinued operations.
For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2004.
Note 2 - Accounting Pronouncements Outstanding
During 2003, the Company adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation, and selected the prospective method of adoption allowed under the provisions of Statement of Financial Accounting Standards No. 148 (SFAS 148), Accounting for Stock-Based Compensation – Transition and Disclosure. The recognition provisions were applied to all employee awards granted, modified, or settled after January 1, 2003. Statement of Financial Accounting Standards No. 123 (revised 2004) (SFAS 123 (R)), Share-Based Payment, was issued in December 2004 and requires all stock-based employee compensation, including grants of employee stock options, to be recognized in the financial statements using the fair value based method. SFAS 123(R) is a revision of SFAS 123 and supersedes Accounting Principles Board (APB) Opinion No. 25 (Opinion 25), Accounting for Stock Issued to Employees, and related Interpretations. The provisions of SFAS 123(R) were initially to have become effective July 1, 2005. However, in April 2005, the Securities and Exchange Commission delayed the date for compliance with SFAS 123(R) until the first interim or annual reporting period of the first fiscal year beginning on or after June 15, 2005. The Company will therefore adopt SFAS 123(R) effective January 1, 2006. Because the Company had previously adopted the fair value recognition provisions of SFAS 123, the adoption of the pronouncement will have an immaterial impact on the Company’s financial position and results of operations.
Statement of Position 05-1 (SOP 05-1), Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of insurance Contracts, was issued by the Accounting Standards Executive Committee on September 19, 2005. SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in Statement of Financial Accounting Standards No. 97 (SFAS 97), Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. The Company has not yet determined the impact of the adoption of SOP 05-1 on its financial position or results of operations.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) - Continued
Note 3 - Discontinued Operations
During 2003, the Company entered into an agreement to sell its Canadian branch. The transaction closed April 30, 2004, and in the second quarter of 2004, the Company reported a loss of $113.0 million before tax and $70.9 million after tax on the sale of the branch. The Company also recognized a loss of $0.6 million before tax and $0.4 million after tax in the first quarter of 2004 to write down the value of bonds in the Canadian branch investment portfolio to market value.
Assets transferred to the buyer included available-for-sale fixed maturity securities with a fair value of $1,099.4 million (book value of $957.7 million) and cash of $31.7 million. Liabilities transferred included reserves of $1,254.8 million.
The Company retained a portion of the Canadian branch fixed maturity bond portfolio according to the terms of the transaction. At the close of the transaction, the bonds retained had a fair value of $732.9 million and a yield of 7.14 percent. These investments were subsequently redeployed to other lines of business.
Selected results for the Canadian branch for the period January 1, 2004 through April 30, 2004 are as follows (in million of dollars, except share data):
Total Revenue
Income Before Income Tax, Excluding Loss on Sale and Write-downs
Loss on Sale and Write-downs
Income Excluding Loss on Sale and Write-downs
Loss on Sale and Write-downs, Net of Income Tax
Loss
Loss Per Share
Note 4 - Segment Information
Effective July 1, 2005, the Company modified its reporting segments to separate its United States business from that of its United Kingdom subsidiary, Unum Limited, due to the continued growth in that subsidiary and to recent organizational changes within the Company which established a separate management team to focus solely on the U.S. Brokerage lines of business. The Company’s new reporting segments are comprised of the following: U.S. Brokerage, Unum Limited (U.K. business), Colonial, Individual Income Protection – Closed Block, Other, and Corporate.
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Note 4 - Segment Information - Continued
The U.S. Brokerage segment includes the results of the Company’s U.S. group income protection insurance, group life and accidental death and dismemberment products, and supplemental and voluntary lines of business, including individual income protection – recently issued, group and individual long-term care, and brokerage voluntary workplace benefits products. The Unum Limited segment is comprised of the Company’s U.K. group and individual income protection and group life products. The products now reported in the U.S. Brokerage segment and the Unum Limited segment were previously combined and reported in the Income Protection and Life and Accident segments. The modification of the Company’s reporting segments had no impact on the level at which the Company performs impairment testing for goodwill or loss recognition testing for the recoverability of deferred policy acquisition costs and value of business acquired.
The results of the disability management services business are now reported in the Other segment, which has been redefined to include the disability management services business as well as results from U.S. Brokerage insured products not actively marketed (with the exception of certain individual income protection products), including individual life and corporate-owned life insurance, reinsurance pools and management operations, group pension, health insurance, and individual annuities. There were no changes to the Colonial, Individual Income Protection – Closed Block or Corporate segments.
In the first quarter of 2004, the Company restructured its individual income protection – closed block business wherein three of its insurance subsidiaries entered into reinsurance agreements to reinsure approximately 66.7 percent of potential future losses that occur above a specified retention limit. The individual income protection – closed block reserves in these three subsidiaries comprise approximately 90 percent of the Company’s overall retained risk in the closed block of individual income protection. The reinsurance agreements effectively provide approximately 60 percent reinsurance coverage for the Company’s overall consolidated risk above the retention limit. The maximum risk limit for the reinsurer is approximately $783.0 million initially and grows to approximately $2.6 billion over time, after which any further losses will revert to the Company. These reinsurance transactions were effective as of April 1, 2004.
In conjunction with the restructuring of the individual income protection – closed block business, effective January 1, 2004, the Company modified its reporting segments to include a separate segment for this business. The reporting, monitoring, and management of the closed block of individual income protection business as a discrete segment is consistent with the Company’s financial restructuring and separation of this business from the lines of business which actively market new products. In the past, this business had been reported in combination with the individual income protection – recently issued line of business. Prior to 2004, detailed separate financial metrics and models were unavailable to appropriately manage this block of business separately from the recently issued individual income protection block of business.
The separation of the closed block business into a separate reporting segment required the Company to perform, separately for the individual income protection – closed block business and individual income protection – recently issued business, impairment testing for goodwill and loss recognition testing for the recoverability of deferred policy acquisition costs and value of business acquired. As required under GAAP, prior to the change in reporting segments, these tests were performed for the individual income protection line of business on a combined basis. The testing indicated impairment of the individual income protection – closed block deferred policy acquisition costs, value of business acquired, and goodwill balances of $282.2 million, $367.1 million, and $207.1 million, respectively.
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These impairment charges, $856.4 million before tax and $629.1 million after tax, are included in the net loss reported for the nine month period ended September 30, 2004. The Company also strengthened its claim reserves for the closed block of individual income protection business $110.6 million before tax to reflect the implementation of a lower claim reserve discount rate. The impairment charges and reserve strengthening, which total $967.0 million before tax, are all reported in the Individual Income Protection – Closed Block segment. See Note 5 for additional information concerning the claim reserve strengthening.
In the following segment financial data, “operating revenue” excludes net realized investment gains and losses. “Operating income” or “operating loss” excludes net realized investment gains and losses, income tax, and results of discontinued operations. These are considered non-GAAP financial measures. These non-GAAP financial measures of “operating revenue” and “operating income” or “operating loss” differ from revenue and income (loss) from continuing operations before income tax as presented in the Company’s condensed consolidated operating results reported herein and in income statements prepared in accordance with GAAP due to the exclusion of before tax realized investment gains and losses. The Company measures segment performance for purposes of Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information, excluding realized investment gains and losses because management believes that this performance measure is a better indicator of the ongoing businesses and the underlying trends in the businesses. The Company’s investment focus is on investment income to support its insurance liabilities as opposed to the generation of realized investment gains and losses, and a long-term focus is necessary to maintain profitability over the life of the business. Realized investment gains and losses are dependent on market conditions and not necessarily related to decisions regarding the underlying business of the Company’s segments. Segment results for the three and nine months ended September 30, 2004 have been reclassified to conform to the current reporting segments.
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Selected data by segment is as follows:
U.S. Brokerage
Group Income Protection
Group Long-term Income Protection
Group Short-term Income Protection
Group Life and Accidental Death & Dismemberment
Group Life
Accidental Death & Dismemberment
Supplemental and Voluntary
Individual Income Protection - Recently Issued
Long-term Care
Voluntary Workplace Benefits
Unum Limited
Colonial
Income Protection
Life
Individual Income Protection – Closed Block
Corporate
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Operating Income (Loss) Before Income Tax and Net Realized Investment Gain (Loss)
13
A reconciliation of total operating revenue and operating income (loss) by segment to revenue and net income (loss) as reported in the condensed consolidated statements of operations is as follows:
Operating Revenue by Segment
Revenue
Operating Income (Loss) by Segment
Income Tax (Benefit)
Loss from Discontinued Operations, Net of Tax
Assets by segment are as follows:
Total
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Note 5 - Liability for Unpaid Claims and Claim Adjustment Expenses
The Company estimates the ultimate cost of settling claims in each reporting period based on the information available to management at that time. Claim reserves generally equal the Company’s estimate, at the end of the current reporting period, of the present value of the liability for future benefits and expenses to be paid on claims incurred as of that date. A claim reserve for a specific claim is based on assumptions derived from the Company’s actual historical experience. Consideration is given to current and historical trends in the Company’s experience and to expected deviations from historical experience.
Claim reserves are subject to revision as current claim experience and projections of future factors affecting claim experience change. In a reporting period, actual experience may deviate from the long-term assumptions used to determine the claim reserves. The Company reviews annually, or more frequently as appropriate, emerging experience to ensure that its claim reserves make adequate and reasonable provision for future benefits and expenses. This review includes the determination of a range of reasonable estimates within which the reserve must fall.
In April 2004, the Company completed an analysis of the assumptions related to its individual income protection – closed block claim reserves. The analysis was initiated based on the restructuring effective January 1, 2004, which reflected the individual income protection – closed block as a stand-alone segment. Previously these reserves were analyzed for the individual income protection line of business on a combined basis. Included in the analysis was a review of morbidity assumptions, primarily claim resolution rates, and claim reserve discount rate assumptions. Based upon this analysis, the Company lowered the claim reserve discount rate to reflect the segmentation of assets between the individual income protection – recently issued business and the individual income protection – closed block business, the change in the Company’s investment portfolio yield rates during the first quarter of 2004, the Company’s expectation of future investment portfolio yield rates, and the Company’s desire to maintain the relationship between the claim reserve discount rate and the investment portfolio yield rate for the individual income protection – closed block at the Company’s long-term objective. The segmentation of the investment portfolio was necessary to ensure appropriate matching of the duration of the assets and the related policy liabilities. Based on this analysis, in the first quarter of 2004 the Company increased its individual income protection – closed block claim reserves by $110.6 million before tax, or $71.9 million after tax, to reflect its current estimate of future benefit obligations. The first quarter 2004 change represented a 1.2 percent increase in total net individual income protection – closed block reserves as of March 31, 2004, which equaled $9.530 billion prior to this increase.
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Note 6 - Accounting for Stock-Based Compensation
The Company has various stock-based employee compensation plans. Prior to 2003, the Company accounted for those plans under the recognition and measurement principles of APB Opinion 25. All options granted prior to 2003 under the stock-based employee compensation plans had an exercise price equal to the market value of the underlying common stock on the date of grant.
During 2003, the Company adopted the fair value recognition provisions of SFAS 123 and selected the prospective method of adoption allowed under the provisions of SFAS 148. The recognition provisions are applied to all employee awards granted, modified, or settled after January 1, 2003.
The expense recognized in the three and nine month periods ended September 30, 2005 and 2004 for stock-based employee compensation was less than that which would have been recognized if the fair value method had been applied to all option awards granted after the original effective date of SFAS 123. Had the Company applied the fair value recognition provisions of SFAS 123 as of its original effective date, pro forma net income (loss) and net income (loss) per share would be as follows:
Net Income (Loss), as Reported
Add: Stock-based Employee Compensation Expense
Included in Net Income (Loss) as a Result of the
Prospective Application Allowed Under SFAS 148,
Net of Tax
Deduct: Stock-based Employee Compensation Expense
Determined under SFAS 123, Net of Tax
Pro Forma Net Income (Loss)
Net Income (Loss) Per Share:
Basic - as Reported
Basic - Pro Forma
Assuming Dilution - as Reported
Assuming Dilution - Pro Forma
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Note 7 - Pensions and Other Postretirement Benefits
The components of net periodic benefit cost, including discontinued operations, related to the defined benefit pension and postretirement plans sponsored by the Company for its employees are as follows:
Postretirement
Benefits
Service Cost
Interest Cost
Expected Return on Plan Assets
Amortization of Prior Service Cost
Amortization of Net Loss
Net Periodic Benefit Cost
Curtailment
Net Periodic Benefit Cost (Credit)
The Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Medicare Act) was enacted in December 2003 to add a voluntary prescription drug benefit for Medicare-eligible retirees to be effective January 1, 2006. The Medicare Act allows an employer to choose whether or not to coordinate prescription drug benefits under a retiree medical plan with the Medicare prescription drug benefit or to keep the company plan design as it is and receive a subsidy from the federal government. The Company reviewed the options available as a result of Medicare reform and aligned the options, as appropriate, for each of its designated groups of retirees.
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Note 7 - Pensions and Other Postretirement Benefits - Continued
Based on a preliminary analysis of the Medicare Act, it appears that the Company’s retiree medical plans provided to current grandfathered retirees qualify for a government subsidy under the Medicare Act without change to the plans. For current non-grandfathered retirees (those who do not qualify for the government subsidy) and active employees who meet certain age and service requirements, the Company amended its postretirement medical plan in 2004 to coordinate with the Medicare Act so that Medicare is the primary payer of prescription drug benefits. The Company also amended its postretirement medical plan to eliminate the premium subsidy for employees who had not reached a minimum age of 45 and a specified minimum years of service requirement as of December 31, 2003.
On January 21, 2005, The Centers for Medicare & Medicaid Services issued final regulations regarding the Medicare prescription drug benefit and other key elements of the Medicare Act. The Company still expects that the retiree medical plans provided to current grandfathered retirees will qualify for the government subsidy without change to the plans.
The Company has no regulatory contribution requirements for its U.S. qualified defined benefit plans in 2005, but is considering making a voluntary contribution in 2005, depending on fourth quarter 2005 legislative developments for pension reform. The Company’s U.K. operation maintains a separate defined benefit plan for its employees, wherein the Company anticipates it will make a minimum funding contribution of approximately $11.9 million in 2005.
Note 8 - Debt, Stockholders’ Equity, and Earnings Per Common Share
In May 2004, the Company issued 12.0 million 8.25% adjustable conversion-rate equity security units (units) in a private offering for $300.0 million. The Company subsequently registered the privately placed securities for resale by the private investors. Each unit has a stated amount of $25 and will initially consist of (a) a contract pursuant to which the holder agrees to purchase, for $25, shares of the Company’s common stock on May 15, 2007 and which entitles the holder to contract adjustment payments at the annual rate of 3.165 percent, payable quarterly, and (b) a 1/40 or 2.5 percent ownership interest in a senior note issued by the Company due May 15, 2009 with a principal amount of $1,000, on which the Company will pay interest at the initial annual rate of 5.085 percent, payable quarterly. Upon settlement of the common stock purchase contract and successful remarketing of the senior note element of the units, the Company will receive proceeds of approximately $300.0 million and will issue between 17.7 million and 20.4 million shares of common stock. The present value of the quarterly contract adjustment payments, which is included in other liabilities in the consolidated statements of financial condition, and the related purchase contract issuance costs reduced additional paid-in capital by $27.6 million.
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Note 8 - Debt, Stockholders’ Equity, and Earnings Per Common Share - Continued
Net income (loss) per common share is determined as follows:
Numerator
Denominator (000s)
Weighted Average Common Shares - Basic
Dilution for the Purchase Contract Element of the Adjustable Conversion-Rate Equity Security Units
Dilution for Assumed Exercises of Stock Options and Other Dilutive Securities
Weighted Average Common Shares - Assuming Dilution
Net Income (Loss) Per Common Share
The Company accounts for the effect of the purchase contract element of the Company’s adjustable conversion-rate equity security units and the Company’s outstanding stock options and other dilutive securities on the number of weighted average common shares, assuming dilution, using the treasury stock method. As such, the purchase contract element of the Company’s adjustable conversion-rate equity security units and the Company’s outstanding stock options and other dilutive securities will have a dilutive effect only when the average market price of the Company’s common stock during the period exceeds the threshold appreciation price of the purchase contract element of the units or the exercise price of the stock options. The purchase contract elements of the Company’s units issued in 2004 and 2003 have a threshold appreciation price of $16.95 per share and $13.27 per share, respectively. The Company’s outstanding stock options and other dilutive securities have exercise prices ranging from $9.48 to $58.56.
In computing earnings per share assuming dilution, only potential common shares that are dilutive (those that reduce earnings per share) are included. Potential common shares are not used when computing earnings per share assuming dilution if the results would be antidilutive, such as when a net loss from continuing operations is reported. For the nine month period ending September 30, 2004, approximately 5.6 million issuable shares related to the purchase contract elements of the units and approximately 1.5 million issuable common shares for the assumed exercises of stock options and other dilutive securities were not used in the calculation of earnings per share due to the antidilutive effect when a net loss from continuing operations is reported.
Options to purchase approximately 12.1 million and 12.4 million shares of common stock for the three and nine month periods ended September 30, 2005, respectively, and 14.2 million and 14.7 million shares for the three and nine month periods ended September 30, 2004, respectively, were outstanding during the respective periods but were not included in the computation of net income (loss) per common share, assuming dilution, because the exercise prices of the options were greater than the average market price of the Company’s common stock.
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The Company has 25,000,000 shares of preferred stock authorized with a par value of $0.10 per share. No preferred stock has been issued to date.
Note 9 - Comprehensive Income (Loss)
The components of accumulated other comprehensive income, net of deferred tax, are as follows:
Net Unrealized Gain on Securities
Net Gain on Cash Flow Hedges
Foreign Currency Translation Adjustment
Minimum Pension Liability Adjustment
The components of comprehensive income (loss) and the related deferred tax are as follows:
Change in Net Unrealized Gain on Securities:
Change Before Reclassification Adjustment
Reclassification Adjustment for Net Realized Investment (Gain) Loss - Continuing Operations
Reclassification Adjustment for Net Realized Investment Gain - Discontinued Operations
Change in Deferred Tax
Other Comprehensive Income (Loss)
Comprehensive Income (Loss)
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Note 10 - Reinsurance
During the third quarter of 2005, the Company recaptured its closed block individual income protection business originally ceded to Centre Life Reinsurance Ltd. in 1996. The recaptured business includes approximately $1.6 billion in invested assets and $185.0 million of annual premium. The effective date of the recapture was August 8, 2005.
Prior to recapture, the reinsurance contract had an embedded derivative that required the bifurcation of the derivative from the basic reinsurance contract. The fair value attributed to the embedded derivative was reported in fixed maturity securities, and the change in the fair value of this embedded derivative was reported as a realized investment gain or loss during the period of change. At the date of recapture, the embedded derivative was terminated, and the time value component of this derivative was recognized as a realized investment loss of $9.4 million before tax.
The underlying operating results of the reinsurance contract, prior to recapture, were reflected in other income. The recapture therefore did not have a material impact on operating income for the Individual Income Protection – Closed Block segment.
Note 11 - Commitments and Contingent Liabilities
Putative Class Actions and Shareholder Derivative Multidistrict Litigation
On May 22, 2003, UnumProvident, several of its subsidiaries, and some of their officers and directors filed a motion with the Judicial Panel on Multidistrict Litigation seeking to transfer more than twenty class actions and derivative suits now pending against them in various federal district courts to a single district for coordinated or consolidated pre-trial proceedings. Each of these actions, discussed below, contends, among other things, that the defendants engaged in improper claims handling practices in violation of the Employee Retirement Income Security Act (ERISA) or various state laws or failed to disclose the effects of those practices in violation of the federal securities laws. On September 2, 2003, the Judicial Panel on the Multidistrict Litigation entered an order transferring these cases, described below, to the U.S. District Court for the Eastern District of Tennessee for coordinated or consolidated pretrial proceedings. These lawsuits are in a very preliminary stage, the outcome is uncertain, and the Company is unable to estimate a range of reasonably possible losses. Reserves have not been established for these matters. An adverse outcome in one or more of these actions could, depending on the nature, scope, and amount of the ruling, materially adversely affect the Company’s consolidated results of operations in a period, encourage other litigation, and limit the Company’s ability to write new business, particularly if the adverse outcomes negatively impact certain of the Company’s debt and financial strength ratings.
Shareholder Derivative Actions
On November 22, 2002, the first of five purported shareholder derivative actions was filed in the State of Tennessee Chancery Court of Hamilton County. Between December 27, 2002 and March 11, 2003, four additional purported derivative actions were filed in Tennessee state court or the United States District Court for the Eastern District of Tennessee. The defendants removed each of the actions that were filed in Tennessee state court to the United States District Court for the Eastern District of Tennessee. On October 23, 2003, the district court denied motions filed by the plaintiffs to remand those actions back to Tennessee state court.
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Note 11 - Commitments and Contingent Liabilities - Continued
Each of these actions purport to be a shareholder derivative action brought for the benefit of nominal defendant UnumProvident Corporation against certain current and past members of its Board of Directors and certain executive officers alleging breaches of fiduciary duties and other violations of claims paying law by defendants. Plaintiffs allege, among other things, that the individual defendants established and perpetuated an illegal and improper policy of denying legitimate disability claims, engaged in improper financial reporting, and for certain defendants, engaged in insider trading. Further, plaintiffs allege as a result of their responsibility for and knowledge of the Company’s policies and practices, the individual defendants knew that the Company was violating various state and federal laws, including the federal securities laws, thus exposing the Company to liability and damages. Plaintiff alleges these acts violated, among other things, their fiduciary duties of good faith and loyalty.
On October 17, 2003, the district court consolidated these actions under the caption In re UnumProvident Corporation Derivative Actions. On April 19, 2004, the plaintiffs filed a single consolidated amended complaint. On September 10, 2004, the defendants answered the consolidated amended complaint by denying generally the salient factual allegations in the complaint and by asserting various affirmative defenses. The defendants strongly deny the allegations in the complaints and will vigorously defend both the substantive and procedural aspects of the litigation.
Federal Securities Law Class Actions
On February 12, 2003, the first of five virtually identical alleged securities class action suits was filed in the United States District Court for the Eastern District of Tennessee. On February 27, 2003, a sixth complaint was filed in the United States District Court for the Southern District of New York, and later was transferred to the Eastern District of Tennessee by agreement of the parties. In two orders dated May 21, 2003 and January 22, 2004, the district court consolidated these actions under the caption In re UnumProvident Corp. Securities Litigation.
On November 6, 2003, the district court entered an order appointing a Lead Plaintiff in the consolidated action. On January 9, 2004, the Lead Plaintiff filed its consolidated amended complaint. The Lead Plaintiff seeks to represent a putative class of purchasers of UnumProvident Corporation publicly traded securities between March 30, 2000 and April 24, 2003. The plaintiffs allege, among other things, that the Company issued misleading financial statements, improperly accounted for certain impaired investments, failed to properly estimate its disability claim reserves, and pursued certain improper claims handling practices. The complaint asserts claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. On March 19, 2004, the defendants filed a motion to dismiss the consolidated amended complaint. On September 12, 2005, the court issued a Memorandum and Order denying in part, and granting in part, the motion to dismiss. The court granted the motion with respect to Lead Plaintiff’s claims concerning UnumProvident’s investments and denied the motion challenging the other alleged misstatements. Discovery, which has been stayed in this action pursuant to the Private Securities Litigation Reform Act of 1995, has now begun. The Company denies the allegations and will vigorously defend against the allegations raised by the complaints.
On May 7, 2003, Azzolini v. CorTs Trust II for Provident Financial Trust, et al., was filed in the Southern District of New York. This is a federal securities law class action on behalf of a putative class of purchasers of UnumProvident Corporate-Backed Trust Securities (CorTs) certificates issued by the defendant underwriters in an initial public offering unaffiliated with the Company. Plaintiff alleges claims against UnumProvident, certain of its officers, and certain of the underwriter defendants under the Securities Act of 1933 and the Securities Exchange Act of 1934. Plaintiff asserts that UnumProvident issued and/or failed to correct false and misleading financial statements and press releases concerning the Company’s publicly reported revenues and earnings directed to the investing public.
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Two virtually identical putative class actions were filed in the Southern District of New York in March and May 2003, which were consolidated with the Azzolini action. A separate action, Bernstein v. CorTs for Provident Financing Trust I, et al., was filed in the Eastern District of New York on July 7, 2003. The Bernstein action makes identical allegations as the Azzolini action, but with respect to a different series of CorTs securities. These actions all were transferred to the Eastern District of Tennessee for coordinated pre-trial proceedings.
On March 19, 2004, amended complaints were filed in both the Azzolini andBernstein actions. The amended complaints assert claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder against UnumProvident and one of its officers. The Azzolini plaintiff seeks to represent a putative class of purchasers of certain CorTs certificates between March 21, 2001 and March 24, 2003. The Bernstein plaintiff seeks to represent a putative class of purchasers of a different series of CorTs certificates between February 8, 2001 and March 10, 2003. On April 19, 2004, the defendants moved to dismiss the complaints in each of these actions. On September 12, 2005, the court issued a Memorandum and Order granting the motion to dismiss filed by UnumProvident and its employee.
Policyholder Class Actions
On July 15, 2002, Rombeiro v. Unum Life Insurance Company of America, et al., was filed in the Superior Court of Sonoma County, California and subsequently was removed to the United States District Court for the Northern District of California. On January 21, 2003, a First Amended Complaint was filed, purporting to be a class action. This complaint alleges that plaintiff individually was wrongfully denied disability benefits under a group long-term disability plan and alleges breach of state law fiduciary duties on behalf of himself and others covered by similar plans whose disability benefits have been denied or terminated after a claim was made. The complaint seeks, among other things, injunctive and declaratory relief and payment of benefits. On April 30, 2003, the court granted in part and denied in part the defendants’ motion to dismiss the complaint. On May 14, 2003, the plaintiff filed a Second Amended Complaint seeking injunctive relief on behalf of a putative nationwide class of long-term disability insurance policyholders.
Between November 2002 and November 2003, six additional similar putative class actions were filed in (or later removed to) federal district courts in Illinois, Massachusetts, New York, Pennsylvania, and Tennessee. The complaints allege that the putative class members’ claims were evaluated improperly and allege that the Company and its insurance subsidiaries breached certain fiduciary duties owed to the class members under ERISA, Racketeer Influenced Corrupt Organizations Act (RICO), and/or various state laws. The complaints sought various forms of equitable relief and money damages, including punitive damages.
These actions all were transferred to the Eastern District of Tennessee as part of the multidistrict litigation transfer order. On December 22, 2003, the Tennessee Federal District Court entered an order consolidating all of the above actions for all pretrial purposes under the caption In re UnumProvident Corp. ERISA Benefit Denial Actions. Among other things, the court in that order appointed a lead counsel in the actions and directed lead counsel to file a consolidated amended complaint, which was filed on February 20, 2004. On March 26, 2004, the defendants answered the complaints and simultaneously filed a motion for judgment on the pleadings in the ERISA Benefit Denial Actions. The court has not yet ruled upon that motion.
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On April 30, 2003, a separate putative class action, Taylor v. UnumProvident Corporation, et al., was filed in the Circuit Court for Shelby County, Tennessee in the Thirteenth Judicial District at Memphis. The plaintiff seeks to represent all individuals who were insured by long-term disability policies issued by subsidiaries of UnumProvident and who did not obtain their coverage through employer sponsored plans and who had a claim denied, terminated, or suspended by a UnumProvident subsidiary after January 1, 1995. Plaintiff alleges that UnumProvident Corporation and its subsidiaries employed various unfair claim practices in assessing entitlement to benefits by class members during this period and, as a result, wrongfully denied legitimate claims. The plaintiff and the class seek contractual, equitable, and injunctive relief under various state laws. On June 9, 2003, the defendants removed this action to the United States District Court for the Western District of Tennessee. This action was transferred to the Eastern District of Tennessee as part of the multidistrict litigation transfer order.
The parties in the ERISA Benefit Denial Actions andTaylor have engaged in certain limited discovery in connection with ongoing court-ordered mediation, as well as certain discovery on the merits of the claims asserted in the actions.
On April 9, 2004, the plaintiffs in Taylor and in the ERISA Benefit Denial Actions separately filed motions seeking certification of a plaintiff class. The defendants opposed each of those motions. The court has not yet ruled upon the motions. On July 1, 2005, the defendants also filed motions for summary judgment in each action.
The court entered a schedule providing for the completion of all pretrial proceedings in these actions by December 2005. The Company denies the allegations in the complaints in each of these actions and will vigorously defend the litigation and any attempt to certify the putative class.
Plan Beneficiary Class Actions
On April 29, 2003, the case of Gee v. UnumProvident Corporation, et al., was filed in the U.S. District Court for the Eastern District of Tennessee on behalf of a putative class of participants and beneficiaries of UnumProvident’s 401(k) Retirement Plan (Plan). On May 16, 2003, a similar action, Scanlon v. UnumProvident Corp., et al., was filed in the Eastern District of Tennessee.
On October 2, 2003, the court issued an order consolidating these cases for all purposes. On January 9, 2004, plaintiffs filed their consolidated amended complaint against UnumProvident, several of its Officers and Directors, and several Plan fiduciaries, purportedly on behalf of a putative class of Plan participants and beneficiaries during the period since November 17, 1999. Plaintiffs allege that the named defendants violated the fiduciary provisions of ERISA by making direct and indirect communications to Plan participants that included material misrepresentations and omissions regarding investment in UnumProvident stock. Further, the plaintiffs allege the defendants failed to take action to protect participants from losses sustained from investment in the Plan’s UnumProvident Stock Fund.
On February 26, 2004, the defendants filed a motion to dismiss contending that the complaint failed to state a valid claim under ERISA. On January 13, 2005, the court denied that motion. The defendants filed an answer to the complaint denying all material allegations on February 28, 2005.
The parties have engaged in certain limited document discovery in this action on issues unique to this action that are not raised in the other actions.
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On March 10, 2005, plaintiffs filed a motion for class certification. The defendants opposed that motion.
The court entered a schedule providing for the completion of all pretrial proceedings in these actions by December 2005. The parties are in the process of discussing an amendment to that schedule which will likely extend the period for pre-trial proceedings. The defendants strongly deny the allegations in the complaints and will vigorously defend the litigation and any attempt to certify the class.
Claim Litigation
The Company and its insurance company subsidiaries, as part of their normal operations in managing disability claims, are engaged in claim litigation where disputes arise as a result of a denial or termination of benefits. Most typically those lawsuits are filed on behalf of a single claimant or policyholder, and in some of these individual actions punitive damages are sought, such as claims alleging bad faith in the handling of insurance claims. For its general claim litigation, the Company and its insurance company subsidiaries maintain reserves based on experience to satisfy judgments and settlements in the normal course. Management expects that the ultimate liability, if any, with respect to general claim litigation, after consideration of the reserves maintained, will not be material to the consolidated financial condition of the Company. Nevertheless, given the inherent unpredictability of litigation, it is possible that an adverse outcome in certain claim litigation involving punitive damages could, from time to time, have a material adverse effect on the Company’s consolidated results of operations in a period, depending on the results of operations of the Company for the particular period. The Company is unable to estimate a range of reasonably possible punitive losses.
On December 11, 2003, the case of Jewel, et al. v. UnumProvident Corporation, et al., was filed in the Worcester County Superior Court, Commonwealth of Massachusetts. The Company received service of this matter on March 8, 2004. Plaintiffs seek to represent all individual long-term disability policyholders and all participants in group long-term disability plans which are not covered by ERISA who (a) had coverage issued by an insuring subsidiary and (b) whose claims for long-term disability benefits were denied, or whose payments of long-term disability benefits were terminated or suspended, on or after July 1, 1999. Plaintiffs allege that the defendants employed various unfair claim practices and seek declaratory, contractual, and injunctive relief. On April 20, 2004, the defendants answered the complaint by denying generally the allegations and asserting various defenses. On July 15, 2004, plaintiffs filed a motion seeking to certify a plaintiff class. On February 18, 2005, the Court denied that motion. The plaintiffs appealed the decision to the Massachusetts Court of Appeals. On April 8, 2005, the Court of Appeals upheld the trial court’s decision. The Company denies the allegations in the complaint and will vigorously defend the litigation. On July 18, 2005, the Jewel plaintiffs filed a motion to intervene in the multidistrict litigation proceeding entitled Taylor v. UnumProvident Corp. et al., currently pending in the Eastern District of Tennessee. No ruling has been made on that motion.
From time to time class action allegations are pursued, as in Jewel, where the claimant or policyholder purports to represent a larger number of individuals who are similarly situated. Since each insurance claim is evaluated based on its own merits, there is rarely a single act or series of actions, which can properly be addressed by a class action. Nevertheless, the Company monitors these cases closely and defends itself appropriately where these allegations are made.
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On December 20, 2004, Jeffrey A. Weiller v. New York Life Insurance Company, UnumProvident Corporation, and The Paul Revere Life Insurance Company, was filed in the Supreme Court of the State of New York. This complaint is brought by the plaintiff on behalf of himself and a purported class alleging that UnumProvident schemed to improperly deny or terminate legitimate claims filed under policies issued by several non-UnumProvident insurers on behalf of whom UnumProvident administers claims. On February 18, 2005, the defendants filed a motion to dismiss this action. On June 20, 2005, the plaintiff filed a motion seeking certification of a putative class. These motions remain pending. The Company denies the allegations and will vigorously defend against the allegations raised in the complaint.
Examinations and Investigations
Broker Compensation, Quoting Process, and Related Matters
In June 2004, the Company received a subpoena from the Office of the New York Attorney General (NYAG) requesting documents and information relating to compensation agreements between insurance brokers and the Company and its subsidiaries. The Company has received subpoenas or requests for additional information from the NYAG, including information regarding its quoting process and the placement of reinsurance coverages, and compensation arrangements between its subsidiary, GENEX Services, Inc. (GENEX), which provides services for those administering workers’ compensation claims, and third party administrators that contract with employers to administer the claims by employees. Shortly after the NYAG filed a lawsuit in October 2004 against a major insurance broker raising a number of issues relating to broker compensation practices and bid-rigging in the insurance industry, the Company announced its support for complete and timely disclosure of compensation paid to the broker of a customer. The Company is cooperating with the NYAG’s investigations and inquiries.
The Company has been reviewing its compensation policies and quoting practices both for compliance with applicable legal requirements and in response to various issues raised. The Company has also provided information to the NYAG relating to insurance policies sold to businesses in which Universal Life Resources, Inc. (ULR), acted as a consultant or broker for its client employers. On November 12, 2004, the NYAG filed a lawsuit against ULR alleging that its client employers were not aware of compensation arrangements ULR had with insurers or that the arrangements influenced ULR to steer business to certain insurers. Several insurers were cited in the complaint, including the Company, but not named as defendants. See “Brokerage Compensation Litigation” below for other lawsuits involving ULR and its principal, Douglas Cox.
Since October 2004, the Company and/or its insurance subsidiaries have received subpoenas or information requests from the Office of the Attorney General, insurance departments, and/or other state regulatory agencies of at least seven additional states including Connecticut, Florida, Maine, Massachusetts, North Carolina, Oklahoma, and South Carolina. The subpoenas and information requests sought information regarding, among other things, quoting processes, producer compensation, solicitation activities, policies sold to state or municipal entities, and information regarding compensation agreements with brokers. The Company is cooperating fully with these investigations.
The Company also has had discussions with the U.S. Department of Labor (DOL) regarding compliance with ERISA, relating to the Company’s interactions with insurance brokers and to regulations concerning insurance information provided by the Company to plan administrators of ERISA plans, including specifically the reporting of fees and commissions paid to agents, brokers and others in accordance with the requirements of Schedule A of Form 5500. The DOL is pursuing an investigation of the Company concerning these issues, both generally and specifically in connection with certain brokers, including ULR, which is a defendant referred to below under “Brokerage Compensation Litigation.” The Company is cooperating with the DOL’s investigation.
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Claim Related
The Company experienced increased market conduct examinations by state insurance departments during 2002 and 2003 focused specifically on its disability claims handling policies and practices. On March 19, 2003, the Company consented to the entry of an order by the Georgia Insurance Commissioner that, among other things, ordered four of the Company’s insurance subsidiaries to each pay a monetary penalty of $250,000 and to adhere to certain claims handling practices. The order also placed these four companies on regulatory probation for two years, during which period certain Georgia claims and complaints will be reviewed on a quarterly basis by representatives of the Georgia Department of Insurance. The Georgia order did not cite any violations of Georgia law or regulations.
Because of the number of market conduct examinations initiated during 2002 and 2003, the insurance commissioners of Maine, Massachusetts, and Tennessee, the states of domicile of the Company’s principal insurance subsidiaries, initiated a multistate targeted market conduct examination in September 2003 that focused on the disability claims handling policies and practices of these subsidiaries and whether they reflected unfair claim settlement practices. This multistate examination resulted in a report and regulatory settlement agreements that became effective on December 21, 2004 when the required number of participating states consented to the agreements. The examination report made no findings of violations of law or regulations. The examination identified areas of concern which became the focus of certain changes and enhancements to the Company’s disability claims handling operations and were designed to assure that each claim decision is made in a consistently high quality manner. In addition to enhancements to the Company’s claims handling procedures, the primary components of the settlement agreements include a reassessment of certain previously denied or closed claims, additional corporate and board governance and payment of a fine in the amount of $15.0 million that was allocated among the states and jurisdictions participating in the agreements. Forty-eight states and the District of Columbia consented to the settlement agreements. The agreements will remain in place until the later of January 1, 2007, or the completion of an examination of claims handling practices and an examination of the reassessment process, both of which will be conducted by the lead state regulators. The Company is subject to a potential contingent fine of $145.0 million for failure to satisfactorily meet the performance standards in the settlement agreements relating to these subsequent examinations.
In addition, the DOL, which had been conducting an inquiry relating to certain ERISA plans, has joined the settlement agreements. The NYAG, which had engaged in its own investigation of the Company’s claim handling practices, notified the Company that it supported the settlement and had closed its investigation on this issue.
In the fourth quarter of 2004, the Company recorded a charge related to the settlement of the multistate market conduct examination of $127.0 million, before tax, or $87.8 million, after tax, comprised of four elements: $27.5 million of incremental direct operating expenses to conduct the two-year reassessment process; $44.0 million for benefit costs and reserves from claims reopened from the reassessment; $40.5 million for additional benefit costs and reserves for claims already incurred and currently in inventory that are anticipated as a result of the claim process changes being implemented; and the $15.0 million fine.
On October 3, 2005, certain of the Company’s insurance subsidiaries entered into a settlement agreement with the California Department of Insurance (DOI), concluding a market conduct examination and investigation of the subsidiaries’ disability claims handling practices. The California DOI had chosen not to join the 2004 multistate settlement agreements.
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As part of the settlement with the California DOI, the Company agreed to change certain practices and policy provisions related to its California business and make them consistent with California case law. The settlement also incorporates claims handling practices previously covered by the multistate settlement agreements and includes certain additional claim handling changes. In entering the settlement, the Company did not agree with the allegations and characterization of the Company’s past claims handling practices made by the California DOI.
Under the terms of the settlement, the Company will change a number of provisions specific to California disability policies. Additionally as part of the settlement, the Company will receive approval from the California DOI for the use of new individual and group disability policy forms.
The California settlement also incorporates the claim reassessment process contained in the 2004 multistate settlement agreements. California claimants were included in the 2004 multistate settlement agreements and could choose to participate in that claim reassessment process even though California did not join the multistate settlement agreements. The Company has amended the multistate settlement agreements to include mailing a notice of eligibility to participate in the claim reassessment process to approximately 29,500 individuals whose claims were denied or terminated between January 1, 1997, and December 31, 1999. Under the original multistate settlement agreements, claimants during this period could request participation in the reassessment process, but they were not sent a notice.
Separately, the Company is proceeding with a plan to offer to reassess private label, acquired, and reinsured block claims, as well as claims administered on behalf of certain employers.
Based on the California DOI settlement agreement and related matters described above, in the third quarter of 2005 the Company recorded a charge of $75.0 million before tax, or $51.6 million after tax, comprised of four elements: $14.3 million of incremental direct operating expenses to conduct the reassessment process; $37.3 million for benefit costs and reserves from claims reopened from the reassessment; $15.4 million for additional benefit costs and reserves for claims already incurred and currently in inventory that are anticipated as a result of the claim process changes being implemented; and an $8.0 million fine.
While the 2004 multistate regulatory settlement agreements and the recent California DOI settlement agreement resulted in changes in the Company’s claim handling practices and a process for reassessing certain claims to determine whether the earlier claim decision was properly decided, other regulatory examinations or investigations could result in, among other things, changes in business practices, including changes in broker compensation and related disclosure practices, changes in the use and oversight of finite reinsurance, changes in governance and other oversight procedures, fines, and other administrative action. Such results, singly or in combination, could injure the Company’s reputation, cause negative publicity, adversely affect the Company’s debt and financial strength ratings, or impair the Company’s ability to sell or retain insurance policies, thereby adversely affecting the Company’s business, and potentially materially adversely affecting the consolidated results of operations in a period, depending on the results of operations of the Company for the particular period. Determination by regulatory authorities that the Company or its insurance subsidiaries have engaged in improper conduct could also adversely affect the Company’s defense of various lawsuits described herein.
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Brokerage Compensation Litigation
Since October 2004, the Company and certain of its subsidiaries, along with many other insurance brokers and insurers, have been named as defendants in putative class actions arising out of allegations relating to insurance brokerage compensation practices. Each of these actions, as discussed below, contends, among other things, that the defendants violated various federal and state laws by engaging in alleged bid rigging and by paying undisclosed compensation to insurance brokers to steer business to defendant insurers. Several of these cases have been transferred to the United States District Court for the District of New Jersey for coordinated or consolidated pre-trial proceedings as part of multidistrict litigation (MDL) No. 1663, In re Insurance Brokerage Antitrust Litigation. Those cases which have either not been transferred to MDL No. 1663 or will remain in the jurisdiction where they were filed are discussed in more detail below. These lawsuits are in a very preliminary stage, the outcome is uncertain, and the Company is unable to estimate a range of reasonably possible losses. Reserves have not been established for these matters. An adverse outcome in one or more of these actions could, depending upon the nature, scope, and amount of the ruling, materially adversely affect the Company’s consolidated results of operations in a period, encourage other litigation, and limit the Company’s ability to write new business, particularly if the adverse outcomes negatively impact certain of the Company’s debt and financial strength ratings.
On October 20, 2004, a purported class action complaint for violations of RICO,Ronald Scott Shirley v. Universal Life Resources, et al., was filed in the United States District Court for the Southern District of California. The allegations are made against ULR and several major insurers, including UnumProvident, claiming there was a conspiracy to fraudulently market, sell and administer insurance products to employee benefit plans by extracting undisclosed compensation and fees from the employers sponsoring the plans and from the participants of those plans. On January 10, 2005, an amended complaint was filed and the amendment included the insertion of a new plaintiff, Cynthia Brandes. The case was entitled, Cynthia Brandes individually and on behalf of all those similarly situated v. Universal Life Resources, et al. A Second Amended Complaint was filed on April 8, 2005, which asserts claims against the Company and certain of its subsidiaries for alleged violations of RICO, the Sherman Act, and ERISA. On April 18, 2005, co-defendant MetLife filed a notice of potential tag along and a request that this action be transferred to the United States District Court for the District of New Jersey as part of MDL No. 1663. A conditional transfer order to MDL No. 1663 was issued on June 1, 2005, which was opposed by one of the defendants. The remaining defendants, including UnumProvident, continued to seek transfer of this matter. The defendants filed a motion to dismiss on June 2, 2005. On August 31, 2005, plaintiffs voluntarily dismissed this action without prejudice.
On November 17, 2004, an action purporting to seek injunctive relief pursuant to the California Insurance Code, The People of the State of California by and through John Garamendi, Insurance Commissioner of the State of California v. Universal Life Resources, et al., was filed in the Superior Court of the State of California for the County of San Diego. Allegations are made against ULR and several major insurers, including UnumProvident, claiming that the broker was paid undisclosed or inadequately disclosed fees, commissions, and other compensation as kickbacks by the insurer defendants in return for the broker steering its clients to purchase insurance policies and other services from the insurer defendants. In addition to injunctive relief, the complaint purported to seek the imposition of a constructive trust to recover any funds acquired by any practice the Court may find to have been in violation of the Insurance Code or the regulations promulgated thereunder. The case was removed to the United States District Court for the Southern District of California on January 3, 2005. On January 24, 2005, the plaintiff filed a motion to remand the case to state court. At a hearing on this motion on April 15, 2005, plaintiffs withdrew their demand for a constructive trust, which had furnished the basis for the removal to federal court. Thereafter, on April 18, 2005, the
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matter was remanded to state court. A Second Amended Complaint (SAC) was filed on June 3, 2005, and defendants filed a demurrer to the SAC on July 21, 2005. A hearing on the demurrer was set for October 28, 2005. The Company denies the allegations of the complaint and will vigorously defend the litigation.
On April 13, 2005 the Company received service of the complaint entitled, Palm Tree Computers Systems, Inc. et al. on behalf of itself and all others similarly situated v. ACE USA, et al., which was filed in the Circuit Court of Seminole County, Florida on February 16, 2005. Prior to the Company being served, two other defendants filed petitions to remove the case to the United States District Court of the Middle District of Florida. One defendant has since stipulated that diversity jurisdiction does not exist, and the federal court has dismissed the removed action. The second defendant’s removal based on federal question jurisdiction is currently the subject of a motion to remand by plaintiffs. The complaint is a putative class action and alleges violations of the Deceptive and Unfair Trade Practices Act of Florida and other states, breach of fiduciary duty, and unjust enrichment. The allegations are brought against numerous broker organizations and insurers and assert the Company and its subsidiaries and affiliates engaged in illegal and unethical contingent commission arrangements. The complaint seeks damages and injunctive relief as provided under the laws of the State of Florida and various other states. A conditional transfer order to MDL No. 1663 was issued on June 1, 2005, which was opposed by plaintiffs and one defendant. The defendant subsequently withdrew its opposition to transfer. On October 20, 2005, the judicial panel on multidistrict litigation issued a ruling transferring the matter to MDL No. 1663.
On May 17, 2005, the Company received service of the First Amended Complaint entitled,Bensley Construction, Inc., on its own behalf and on behalf of others similarly situated, v. Marsh & McLennan Companies, Inc., et al., filed in Superior Court for Essex County, Commonwealth of Massachusetts on May 16, 2005, by the same counsel as in Palm Tree. The original complaint was filed on February 17, 2005, but was never served. The allegations in this purported Massachusetts plaintiffs’ only class action allege violations of breach of fiduciary duty and unjust enrichment, similar to those in Palm Tree under Massachusetts state law. The case was removed to Federal Court and a tag-along notice filed seeking transfer to MDL No. 1663. A conditional transfer order to MDL No. 1663 was issued on October 4, 2005, and plaintiff and one defendant group have filed a notice of opposition to the transfer. Plaintiff filed a motion to remand, which defendants have opposed. Plaintiffs have also filed a motion to substitute a new plaintiff for Bensley Construction, and defendants have moved to stay proceedings pending a ruling on the motion to transfer the case to MDL No. 1663. The District Court has set a hearing on these motions for November 28, 2005. The Company denies the allegations of the complaint and will vigorously defend the case.
Additional Litigation
In September 2003, United States of America ex. rel. Patrick J. Loughren v. UnumProvident Corporation and GENEX Services, Inc., was filed in the United States District Court for the District of Massachusetts. This is a qui tam action to recover damages and civil penalties on behalf of the United States of America alleging false statements and claims were made or caused to be made by UnumProvident and GENEX to the United States of America in violation of the False Claims Act. The action was originally filed under seal to provide the government the opportunity to investigate the allegations and prosecute the action if they believed that the case had merit and warranted their attention. The government has turned down the option to prosecute the case and as a result the seal was lifted and the case became a matter of public record on December 23, 2004. This litigation relates to the assistance provided to UnumProvident Corporation insurance subsidiary claimants in their pursuit of, or application for, benefits from the Social Security Administration by UnumProvident and GENEX employees, agents or any employees of its subsidiary companies. On September 13, 2005, the magistrate judge filed a recommended decision granting the Company’s motion to dismiss. The plaintiffs appealed that finding to the district court judge.
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On October 6, 2005, the district court judge adopted, in full, the recommended decision of the magistrate judge thereby granting dismissal of the case. The plaintiffs have 30 days from October 6, 2005 to amend their complaint. On December 21, 2004, a putative derivative action styled Leonard v. UnumProvident Corporation, et al., was filed in the State of Tennessee Chancery Court for Hamilton County against the Company and various members of its board of directors alleging claims on behalf of the Company against the named director defendants for breach of duty, mismanagement, and corporate waste, challenging certain compensation paid to insurance brokers and alleging insider trading against certain director defendants. On April 1, 2005, the defendants moved to dismiss the complaint on the grounds that the plaintiff failed to make a pre-suit demand on the UnumProvident board of directors and that the complaint fails to state a claim upon which relief could be granted. That motion remains pending. The defendants strongly deny the allegations in the complaint and will vigorously defend both the substantive and procedural aspects of the litigation.
In certain of the Company’s reinsurance businesses there are disputes among the pool members, reinsurance participants, and/or reinsurers concerning the scope of their obligations and liabilities within the reinsurance contracts, including the reinsurance pools for which subsidiaries of the Company acted either as pool managers or underwriting agents, as pool members, or as reinsurers. The Company or the Company’s subsidiaries either have been or may in the future be brought into disputes, arbitration proceedings, or litigation with other pool members or reinsurers in the process of resolving the various claims.
Various other lawsuits against the Company have arisen in the normal course of its business. Contingent liabilities that might arise from such other litigation incurred in the normal course of business are not deemed likely to materially adversely affect the consolidated financial position or results of operations of the Company in a period, depending on the results of operations of the Company for the particular period.
Note 12 - Acquisitions and Dispositions
In July 2005, Unum Limited completed the sale of its Netherlands branch. The gain on the sale was approximately $5.7 million before tax and $4.0 million after tax and is included in the operating results for the three and nine month periods ended September 30, 2005.
During the third quarter of 2005, the Company’s wholly-owned subsidiary, GENEX Services, Inc. (GENEX), acquired Independent Review Services, Inc., a provider of medical diagnostic networks and independent medical examinations, at a price of $3.5 million.
Note 13 - Income Tax
In April 2005, the Internal Revenue Service completed its examination of tax years 1999 through 2001 and issued its revenue agent’s report (RAR). Income tax liabilities of approximately $32.0 million that relate primarily to interest on the timing of expense deductions were released in the first quarter of 2005, all of which was reflected as a reduction to income tax expense. Separately, a number of additional adjustments in the RAR are in dispute and will be appealed by the Company. The Company holds adequate reserves for the liabilities associated with the proposed adjustments.
In the third quarter of 2005, the Company recognized an income tax benefit of approximately $10.8 million related to the finalization of income tax reviews of the Company’s U.K. subsidiaries.
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Note 13 - Income Tax - Continued
During the fourth quarter of 2005, the Company intends to repatriate up to $450.0 million in unremitted foreign earnings under the Homeland Investment Act of 2004, contingent on the issuance of up to $400.0 million in debt by one of its wholly-owned U.K. subsidiaries. The Company expects to record in the fourth quarter of 2005 an income tax benefit of up to $5.5 million as a result of the repatriation.
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Board of Directors and Shareholders
We have reviewed the condensed consolidated statement of financial condition of UnumProvident Corporation and subsidiaries as of September 30, 2005, and the related condensed consolidated statements of operations for the three and nine month periods ended September 30, 2005 and 2004, and the condensed statements of stockholders’ equity and cash flows for the nine month periods ended September 30, 2005 and 2004. These 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, 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 condensed 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 statement of financial condition of UnumProvident Corporation and subsidiaries as of December 31, 2004, and the related consolidated statements of operations, stockholders’ equity, and cash flows for the year then ended not presented herein, and in our report dated March 7, 2005, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated statement of financial condition as of December 31, 2004, is fairly stated, in all material respects, in relation to the consolidated statement of financial condition from which it has been derived.
Chattanooga, Tennessee
November 2, 2005
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Introduction
UnumProvident Corporation (the Company) is the parent holding company for a group of insurance and non-insurance companies that collectively operate in the United States, the United Kingdom, and, to a limited extent, in certain other countries around the world. The Company’s principal operating subsidiaries in the United States are Unum Life Insurance Company of America, Provident Life and Accident Insurance Company, The Paul Revere Life Insurance Company, and Colonial Life & Accident Insurance Company, and in the United Kingdom, Unum Limited.
The Company is the largest provider of group and individual income protection insurance products and a leading provider of life, accident, and long-term care products in the United States and the United Kingdom. The Company believes that its product line, its commitment to high quality service, and its claims management approach position the organization well to compete in this highly competitive business. In addition to competition, portions of the Company’s business are sensitive to economic and financial market factors, including consumer confidence, employment levels, and the level of interest rates.
This discussion and analysis should be read in conjunction with the condensed consolidated financial statements and notes thereto in Part I, Item 1 contained herein and with the discussion, analysis, and consolidated financial statements and notes thereto in Part I, Item 1 and Part II, Items 6, 7, 7A, and 8 of the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2004.
Executive Summary
Segment operating performance improved during the third quarter of 2005 relative to the prior year third quarter, with the Unum Limited segment, the Colonial segment, and many of the lines of business in the U.S. Brokerage segment reporting stable or improving operating performance. Operating income by segment, which excludes realized investment gains and losses and income taxes, was $139.7 million in the third quarter of 2005. Excluding the before tax charges of $75.0 million associated with the California Department of Insurance (DOI) settlement agreement and related matters, as discussed herein, operating income by segment was $214.7 million in the third quarter of 2005, compared to $191.3 million in the third quarter of 2004. The Company believes that its U.S. Brokerage segment group income protection business continues to exhibit long-term improvement with respect to underwriting, pricing, and expense management due to the actions taken over the past several quarters to increase the profitability in this business. Claims management results in the third quarter of 2005 improved over the first and second quarter of 2005 results, but were still below the Company’s long-term expectations for this business.
The Company’s U.S insurance subsidiaries’ statutory results for the third quarter of 2005 continued the healthy trend experienced over the last several quarters, maintaining the desired capital strength and dividend capacity. Combined statutory capital and surplus was approximately $4.235 billion at September 30, 2005, compared to $4.105 billion at December 31, 2004.
The Company’s 2005 priorities are as follows:
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Progress in the first three quarters of 2005 included the following:
The continued low level of new money rates and the limited supply of longer duration quality investments currently available in the marketplace continue to pressure the Company’s investment results. The Company believes its portfolios are well positioned from an asset-liability management perspective and that an increase in interest rates, even slightly, will improve the Company’s ability to grow the profitability of its businesses. The Company’s margins between its claim reserve discount rates and its investment
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portfolio yield rates remained above the Company’s target spread during the third quarter of 2005, and in the current interest rate environment, the Company believes its margins will remain adequate.
First Nine Months of 2005 Significant Transactions and Events
California Settlement Agreement and Amendment of the Multistate Market Conduct Examination Settlement Agreements
On October 3, 2005, certain of the Company’s insurance subsidiaries entered into a settlement agreement with the California DOI, concluding a market conduct examination and investigation of the subsidiaries’ disability claims handling practices. The California DOI had chosen not to join the fourth quarter of 2004 multistate settlement agreements the Company’s insurance subsidiaries entered into with state insurance regulators of 48 states upon conclusion of a multistate market conduct examination. See “Settlement of Multistate Market Conduct Examination” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2004 for further discussion of the multistate settlement agreements.
As part of the settlement with the California DOI, the Company agreed to change certain practices and policy provisions related to its California business and make them consistent with California case law. The settlement also incorporates claims handling practices previously covered by the multistate settlement agreements reached last year and includes certain additional claim handling changes. In entering the settlement, the Company did not agree with the allegations and characterization of the Company’s past claims handling practices made by the California DOI. During the past two years, the Company has undertaken broad changes designed to improve the quality of claims decisions and its service levels to policyholders, including changes made as a result of the multistate settlement agreements. Because of this, the Company does not believe that the California DOI’s allegations or its market conduct examination report provide an accurate portrayal of the Company’s claim practices today.
Under the terms of the settlement, the Company will change a number of provisions specific to California disability policies, including the definition of “total disability.” Additionally as part of the settlement, the Company will receive approval from the California DOI for the use of new individual and group disability policy forms, which will become available for sale on November 1, 2005.
The California settlement also incorporates the claim reassessment process contained in the 2004 multistate settlement agreements. California claimants were included in the 2004 multistate settlement agreements and could choose to participate in that claim reassessment process even though California did not join the multistate settlement agreements. Under the California agreement, reassessment notices will be mailed to approximately 26,000 individuals whose claims were denied or terminated between January 1, 1997, and September 30, 2005. Many of
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these individuals have already received reassessment notices under the multistate settlement agreements. Additionally, as part of the California agreement, an individual whose claim denial or termination is upheld by the Company’s reassessment unit may request an independent review by a member of a panel established for that purpose. Following such review, the final decision on the claim is that of the Company’s reassessment unit; however, if there is information that the reviewer believes is appropriate relating to the handling of the claim, the reviewer may add a report to the claim file.
The Company has amended the multistate settlement agreements to include mailing a notice of eligibility to participate in the claim reassessment process to approximately 29,500 individuals whose claims were denied or terminated between January 1, 1997, and December 31, 1999. Under the original multistate settlement agreements, claimants during this period could request participation in the reassessment process, but they were not sent a notice. Those claimants who are eligible to participate but do not receive notice pursuant to the amendment remain eligible to request participation until June 30, 2006.
Separately, the Company is proceeding with a plan to offer to reassess private label, acquired, and reinsured block claims, as well as claims administered on behalf of certain employers from January 1, 1997, through January 18, 2005 (and through September 30, 2005 for California residents). These approximately 24,000 claims were not included in the 2004 multistate settlement agreements, but the offer being made will generally follow the reassessment procedures contained in those agreements.
Based on the settlement agreement and related matters, in the third quarter of 2005 the Company recorded a charge of $75.0 million before tax, or $51.6 million after tax, comprised of four elements: $14.3 million of incremental direct operating expenses to conduct the reassessment process; $37.3 million for benefit costs and reserves from claims reopened from the reassessment; $15.4 million for additional benefit costs and reserves for claims already incurred and currently in inventory that are anticipated as a result of the claim process changes being implemented; and an $8.0 million fine. The charge decreased before-tax operating results for the U.S. Brokerage segment group income protection line of business and supplemental and voluntary lines of business $37.4 million and $3.3 million, respectively, and the Individual Income Protection – Closed Block segment $34.3 million. The ongoing costs of changes in the claims handling process and governance improvements will be included in the Company’s operating expenses as incurred going forward.
Other Regulatory Investigations
Beginning in 2004, several of the Company’s insurance subsidiaries’ insurance regulators requested information relating to the subsidiaries’ policies and practices on one or more aspects of broker compensation, quoting insurance business, and related matters. Additionally, the Company has responded to investigations about certain of these same matters by state attorneys general and the U.S. Department of Labor. Following highly publicized litigation involving the alleged practices of a major insurance broker, the National Association of Insurance Commissioners (NAIC) has undertaken to provide a uniform Compensation Disclosure Amendment to the Producer Licensing Model Act that can be adopted by states in an effort to provide uniform guidance to insurers, brokers, and customers relating to disclosure of broker compensation. The Company expects there to be continued uncertainty surrounding this matter until clearer regulatory guidelines are established.
In June 2004, the Company received a subpoena from the New York Attorney General (NYAG) requesting documents and information relating to compensation agreements between insurance brokers and the Company and its subsidiaries. The Company has received subpoenas and information requests for additional information from the NYAG and various other regulatory agencies, including information regarding its broker compensation arrangements, quoting process, the placement of reinsurance coverages, and arrangements between the Company’s GENEX Services, Inc. subsidiary and certain third party administrators and preferred provider organizations. The Company is cooperating with these requests. The Company has been reviewing its compensation policies and procedures for compliance with applicable legal requirements. In accordance with its announced support for disclosure of compensation paid to producers, including both brokers and agents, the Company has implemented policies to facilitate customers obtaining information regarding producer compensation from the producers.
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Additionally, the Company provides appropriate notices to customers stating its policy surrounding disclosure and provides information on its website about its producer compensation programs. Under these policies, any customer who wants specific producer compensation related information can obtain this information by contacting the Company’s Producer Compensation Services toll-free number. Other changes include requiring customer approval of compensation paid by the Company to the producer when the customer is also paying a fee to the producer and strengthening certain policies and procedures associated with new business and quoting activities. The Company is still monitoring developments relating to “contingent commissions” and will consider alternative arrangements when there is more clarity on the issue as a component of producer compensation.
In addition to various regulatory agencies investigating issues relating to broker compensation and quoting practices, the Company has been named as a defendant, along with other insurers, in litigation brought by regulatory agencies or private parties in putative class actions making allegations arising out of broker compensation arrangements or quoting practices. In June 2005, one of the Company’s insurance subsidiaries entered into a consent judgment with the Massachusetts Attorney General relating to compensation paid to a broker on group life insurance sold to the Massachusetts Group Insurance Commission. For further information on the various lawsuits, see Note 11 of the “Notes to Condensed Consolidated Financial Statements” contained herein in Item 1.
Beginning in March 2005, several of the Company’s insurance subsidiaries received requests from various regulatory agencies seeking information relating to finite reinsurance and whether there are any ancillary or verbal side agreements that affect the potential loss under the terms of the reinsurance agreement. Additionally, the requests seek information on such matters as the Company’s use of finite reinsurance, controls relating to proper accounting treatment, and maintenance of underwriting files on the reinsurance agreements. The Company has responded to the earlier requests and is in the process of responding to the more recent requests.
While the 2004 multistate regulatory settlement agreements and the recent California DOI settlement agreement resulted in changes in the Company’s claim handling practices and a process for reassessing certain claims to determine whether the earlier claim decision was properly decided, other regulatory examinations or investigations could result in, among other things, changes in business practices, including changes in broker compensation and related disclosure practices, changes in the use and oversight of finite reinsurance, changes in governance and other oversight procedures, fines, and other administrative action. Such results, singly or in combination, could injure the Company’s reputation, cause negative publicity, adversely affect the Company’s debt and financial strength ratings, or impair the Company’s ability to sell or retain insurance policies, thereby adversely affecting the Company’s business, and potentially materially adversely affecting the consolidated results of operations in a period, depending on the results of operations of the Company for the particular period. Determination by regulatory authorities that the Company or its insurance subsidiaries have engaged in improper conduct could also adversely affect the Company’s defense of various lawsuits described in Note 11 of the “Notes to Condensed Consolidated Financial Statements” contained herein in Item 1.
Acquisitions and Dispositions
During the third quarter of 2005, the Company’s wholly-owned subsidiary, GENEX Services, Inc. (GENEX), acquired Independent Review Services, Inc., a provider of medical diagnostic networks and independent medical examinations, at a price of $3.5 million. This acquisition will broaden GENEX’s product offerings through the addition of medical diagnostic services.
In July 2005, Unum Limited, completed the sale of its Netherlands branch. The gain on the sale was approximately $4.0 million after tax and is included in the operating results for the three and nine month periods ended September 30, 2005.
In April 2005, the Internal Revenue Service completed its examination of tax years 1999 through 2001 and issued its revenue agent’s report (RAR). Income tax liabilities of approximately $32.0 million that relate primarily to interest on the timing of expense deductions were released in the first quarter of 2005, all of which was reflected as a reduction to income tax expense. Separately, a number of additional adjustments in the RAR are in dispute and will
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be appealed by the Company. The Company holds adequate reserves for the liabilities associated with these proposed adjustments.
Closed Block Reinsurance Recapture from Centre Life Reinsurance Ltd.
The underlying operating results of the reinsurance contract, prior to recapture, were reflected in other income. The recapture therefore does not have a material impact on operating income for the Individual Income Protection – Closed Block segment.
On a statutory basis of reporting, the recapture increased statutory surplus $57.5 million in Unum Life Insurance Company of America. The recapture did not have a material impact on the Company’s targeted risk-based capital objectives for its U.S. insurance subsidiaries.
Impact of Hurricanes
During the third quarter of 2005, several hurricanes struck the United States gulf coast region in close proximity and timing. The Company has client companies and sales offices that were impacted by the storms. The Company does not believe that direct claims from the storms will be significant; however, some individual policyholders who resided in the area have moved, taken other jobs, or lost their jobs as a result of the storms. In addition, some of the Company’s group policyholders may be unable to continue business as a result of the storms.
The Company has extended its grace period for premium payments due from its policyholders in counties and parishes proclaimed disaster areas by the Federal Emergency Management Agency (FEMA) due to these hurricanes. The Company is unable to estimate a range of reasonably possible losses on policies that may ultimately lapse, but the Company will likely experience some persistency and premium collection reductions as a result of the storms. It is also expected that sales in the affected region will be lower for some period of time until recovery is achieved.
The Company does not believe the impact on its financial position or results of operations as a result of these storms will be material.
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First Nine Months of 2004 Significant Transactions and Events
Restructuring of Individual Income Protection – Closed Block Business
In the first quarter of 2004, the Company restructured its individual income protection – closed block business wherein three of its insurance subsidiaries entered into reinsurance agreements to reinsure approximately 66.7 percent of potential future losses that occur above a specified retention limit. The individual income protection – closed block reserves in these three subsidiaries comprise approximately 90 percent of the Company’s overall retained risk in the closed block of individual income protection. The reinsurance agreements effectively provide approximately 60 percent reinsurance coverage for the Company’s overall consolidated risk above the retention limit, which equaled approximately $8.0 billion in existing statutory reserves at the date of the transaction. The maximum risk limit for the reinsurer was approximately $783.0 million initially and grows to approximately $2.6 billion over time, after which any further losses will revert to the Company. These reinsurance transactions were effective as of April 1, 2004. The Company transferred cash equal to $521.6 million of reserves ceded in the Individual Income Protection – Closed Block segment plus an additional $185.8 million in cash for a before-tax prepaid cost of insurance which was deferred and is being amortized into earnings over the expected claim payment period covered under the Company’s retention limit. The Company retained the higher yielding investments historically associated with these reserves and redeployed these investments to other lines of business.
The separation of the closed block business into a separate reporting segment required the Company to perform, separately for the individual income protection – closed block business and individual income protection – recently issued business, impairment testing for goodwill and loss recognition testing for the recoverability of deferred policy acquisition costs and value of business acquired. As required under GAAP, prior to the change in reporting segments, these tests were performed for the individual income protection line of business on a combined basis. The testing indicated impairment of the individual income protection – closed block deferred policy acquisition costs, value of business acquired, and goodwill balances of $282.2 million, $367.1 million, and $207.1 million, respectively. These impairment charges, $856.4 million before tax and $629.1 million after tax, were recorded in the first quarter of 2004 and are included in the results reported for the first nine months of 2004.
Also as part of the restructuring, the Company analyzed the reserve assumptions related to its individual income protection – closed block reserves as a stand-alone segment. Previously these reserves were analyzed for the individual income protection line of business on a combined basis. Included in the analysis was a review of morbidity assumptions, primarily claim resolution rates, and claim reserve discount rate assumptions. Based upon this analysis, the Company lowered the claim reserve discount rate to reflect the segmentation of assets between the individual income protection – recently issued business and the individual income protection – closed block business, the change in the Company’s investment portfolio yield rates during the first quarter of 2004, the Company’s expectation of future investment portfolio yield rates, and the Company’s desire to maintain the relationship between
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the claim reserve discount rate and the investment portfolio yield rate for the individual income protection – closed block at the Company’s long-term objective. The segmentation of the investment portfolio was necessary to ensure appropriate matching of the duration of the assets and the related policy liabilities. Based on this analysis, in the first quarter of 2004 the Company increased its individual income protection – closed block claim reserves by $110.6 million before tax, or $71.9 million after tax, to reflect its current estimate of future benefit obligations. The first quarter 2004 change represented a 1.2 percent increase in total net individual income protection – closed block reserves as of March 31, 2004, which for continuing operations equaled $9.530 billion prior to this increase.
Financing
As part of the restructuring, in May 2004, the Company issued 12.0 million 8.25% adjustable conversion-rate equity security units (units) in a private offering for $300.0 million. The Company subsequently registered the privately placed securities for resale by the private investors. Proceeds from the offering were used to restore the Company’s insurance subsidiaries’ risk-based capital to the approximate overall level that existed prior to the individual income protection – closed block reinsurance transaction and to provide additional liquidity at the holding company level.
In the first quarter of 2004, Unum Limited became responsible for the ongoing administration and management of the United Kingdom portion of the group income protection claims portfolio of Swiss Life (UK) plc (Swiss Life), and Swiss Life reinsured this portfolio to Unum Limited. Unum Limited also became a multi-national pooling partner for Swiss Life Insurance & Pension Company with respect to business written in the United Kingdom.
With the goal of focusing on its core operations, in the first quarter of 2004, the Company sold its Japanese operation, Unum Japan Accident Insurance Co., Ltd. The Company also entered into an agreement with the buyer to reinsure certain existing income protection business and intends to have a continuing presence in these operations for at least one year. The Company wrote down the book value of the Japan operations to the estimated fair value less cost to sell during the fourth quarter of 2003 and at that time recognized an impairment loss of $1.2 million before tax and $0.8 million after tax. The Company also recognized a tax benefit of $6.8 million, for a net after-tax gain of $6.0 million in 2003.
During the second quarter of 2004, the Company completed the sale of its Canadian branch and reported a loss of $70.9 million after tax on the sale. On a statutory basis of reporting, the Company’s U.S. insurance subsidiaries reported a 2004 gain of $250.6 million after tax on the sale of the branch. Additionally, the transaction resulted in an approximate 29 point improvement in the Company’s RBC ratio for its U.S. insurance subsidiaries, calculated on a weighted average basis.
Assets transferred to the buyer included available-for-sale fixed maturity securities with a fair value of $1,099.4 million (book value of $957.7 million) and cash of $31.7 million. Liabilities transferred included reserves of $1,254.8 million. The Company retained a portion of the Canadian branch fixed maturity bond portfolio according to the terms of the transaction. At the close of the transaction, the bonds retained had a fair value of $732.9 million and a yield of 7.14 percent, which added approximately four basis points to the investment portfolio yield rate in the Company’s continuing operations. These investments were subsequently redeployed to the Company’s other lines of business. Financial results for the Canadian branch are reported as discontinued operations in the condensed consolidated financial statements. Accordingly, the discussion of results by segment as follows does not include amounts related to those operations. See “Discontinued Operations” contained herein in Item 2 and Note 3 of the “Notes to Condensed Consolidated Financial Statements” contained herein in Item 1 for further discussion of the Company’s discontinued operations.
In the second quarter of 2004, GENEX acquired Integrated Benefits Management, a provider of case management services, to further broaden GENEX’s relationship and distribution partnerships. The purchase price was $0.7 million.
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Critical Accounting Policies
Reserves for Policy and Contract Benefits
The two primary categories of liabilities for policy and contract benefits are policy reserves for claims not yet incurred and claim reserves for claims that have been incurred and have future benefits to be paid. Policy reserves equal the present value of the difference between future policy benefits and expenses and future premiums, allowing a margin for profit. These reserves are applicable for the majority of the Company’s business, which is traditional non interest-sensitive in nature. The claim payments are estimated using assumptions established when the policy was issued. Throughout the life of the policy, the reserve is based on the original assumptions used for the policy’s issue year. Ordinarily, generally accepted accounting principles require that these assumptions not be subsequently modified unless the policy reserves are determined to be inadequate.
A claim reserve is established when a claim is incurred or is estimated to have been incurred but not yet reported to the Company. Policy reserves for a particular policy continue to be maintained after a claim reserve has been established for as long as the policy remains in force. Claim reserves generally equal the Company’s estimate, at the current reporting period, of the present value of the liability for future benefits and expenses to be paid on claims incurred as of that date. A claim reserve for a specific claim is based on assumptions derived from the Company’s actual historical experience as to claim duration as well as the specific characteristics of the claimant such as benefits available under the policy, the covered benefit period, and the age and occupation of the claimant. Consideration is given to current and historical trends in the Company’s experience and to expected deviations from historical experience that result from changes in benefits available, changes in the Company’s risk management policies and procedures, and other economic, environmental, or societal factors. Reserves for claims that are estimated to have already been incurred but that have not yet been reported to the Company are based on factors such as historical claim reporting patterns, the average cost of claims, and the expected volumes of incurred claims.
Claim reserves, unlike policy reserves, are subject to revision as current claim experience and projections of future factors affecting claim experience change. In a reporting period, actual experience may deviate from the long-term assumptions used to determine the claim reserves. The Company reviews annually, or more frequently as appropriate, emerging experience to ensure that its claim reserves make adequate and reasonable provision for future benefits and expenses. The Company’s reserves for group and individual income protection products include a provision for future payments, other than legal expenses, on all claim related lawsuits for which the cause of action has already occurred. This includes known lawsuits and those yet to be filed. The reserve amount is the Company’s estimate of the payments on all such lawsuits based on past payments and expected future payments.
Claim reserves, in general, are an estimate of the current value of future, otherwise unfunded, benefit commitments or liabilities. The calculation of claim reserves involves numerous assumptions. In setting these assumptions, the Company depends upon industry information and experience, Company experience and analysis, and reasoned judgment. There can be no guarantee that these assumptions individually, or collectively, will be duplicated by actual experience over time. The primary assumptions related to claim reserves are the discount rate, the claim resolution rate, and the incidence rate for incurred but not reported (IBNR) claims.
The discount rate is the interest rate at which future benefit cash flows are discounted to determine the present value of those cash flows. It is important since higher discount rates produce lower reserves. If the discount rate is higher than future investment returns, the Company’s reserves will not earn sufficient investment income to support future liabilities. In this case, the reserves will eventually be insufficient. Alternatively, if a discount rate is chosen that is too low relative to future investment results, the reserve, and thus the claim cost in the current period, will be overstated and profits will be accumulated in the reserves rather than released to current shareholders through earnings. The Company sets its discount rate assumptions in conjunction with the current and expected future investment income rate of the assets supporting the reserves. If the investment yield at which new investments are purchased is below or above the investment yield of the existing investment portfolio, it is likely that the discount rate on new claims will be established below or above the discount rate on existing claims. It is the Company’s intent to use a discount rate that provides some margin for adverse movement in the investment portfolio yield rate.
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Since policies may receive claim payments for a number of years, it is unlikely that the chosen discount rate assumption will prove to be accurate for any one policy; rather, the discount rate is chosen to apply to many claims with various characteristics of length and severity. The Company uses its experience and analysis of its existing claims and investment performance to determine the appropriate discount rate assumption. Actual claim reserves incurred in the calendar quarter are sensitive to the choice of discount rate. For example, a 25 basis point increase or decrease in the U.S. Brokerage group long-term income protection claim discount rate for current year claims would change a quarter’s incurred claim cost in 2005 by approximately $5.0 million.
The claim resolution rate is the rate of probability that a disability claim will close or change due to maximum benefits being paid under the policy, the recovery or death of the insured, or a change in status in any given period. It is important because it is used to estimate how long benefits will be paid for a claim. Estimated resolution rates that are set too high will result in reserves that are lower than they need to be to pay the claim benefits over time. A claim closes due to maximum benefits being paid if all of the contractual benefits under the policy have been paid. A claim also closes if the policyholder recovers from his or her disability and is no longer receiving disability benefit payments or if the policyholder dies in the period. A claim may change status during the period. For example, a policyholder receiving disability benefits may return to part time work, and the claim benefit may be reduced to reflect the change to partial disability. Establishing claim resolution assumptions is complex and involves many factors, including the cause of disability, the policyholder’s age, the type of contractual benefits provided, etc. Claim resolution assumptions also vary by duration of disability and time since initially becoming disabled. The Company uses its extensive claim experience and analysis to develop its claim resolution assumptions. Claim resolution experience is studied over a number of years with more weight placed on the more recent experience. Claim resolution assumptions are established to represent the Company’s future resolution rate expectations. Due to the individual nature of each claim, it is unlikely that the claim resolution rate will be accurate for any particular claim. The Company establishes its claim resolution assumptions to apply as an average to its large base of active claims. In this manner, the assumed rates are much more accurate over the broad base of claims. Actual claim reserves incurred in the calendar quarter are sensitive to the choice of resolution rate. For example, a one percent increase or decrease in the U.S. Brokerage group long-term income protection claim resolution rate would change a quarter’s incurred claim cost in 2005 by approximately $3.0 million.
The Company has liability for claims that have been incurred but not reported to the Company and must establish a liability for these claims equal to the present value of the expected benefit payments. In addition to the discount rate and claim resolution rate, the incidence rate is also a primary assumption in the IBNR reserve. The incidence rate is the rate at which new claims per thousand insured lives are submitted to the Company. The incidence rate is affected by many factors including the age of the insured, the insured’s occupation or industry, the benefit plan design, and certain external factors such as consumer confidence and levels of unemployment. The Company establishes the incidence assumption using a historical review of actual incidence results along with an outlook of future incidence expectations. As the actual claims are reported and claim reserves are established, the accuracy of the IBNR emerges. While the Company expects its IBNR reserve to be appropriate over the long term, it will not always equal, in a particular reporting period, the actual reserve established for a reported claim. For example, a 10 basis point deviation in the actual incidence rate from that assumed in the U.S. Brokerage IBNR reserve would result in an increase or decrease of approximately $10.0 million in claim reserves established during a quarter in 2005, relative to the IBNR reserve previously established to cover those claims.
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Presented as follows are reserves by each major line of business within each segment with discussion regarding material changes.
(in millions of dollars)
U.S. Brokerage Segment
Unum Limited Segment
Colonial Segment
Individual Income Protection - Closed Block Segment
Other Segment
Consolidated
The decrease in IBNR reserves from December 31, 2004 is due primarily to decreases in insured lives in the U.S. Brokerage group income protection and group life and accidental death and dismemberment lines of business. Partially offsetting this decrease is the increase in IBNR reserves due to the charge related to the California DOI settlement agreement and other related matters and also due to the growth in the remaining U.S. Brokerage lines of business, as well as growth in the Unum Limited and Colonial segments. The increase in all other reserves from December 31, 2004 is driven by growth in the active life reserves for the long-term care and individual income protection – recently issued lines of business and growth in the disabled life reserves in the group income protection line of business.
The Company defers certain costs incurred in acquiring new business and amortizes (expenses) these costs over the life of the related policies. Deferred costs include certain commissions, other agency compensation, selection and policy issue expenses, and field expenses. Acquisition costs that do not vary with the production of new business, such as commissions on group products which are generally level throughout the life of the policy, are excluded from deferral. The Company uses its own historical experience and expectation of the future performance of its business in determining
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the expected life of the policies. Over 90 percent of the Company’s deferred policy acquisition costs relate to traditional non interest-sensitive products, for which the costs are amortized in proportion to the estimated premium income to be received over the life of the policies in accordance with the provisions of Statement of Financial Accounting Standards No. 60, Accounting and Reporting by Insurance Enterprises. The estimated premium income in the early years of the amortization period is higher than in the later years due to higher anticipated policy persistency in the early years, which results in a greater proportion of the costs being amortized in the early years of the life of the policy. Amortization of deferred costs on traditional products is adjusted to reflect the actual policy persistency as compared to the anticipated experience. The Company will experience accelerated amortization if policies terminate earlier than projected.
Deferred costs related to U.S. Brokerage group and individual income protection products are generally amortized over a twenty-year period, with approximately 75 percent and 90 percent of the original deferred costs related to group income protection products expected to be amortized by years ten and fifteen, respectively. For individual income protection policies, approximately 40 percent and 70 percent of the original deferred costs are expected to be amortized by years ten and fifteen, respectively. Deferred costs for U.S. Brokerage group and individual long-term care products are amortized over a twenty-year period, with approximately 45 percent and 70 percent of the original deferred costs expected to be amortized by years ten and fifteen, respectively. Deferred costs for U.S. Brokerage group life and accidental death and dismemberment products are amortized over a fifteen-year period, with approximately 80 percent of the cost expected to be amortized by year ten. Deferred costs for U.S. Brokerage voluntary products are amortized over a fifteen-year period, with approximately 80 percent of the cost expected to be amortized by year ten.
Deferred costs for Unum Limited group and individual income protection and group life products are generally amortized over a fifteen-year period, with approximately 80 percent of the original deferred costs expected to be amortized by year ten. Deferred costs for products issued by the Colonial segment are generally amortized over a seventeen-year period, on average, with approximately 80 percent and 90 percent of the original deferred costs expected to be amortized by years ten and fifteen, respectively.
Due to the Company’s actual persistency experienced in recent years relative to what was expected when policies were issued, the Company lowered its premium persistency assumptions for costs deferred in 2002 and thereafter for certain of its products to reflect the Company’s current estimate of persistency. This accelerates the amortization of acquisition costs deferred in those years into the early life of the policy.
Valuation of Fixed Maturity Securities
In determining when a decline in fair value below amortized cost of a fixed maturity security is other than temporary, the Company evaluates the following factors:
The Company’s review procedures include, but are not limited to, monthly meetings of certain members of the Company’s senior management personnel to review reports on the entire portfolio, identifying investments with changes in market value of five percent or more, investments with changes in rating either by external rating agencies or internal analysts, investments segmented by issuer, industry, and foreign exposure levels, and any other relevant investment information to help identify the Company’s exposure to possible credit losses.
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Based on this review of the entire investment portfolio, individual investments may be added to or removed from the Company’s “watch list”, which is a list of securities subject to enhanced monitoring and a more intensive review. The Company also determines if its investment portfolio is overexposed to an issuer that is showing warning signs of deterioration and, if so, the Company makes no further purchases of that issuer’s securities and may seek opportunities to sell securities it holds from that issuer to reduce the Company’s exposure. The Company monitors below-investment-grade securities as to individual exposures and in comparison to the entire portfolio as an additional credit risk management strategy, looking specifically at the Company’s exposure to individual securities currently classified as below-investment-grade. In determining current and future business prospects and cash availability, the Company considers the parental support of an issuer in its analysis but does not rely heavily on this support.
If the Company determines that the decline in value of an investment is other than temporary, the investment is written down to fair value, and an impairment loss is recognized in the current period to the extent of the decline in value. If the decline is considered temporary, the security continues to be carefully monitored. These controls have been established to identify the Company’s exposure to possible credit losses and are intended to give the Company the ability to respond rapidly.
The Company has no held-to-maturity fixed maturity securities. All fixed maturity securities are classified as available-for-sale and are reported at fair value. Fair values are based on quoted market prices, where available.
Private placement fixed maturity securities had a fair value of approximately $3.8 billion, or 11.0 percent of total fixed maturity securities at September 30, 2005. Private placement fixed maturity securities do not have readily determinable market prices. For these securities, the Company uses internally prepared valuations combining matrix pricing with vendor purchased software programs, including valuations based on estimates of future profitability, to estimate the fair value. Additionally, the Company obtains prices from independent third-party brokers to establish valuations for certain of these securities. The Company’s ability to liquidate its positions in some of these securities could be impacted to a significant degree by the lack of an actively traded market, and the Company may not be able to dispose of these investments in a timely manner. Although the Company believes its estimates reasonably reflect the fair value of those securities, the key assumptions about the risk-free interest rates, risk premiums, performance of underlying collateral (if any), and other factors involve significant assumptions and may not reflect those of an active market. The Company believes that generally these private placement securities carry a credit quality comparable to companies rated Baa or BBB by major credit rating organizations.
As of September 30, 2005, the key assumptions used to estimate the fair value of private placement fixed maturity securities included the following:
Increasing the 30 basis points added to the risk free rate for lack of liquidity by 1.5 basis points, increasing the five basis points added to the risk free rates for foreign investments by one basis point, and increasing the additional basis points added to each industry considered to be of greater risk by one basis point would have decreased the September 30, 2005 net unrealized gain in the fixed maturity securities portfolio by approximately $2.0 million. Historically, the Company’s realized gains or losses on dispositions of its private placement fixed maturity securities have not varied significantly from amounts estimated under the valuation methodology described above.
Changes in the fair value of fixed maturity securities, other than declines that are determined to be other than temporary, are reported as a component of other comprehensive income in stockholders’ equity. If it is subsequently determined that any of these securities are other than temporarily impaired, the impairment loss is reported as a realized investment loss in the condensed consolidated statements of operations. The recognition of the impairment
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loss does not affect total stockholders’ equity to the extent that the decline in value had been previously reflected in other comprehensive income.
There are a number of significant risks inherent in the process of monitoring the Company’s fixed maturity securities for impairments and determining when and if an impairment is other than temporary. These risks and uncertainties include the following possibilities:
Reinsurance is a contractual agreement whereby the Company’s reinsurance partners assume a defined portion of the risk for future benefits payable under reinsurance contracts. The reinsurance receivable reported as an asset in the Company’s condensed consolidated statements of financial condition includes amounts due from the Company’s reinsurers on current claims and estimates of amounts that will be due on future claims. Policy reserves and claim reserves reported in the Company’s condensed consolidated statements of financial condition are not reduced for reinsurance. The reinsurance receivable is generally equal to the policy reserves and claim reserves related to the risk being reinsured. The Company reduces the reinsurance receivable if recovery is not likely due to the financial position of the reinsurer or if there is disagreement between the Company and the reinsurer regarding the liability of the reinsurer.
Goodwill is the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed. Goodwill is not amortized, but the Company reviews on an annual basis the carrying amount of goodwill for indications of impairment, with consideration given to financial performance and other relevant factors. In accordance with accounting guidance, the Company tests for impairment at either the operating segment level or one level below. In addition, certain events including, but not limited to, a significant adverse change in legal factors or the business environment, an adverse action by a regulator or rating agency, or unanticipated competition would cause the Company to review goodwill for impairment more frequently than annually.
The goodwill reported as an asset in the Company’s condensed consolidated statements of financial condition at September 30, 2005 is attributable primarily to the acquisition of The Paul Revere Life Insurance Company (individual income protection – recently issued business) and GENEX Services, Inc. (disability management services business). The impairment testing for goodwill involves estimating the fair value of the individual income protection block of recently issued business and the fair value of the disability management services business based upon the present value of future cash flows using assumptions such as future sales, morbidity experience, portfolio yield rate, and the rate of return at which the Company believes the market would price the businesses for purchase. Adverse changes in any of these factors could result in an impairment of goodwill for either or both of the blocks of business.
Income Taxes
The Company records a valuation allowance to reduce deferred tax assets to the amount that is more likely than not to be realized. The Company’s valuation allowance relates primarily to assets for foreign net operating loss carryforwards and assets for the Company’s basis in certain of its foreign subsidiaries that are not likely to be realized in the future based on management’s expectations using currently available evidence. In evaluating the ability to recover deferred tax assets, the Company has considered all available positive and negative evidence including past operating results, the existence of cumulative losses in the most recent years, forecasted earnings,
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future taxable income, and prudent and feasible tax planning strategies. In the event the Company determines that it most likely would not be able to realize all or part of its deferred tax assets in the future, an increase to the valuation allowance would be charged to earnings in the period such determination is made. Likewise, if it is later determined that it is more likely than not that those deferred tax assets would be realized, the previously provided valuation allowance would be reversed.
The calculation of the Company’s tax liabilities involves dealing with uncertainties in the application of complex tax laws in a multitude of jurisdictions, both domestic and foreign. The amount of income taxes paid by the Company is subject to ongoing audits in various jurisdictions, and a material assessment by a governing tax authority could affect profitability. The Company records tax liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on management’s estimate of whether, and to the extent which, additional taxes will probably be due. However, due to the complexity of the tax laws and uncertainties in their interpretation, the ultimate resolution may result in a payment that is materially different from the current estimate of the probable tax liabilities. If the estimate of the tax liabilities proves to be less than the ultimate assessment, an additional charge to expense would result. If payment of these amounts ultimately proves to be less than the recorded amounts, the reversal of the liabilities would result in tax benefits being recognized in the period when the Company determines the liabilities are no longer probable. Management believes that adequate accruals have been provided for all years presented.
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Consolidated Operating Results
Benefits and Expenses
Income (Loss) from Continuing Operations Before Income Tax
N.M. = not a meaningful percentage
Included in the third quarter and first nine months of 2005 net income is a charge of $51.6 million, after tax, related to the Company’s settlement of a market conduct examination with the California DOI and related matters. Included in the first nine months of 2004 net loss is a charge of $701.0 million, after tax, related to the restructuring of the individual income protection – closed block business. The 2004 loss from discontinued operations, net of tax, of $60.8 million is related to the sale of the Company’s Canadian branch discontinued operations, which closed effective April 30, 2004. See “First Nine Months of 2005 Significant Transactions and Events,” “First Nine Months of 2004 Significant Transactions and Events,” and “Discontinued Operations” contained herein in Item 2 and the “Notes to Condensed Consolidated Financial Statements” contained herein in Item 1 for further discussion of these items.
The decline in premium income in the third quarter and first nine months of 2005 relative to the prior year periods is generally in line with the Company’s expectations as premium income has declined in the Company’s U.S.
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Brokerage group income protection and group life and accidental death and dismemberment lines of business due to the Company’s pricing strategy for its group business. The Unum Limited segment, Colonial segment, and remaining U.S. Brokerage segment lines of business reported growth in premium income. Premium income in the Individual Income Protection – Closed Block segment increased in the third quarter of 2005 relative to the prior year third quarter due to the recapture of a ceded block of business effective August 8, 2005.
Net investment income was slightly higher than the third quarter and first nine months of 2004 due primarily to the growth in invested assets and an increase in bond call premiums, offset by a lower yield due to the low interest rate environment and the investment of new cash at lower rates and also due to a decline in the level of prepayments on mortgage-backed securities. The third quarter and nine months of 2005 also includes net investment income on the $1.6 billion of bonds transferred to the Company in conjunction with the third quarter of 2005 recapture of the previously ceded closed block individual income protection business. During 2005, the Company has maintained interest rate margins between its investment portfolio and its reserves such that the reserve discount rate on new income protection claims remains unchanged from the prior year. The Company expects that the portfolio yield will continue to gradually decline, until the market rates on new purchases increase above the level of the overall yield. Investment income is expected to increase, however, due to the continued growth in invested assets.
The Company reported a net realized investment loss for the third quarter and first nine months of 2005 compared to a gain in the comparable prior year periods due mainly to changes in the fair value of the embedded derivatives in certain reinsurance contracts. These fair value changes resulted in a net realized loss, before tax, of $73.3 million in the third quarter of 2005 compared to a before tax net realized gain of $83.8 million for the third quarter of 2004. For the first nine months, the fair value changes resulted in a before tax loss of $8.7 million in 2005 compared to a before tax gain of $49.4 million in 2004. The Company also reported a net realized gain from sales and write-downs of $1.9 million in the third quarter of 2005 compared to a net realized loss of $19.3 million in the third quarter of 2004. For the first nine months, the net realized loss from sales and write-downs was $0.4 million in 2005 compared to $46.0 million during the first nine months of the prior year, reflecting a $50.6 million decline in the level of investment write-downs in 2005 relative to 2004. The Company expects the level of realized investment gains or losses during the remainder of 2005, other than those reported gains and losses related to changes in fair values of the embedded derivatives in certain reinsurance contracts, to be consistent with or below the level of 2004. See “Investments” contained herein in Item 2 for further discussion.
The Company’s claims management results for its U.S. Brokerage segment group income protection business showed improvement in the third quarter of 2005, but year to date results still compare unfavorably to the prior year. As previously discussed, improving the U.S. Brokerage claim management results has been a major operational focus during the year. Claim management results for other lines of business within the U.S. Brokerage segment, as well as the Unum Limited, Colonial, and Individual Income Protection – Closed Block segments, are discussed in the segment results contained herein. As previously noted, benefits and change in reserves for future benefits for the third quarter and first nine months of 2005 include charges of $52.7 million related primarily to the settlement agreement with the California DOI and for the first nine months of 2004 include charges of $110.6 million related to the restructuring of the individual income protection – closed block business.
Commissions decreased in the third quarter and first nine months of 2005 relative to the prior year due primarily to the decline in sales and also to the restructuring of the Colonial agency field sales force. The Company is aggressively managing its operating expenses, particularly in those lines of business with declining revenue. Although the Company reported consolidated operating expense ratios in the third quarter and first nine months of 2005 above the levels of the third quarter and first nine months of 2004, operating expenses for 2005 are generally in line with expectations. Excluding the charges of $22.3 million resulting from the California DOI settlement agreement, as discussed herein, the third quarter of 2005 operating expense ratio was 20.6 percent compared to 20.3 percent for the third quarter of 2004.
As previously discussed, the Company’s income tax for the third quarter and first nine months of 2005 includes a tax benefit of $10.8 million and $42.8 million related to the reduction of income tax liabilities in the first and third quarters of 2005.
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Consolidated Sales Results
Fully Insured Products
Group Long-term Care
Individual Long-term Care
Total Fully Insured Products
Administrative Services Only (ASO) Products
Total ASO Products
Total Sales from Continuing Operations
Discontinued Operations
Sales results shown in the preceding chart generally represent the annualized premium or annualized fee income on new sales expected to be received and reported as premium income or fee income during the next twelve months following or commencing in the initial quarter in which the sale is reported, depending on the effective date of the new sale. Sales do not correspond to premium income or fee income reported as revenue under GAAP because new annualized premiums measure current sales performance, while premium income and fee income are recognized when earned and reflect renewals and persistency of in force policies written in prior years as well as current new sales. Prior year sales results by segment have been reclassified to conform to the current reporting segments, the change of which is discussed herein.
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Premiums for fully insured products are reported as premium income while the fees for administrative services only (ASO) products, wherein the risk and responsibility for funding claim payments remains with the customer, are included in other income. Sales, together with persistency of the existing block of business and the Company’s renewal program, are an indicator of growth in the Company’s premium and fee income. Trends in new sales, as well as existing market share, are also indicators of the Company’s potential for growth in its respective markets and the level of market acceptance of price changes and new product offerings. Sales may fluctuate significantly due to case size and timing of sales submissions. Negative media attention or downgrades in the financial strength ratings of the Company’s insurance subsidiaries may adversely affect the Company’s ability to grow sales and renew its existing business. The Company intends to continue with its disciplined approach to pricing and also with the strategy of developing a more balanced business mix of large, small, and mid-employer markets.
The Company has field sales personnel who specialize in (1) employer-provided plans for employees and (2) supplemental benefit plans that include multi-life income protection and long-term care product offerings and products sold to groups of employees through payroll deduction at the workplace. These field sales personnel partner with Company representatives from claims, customer service, and underwriting who work in conjunction with independent brokers and consultants to present coverage solutions to potential customers and to manage existing customer accounts. The Company utilizes a distribution model for the sale of individual income protection and individual long-term care insurance products whereby independent brokers and consultants are provided direct access to a sales support center centrally located in the Company’s corporate offices. The Company intends to maintain its focus on workplace customers and increased integration between supplemental benefit plans and group offerings by continuing to provide highly focused field support. The Company also utilizes an agency field sales force to market the products offered by its Colonial segment.
Segment Operating Results
The U.S. Brokerage segment includes the results of the Company’s U.S. group income protection insurance, group life and accidental death and dismemberment products, and supplemental and voluntary lines of business, including individual income protection – recently issued, group and individual long-term care, and brokerage voluntary workplace benefits products. The Unum Limited segment is comprised of group and individual income protection and group life products. The products now reported in the U.S. Brokerage segment and the Unum Limited segment were previously combined and reported in the Income Protection and Life and Accident segments. The modification of the Company’s reporting segments had no impact on the level at which the Company performs impairment testing for goodwill or loss recognition testing for the recoverability of deferred policy acquisition costs and value of business acquired.
The results of the disability management services business are now reported in the Other segment, which has been redefined to include the disability management services business as well as results from U.S. Brokerage insured products not actively marketed (with the exception of certain individual income protection products), including individual life and corporate-owned life insurance, reinsurance pools and management operations, group pension, health insurance, and individual annuities. There were no changes to the Colonial, Individual Income Protection – Closed Block, or Corporate segments. Segment information for prior periods has been reclassified to conform to the current reporting segments.
In the following segment financial data and discussions of segment operating results, “operating revenue” excludes net realized investment gains and losses. “Operating income” or “operating loss” excludes net realized investment gains and losses, income tax, and results of discontinued operations. These are considered non-GAAP financial measures. A non-GAAP financial measure is a numerical measure of a company’s performance, financial position, or cash flows that excludes or includes amounts that are not normally excluded or included in the most directly
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comparable measure calculated and presented in accordance with accounting principles generally accepted in the United States (GAAP).
These non-GAAP financial measures of “operating revenue” and “operating income” or “operating loss” differ from revenue and income (loss) from continuing operations before income tax as presented in the Company’s consolidated operating results reported herein and in income statements prepared in accordance with GAAP due to the exclusion of before tax realized investment gains and losses. The Company measures segment performance for purposes of Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an Enterprise and Related Information, excluding realized investment gains and losses because management believes that this performance measure is a better indicator of the ongoing businesses and the underlying trends in the businesses. The Company’s investment focus is on investment income to support its insurance liabilities as opposed to the generation of realized investment gains and losses, and a long-term focus is necessary to maintain profitability over the life of the business. Realized investment gains and losses are dependent on market conditions and not necessarily related to decisions regarding the underlying business of the Company’s segments. However, income or loss excluding realized investment gains and losses does not replace net income or net loss as a measure of the Company’s overall profitability. The Company may experience realized investment losses, which will affect future earnings levels as the underlying business is long-term in nature and requires that the Company be able to earn the assumed interest rates in its liabilities.
A reconciliation of total operating revenue by segment to total consolidated revenue and total operating income (loss) by segment to consolidated net income (loss) is as follows.
Included in the third quarter and first nine months of 2005 before-tax operating income by segment of $139.7 million and $524.8 million, respectively, is a before-tax charge of $75.0 million related to the settlement of the market conduct examination with the California DOI and related matters. Included in the first nine months of 2004 before-tax operating loss by segment of $405.7 million is a before-tax charge of $967.0 million related to the first quarter of 2004 restructuring of the individual income protection – closed block of business.
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U.S. Brokerage Segment Operating Results
The U.S. Brokerage segment includes group long-term and short-term income protection insurance, group life and accidental death and dismemberment products, and supplemental and voluntary lines of business. The supplemental and voluntary lines of business are comprised of recently issued individual income protection insurance, group and individual long-term care insurance, and voluntary workplace benefits products. Shown below are financial results for the U.S. Brokerage segment. In the sections following, financial results and key ratios are also presented for the major lines of business within the segment.
Operating Revenue
Operating Expenses
Operating Income Before Income Tax and Net Realized Investment Gains and Losses
Segment Sales
Group long-term income protection sales, on a fully insured basis, increased during the third quarter and first nine months of 2005 compared to the same periods of 2004 by 16.0 percent and 11.6 percent, respectively. Third quarter sales in the small and mid-employer core markets were very strong, and sales in the more competitive large case market increased relative to the prior year quarter but were lower than the sales in the small and mid-employer core markets as the Company continues with its strategy of developing a more balanced business mix. Group short-term income protection sales, on a fully insured basis, increased sharply in the third quarter of 2005 compared to the prior year third quarter due to very low sales in the third quarter of 2004, but declined for the first nine months of 2005 compared to prior year due to sales declines in all size employer market segments.
Group life sales decreased in comparison to the prior year periods and accidental death and dismemberment sales decreased in the third quarter of 2005 but were slightly higher in the first nine months of 2005 as the Company continues its disciplined approach to pricing.
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Individual income protection – recently issued sales in total decreased in the third quarter and first nine months of 2005. The Company continues to emphasize multi-life sales in its U.S. individual income protection product, with new sales attributable to multi-life business approximating 84 percent for the first nine months of 2005 and 81 percent for full year 2004 sales. Group long-term care sales increased in comparison to prior year periods while individual long-term care sales decreased. Voluntary workplace benefits sales increased in comparison to prior year periods due primarily to sales growth in the brokerage voluntary income protection product line as the Company continues to focus on the voluntary product lines for future growth.
Sales for the U.S. Brokerage segment during the third quarter and first nine months of 2005 were generally consistent with Company expectations, with increases of 4.9 percent and 0.9 percent in the third quarter and first nine months of 2005, respectively, relative to the same periods last year. The Company anticipated relatively weaker sales for the first half of 2005 relative to the comparable period of 2004 for both group and individual income protection products, primarily as a result of the competitive pricing environment and, to a lesser extent, due to the adverse publicity surrounding the Company. The Company has begun to restore sales momentum, particularly in the small and mid-employer core markets, relative to the second half of 2004 while maintaining its commitment to a disciplined pricing approach for new business. The Company intends to continue to emphasize profitable premium growth through a balance of new sales, renewal programs, and persistency of existing profitable blocks of business.
Segment Persistency and Renewal of Existing Business
The Company monitors persistency of its existing business and reflects adverse changes in persistency in the current period’s amortization of deferred policy acquisition costs. One way in which the Company monitors persistency is at the overall block of business level (i.e., group long-term income protection, group short-term income protection, and group life). Persistency, at the overall block of business level, is the year-to-date rate at which existing business for all issue years in the block of business at the beginning of the period remains inforce at the end of the period. In determining whether additional amortization of deferred policy acquisition costs is required due to adverse persistency, the Company measures persistency by issue year (i.e., the rate at which existing business for that specific issue year at the beginning of the period remains inforce at the end of the period). The rate of persistency for an overall block of business may improve while individual issue years within the overall block of business may deteriorate and require additional amortization of deferred policy acquisition costs.
Persistency during the first nine months of 2005 for the overall block of fully-insured group long-term income protection on average declined from that experienced in 2004, but at 84.4 percent was slightly higher than expected. Persistency for fully insured group short-term income protection also declined during the first nine months of 2005, on average, over the prior year, and at 79.3 percent was slightly less than expected. Included in the third quarter policy terminations was a group policyholder who did not terminate the relationship with the Company, but transferred from fully insured short-term income protection to ASO. Excluding the effects of this case, short-term income protection persistency was 83.1 percent for the first nine months of 2005. It was anticipated that persistency in the group income protection business would decline due to the Company’s more disciplined approach to pricing, renewals, and risk selection. Since the group life and accidental death and dismemberment products are primarily sold in conjunction with group income protection, the more focused renewal effort in group income protection has reduced persistency somewhat in these lines as well, though the reduction in persistency is less than anticipated. The persistency for the supplemental and voluntary product lines generally continues to be within expected levels.
For the years 2002 and subsequent, the Company lowered its premium persistency assumptions for group income protection policy acquisition costs deferred in those years to reflect its current estimate of persistency. This accelerated the amortization of group long-term and short-term income protection acquisition costs deferred in those years into the early life of the policy by using lower premium persistency assumptions to determine the “scheduled” or expected amortization. Although persistency in the future may be lower than historical levels, particularly in certain issue years due to the Company’s increased emphasis on retaining profitable business, the acceleration of “scheduled” amortization may eliminate the need for additional amortization related to the decline in actual persistency relative to “scheduled” or expected persistency. The Company does not anticipate that the persistency levels for 2005 will result in increased amortization.
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During the third quarter of 2004, the Company completed comprehensive scenario testing with respect to the amortization and recoverability of its group income protection and group life deferred policy acquisition costs under severe prolonged adverse persistency levels. The deferred policy acquisition costs were fully recoverable, even when tested at persistency rates deteriorating to below 70 percent and continuing at that level throughout the remainder of the life of the inforce block. The assessment was performed primarily to test the limits of recoverability. Sustained adverse persistency at the levels tested, while not resulting in a loss recognition charge, would result in lower emerging future profits due to lower overall premium levels and additional acceleration, on a prospective basis, of the amortization of deferred policy acquisition costs relative to the “scheduled” or expected amortization, but the Company does not anticipate prolonged persistency rates at the stress levels tested. The study was the result of normal experience testing. Persistency continues at levels above the adverse levels tested in 2004.
A critical part of the Company’s strategy for U.S. Brokerage group business involves executing its 2005 renewal program and managing persistency in its existing block of business. Although the 2005 renewal program is smaller than that of 2004, the Company believes this strategy will have a positive effect on future profitability. The Company has shifted emphasis from revenue growth to profit margin expansion, raising prices and remaining more disciplined in risk selection, and restoring a more balanced mix of business between small, medium, and large-employer customers, since large-employer customers are often more price sensitive and vulnerable to weak economic conditions. The Company’s renewal programs have generally been successful in retaining business that is relatively more profitable than business that terminated. While it is expected that the additional premium and related profits associated with renewal activity will continue to emerge, the Company intends to balance the renewal program with the need to maximize persistency and retain producer relationships.
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U.S. Brokerage Group Income Protection Operating Results
Shown below are financial results and key performance indicators for U.S. Brokerage group income protection.
(in millions of dollars, except ratios)
Total Premium Income
Operating Income (Loss) Before Income Tax and Net Realized Investment Gains and Losses
Benefit Ratio (% of Premium Income) (1)
Operating Expense Ratio (% of Premium Income) (2)
Before-tax Operating Income (Loss) Ratio (% of Premium Income) (3)
Persistency - U.S. Group Long-term Income Protection
Persistency - U.S. Group Short-term Income Protection
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Operating revenue for group income protection decreased in the third quarter and first nine months of 2005 relative to the prior year due to the expected decline in premium income. Net investment income increased due to the growth in the level of assets supporting these lines of business, mitigating the impact of the lower yield resulting from the low interest rate environment. Other income, which increased slightly, includes ASO fees of $14.8 million and $43.7 million for the third quarter and first nine months of 2005, respectively, and $14.3 million and $42.4 million for the prior year comparable periods.
The increase in the third quarter and first nine months of 2005 benefit ratio relative to the prior year comparable periods was driven primarily by the claims management results, particularly reduced operational effectiveness in the timing of claim decisions and claim recoveries, and the $27.3 million third quarter of 2005 reserve charge related primarily to the settlement agreement with the California DOI. For group short-term income protection, the third quarter 2005 benefit ratio was consistent with the prior year. For the first nine months of 2005, the benefit ratio for short-term income protection was lower than the comparable period of last year due primarily to increased premiums per insured life and a relatively stable paid incidence rate.
Commissions and the deferral of policy acquisition costs are below the prior year periods due primarily to lower sales. Operating expenses for the third quarter and first nine months of 2005 include charges of $10.1 million related primarily to the settlement agreement with the California DOI. Excluding those charges, expenses are lower than the prior year periods, and while the operating expense ratio has increased slightly relative to the prior year, the Company is aggressively managing its expenses against the expected decline in premium income. The before-tax operating income ratio, excluding the total settlement agreement charges of $37.4 million, shows improvement over the prior year periods.
As discussed under “Cautionary Statement Regarding Forward-Looking Statements,” certain risks and uncertainties are inherent in the Company’s group income protection business. Components of claims experience, including, but not limited to, incidence levels and claims duration, may be worse than expected. Adjustments to reserve amounts may be required in the event of changes from assumptions regarding the incidence of claims or the rate of recovery, as well as persistency, mortality, and interest rates used in calculating the reserve amounts.
The Company, similar to all financial institutions, has some exposure in a severe and prolonged economic recession, but many of the Company’s products can be re-priced, which would allow the Company to reflect in its pricing fundamental changes which might occur in the risk associated with a particular industry or company within an industry. Although a portion of the U.S. Brokerage block of group income protection business is in economically sensitive industry segments, the Company believes it has a well-diversified book of insurance exposure, with no disproportionate concentrations of risk in any one industry.
The Company expects to price new business and re-price existing business, at contract renewal dates, in an attempt to mitigate the effect of incidence levels, claims duration, and other factors, including interest rates, on new claim liabilities. Given the competitive market conditions for the Company’s income protection products, it is uncertain whether pricing actions can entirely mitigate the effect.
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U.S. Brokerage Group Life and Accidental Death and Dismemberment Operating Results
Shown below are financial results and key performance indicators for U.S. Brokerage group life and accidental death and dismemberment.
Other Income (Loss)
Benefit Ratio (% of Premium Income)
Operating Expense Ratio (% of Premium Income)
Before-tax Operating Income Ratio (% of Premium Income)
Persistency - U.S. Group Life
Persistency - U.S. Accidental Death & Dismemberment
Premium income decreased in the third quarter and first nine months of 2005 relative to the third quarter and first nine months of 2004 due to decreased sales growth and lower levels of persistency compared to prior periods. The decrease in net investment income relative to the prior year third quarter resulted primarily from a decline in the level of assets supporting this business. The increase in net investment income for the first nine months of 2005 relative to the prior year is due to an increase in the yield on floating rate investments that support certain products within the group life line of business.
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The U.S. group life line of business reported a fairly consistent benefit ratio year over year for the third quarter and a slight decline for the first nine months of 2005 relative to 2004. Submitted claim incidence for the U.S. group life line of business was slightly higher in the third quarter and first nine months of 2005 relative to the prior year comparable periods. The average paid claim size for group life increased in the third quarter and first nine months of 2005 relative to the same periods of 2004. The U.S. accidental death and dismemberment line of business reported an increased benefit ratio for the third quarter of 2005 compared to the prior year due primarily to an increase in the level of paid claim incidence. The benefit ratio decreased slightly for the first nine months of 2005 compared to the prior year due to lower levels of paid claim incidence and average paid claim size.
Commissions and the deferral of policy acquisition costs decreased in the third quarter and first nine months of 2005 compared to the prior year periods due primarily to the decrease in sales in comparison to the prior year periods. The year-to-date decrease was partially offset by a second quarter 2005 buy-out of a block of business from a commissioned sales agency. Operating expenses have remained relatively stable in 2005 relative to the prior year, but the operating expense ratios increased due to the decline in premium income. Although aggressively managing expenses, the Company anticipates continuing pressure on its operating expense ratios.
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U.S. Brokerage Supplemental and Voluntary Operating Results
Shown below are financial results and key performance indicators for U.S. Brokerage supplemental and voluntary product lines.
Benefit Ratios (% of Premium Income)
Individual Income Protection - Recently Issued (1)
Interest Adjusted Loss Ratio
Before-tax Operating Income Ratio (% of Premium Income) (3)
Persistency - Individual Income Protection - Recently Issued
Persistency - Long-term Care
Persistency - Voluntary Workplace Benefits
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The increase in premium income for the third quarter and first nine months of 2005 relative to the comparable period of 2004 for the individual income protection – recently issued business and individual long-term care is due to sales growth in prior periods and stable persistency. For the group long-term care and voluntary workplace benefits products, premium income increased due to sales growth in previous periods, new sales in the current periods, and stable persistency.
Net investment income increased relative to the prior year third quarter primarily from growth in the level of assets supporting these lines of business. Net investment income increased relative to the first nine months of 2004 due primarily to growth in the level of assets supporting these lines of business, partially offset by the inclusion in 2004 of a portion of the investment income attributable to the bonds retained from the sale of the Canadian branch and subsequently redeployed to other lines of business.
The benefit ratio for the individual income protection – recently issued business decreased in the third quarter of 2005 relative to the prior year third quarter, excluding the $2.3 million third quarter of 2005 reserve charge related primarily to the California DOI settlement agreement, due to a decrease in claim incidence rates. For the first nine months, the benefit ratio was slightly higher than in the comparable period of 2004, driven primarily by the claims management results, particularly reduced operational effectiveness in the timing of claim decisions and claim recoveries, partially offset by lower incidence and a release of active life reserves on two large multi-life cases which terminated during the second quarter of 2005. The benefit ratio for long-term care was higher in the third quarter and first nine months of 2005 than in the comparable periods of 2004 due primarily to the aging of the block of business and a lower net claim resolution rate. The benefit ratio for the voluntary workplace benefits products was consistent with the third quarter of 2004 but decreased in comparison to the first nine months of 2004 due primarily to improved mortality experience in the voluntary workplace benefits life line of business.
The deferral of policy acquisition costs decreased during 2005 relative to the prior year third quarter and first nine months due primarily to the lower level of sales in the individual income protection – recently issued and long-term care lines of business, offset somewhat by higher levels of deferral for the voluntary workplace benefits product lines due to increased sales. Amortization of deferred policy acquisition costs was higher for the first nine months due to the termination during the second quarter of 2005 of two large multi-life cases which resulted in the write-off of associated unamortized acquisition costs. This increased amortization was offset by the release of active life reserves, as previously mentioned.
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Segment Outlook
The Company’s primary focus during the remainder of 2005 will be continued improvement of its claims management results and profitability enhancement in its group income protection line of business, along with an emphasis on growth in the small and mid-employer core markets and the supplemental and voluntary product lines. The Company intends to continue its disciplined approach to pricing, renewals, and risk selection, with a more conscious effort to balance growth and profitability. Although this strategy may cause a somewhat lower persistency or market share, historically the profitability of business that terminates has generally been less than the profitability of retained business.
Because of anticipated long-term improvements in the claim management results for the U.S. Brokerage group long-term income protection business, the Company expects its overall benefit ratio for group income protection to gradually improve.
The Company believes that its U.S. Brokerage results will benefit if there is an improvement in overall economic conditions and a higher interest rate environment, although the improvement in results may lag behind the improvements in the economy and interest rate environment.
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Unum Limited Segment Operating Results
The Unum Limited segment includes insurance for group and individual long-term income protection and group life products sold primarily in the United Kingdom through field sales personnel and independent brokers and consultants. Shown below are financial results and key performance indicators for the Unum Limited segment.
Persistency - Group Long-term Income Protection
Persistency - Group Life
Persistency - Other
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Unum Limited group long-term income protection sales decreased in the third quarter and the first nine months of 2005 relative to the comparable prior year periods due primarily to higher sales in the first nine months of 2004 related to the exit of a major insurer from the group long-term income protection market in the U.K. Sales for Unum Limited group life decreased in the third quarter and first nine months of 2005 relative to the same periods in the prior year due to the competitive environment in the U.K. for group life products and the Company’s decision to maintain its pricing discipline.
Operating Results
Premium income increased in comparison to prior year periods due primarily to growth in the U.K. group long-term income protection line of business resulting from block acquisitions and the related growth in prior year sales and increased persistency. The premium income increase in the group life line of business was due to prior period sales growth and increased persistency. Net investment income increased in the third quarter and first nine months of 2005 relative to the same periods of 2004 due to continued growth in the business and the assets supporting it, offset partially by a slight decrease in portfolio yields relative to the prior year. Other income for the third quarter and first nine months of 2005 includes a before tax gain of $5.7 million related to the disposal of Unum Limited’s Netherlands branch in the third quarter of 2005, as previously discussed.
While underlying claims experience was favorable, the benefit ratio for the group long-term income protection line of business increased in comparison to the third quarter and first nine months of 2004 due to the inclusion in the prior year of extremely favorable claim resolution experience on an acquired block of group long-term income protection business. The benefit ratio for the group life line of business decreased in comparison to the third quarter and first nine months of 2004 due to favorable claim experience in 2005 and recent renewal activity which resulted in terminations of less profitable business.
Operating expenses have increased in the third quarter and first nine months of 2005 compared to the same periods of 2004 due to growth of the lines of business, but the operating expense ratios decreased due to an increase in premium income, economies of scale, and the Company’s focus on expense management.
Sales for Unum Limited are expected to be weaker than the level achieved in 2004, although sales momentum for group long-term income protection appears to be improving. The Company intends to focus on maintaining its strong leadership position in the U.K. However, the competitive pricing environment in the U.K. is expected to continue to negatively impact group life sales through the remainder of 2005.
Although claims experience is favorable for the group long-term income protection line of business, it is expected that the benefit ratio may increase during the remainder of the year, relative to the current level, as positive claim resolution trends on recent block acquisitions become less pronounced.
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Colonial Segment Operating Results
The Colonial segment includes insurance for income protection products, life products, and cancer and critical illness products issued by the Company’s subsidiary Colonial Life & Accident Insurance Company and marketed to employees at the workplace through an agency sales force and brokers. Shown below are financial results and key performance indicators for the Colonial segment.
Persistency - Income Protection
Persistency - Life
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Sales in the third quarter and first nine months of 2005 are relatively flat with the level of sales in the same periods of 2004. The Company expects positive sales growth in the Colonial segment during the remainder of 2005.
Growth in premium income was attributable primarily to prior period sales growth. The 2005 third quarter benefit ratio for this segment was higher than in the prior year quarter due primarily to the life product lines. The benefit ratio for the first nine months of 2005 was lower than the prior year due to decreases in the income protection and life product lines. Individual short-term income protection claim incidence decreased in the first quarter of 2005 and is comparable in the second and third quarters of 2005 to the same periods in 2004, while the average claim duration for closed claims was higher in the third quarter and first nine months of 2005 relative to the comparable periods of 2004. The average indemnity for individual short-term income protection was higher in the third quarter and first nine months of 2005 relative to the comparable periods of 2004. For accident and sickness products, which are included in the income protection line of business, the claim incidence rate decreased in the third quarter and first nine months of 2005 relative to the prior year periods, but the average claim payment increased over that reported for the third quarter and first nine months of 2004. The life line of business reported a decrease in the number of paid claims in the third quarter of 2005 and reported an increase in the first nine months of 2005 relative to the comparable periods of 2004. The average incurred claim payment decreased in the third quarter and first nine months of 2005 relative to the same periods of 2004.
Commissions in the third quarter and first nine months of 2005 declined relative to the prior year periods, and operating expenses increased. These changes were due primarily to the restructuring of the agency field sales force wherein the Company is moving certain functions from a commissioned sales agency status to salaried employees of the Company.
Past sales results have not grown at the rate the Company believes it can competitively and profitably achieve. The Company will continue to emphasize consistent, profitable sales growth by focusing on the recruitment and productivity of agents, improved business tools, and enhanced marketing research and development.
The Company expects growth in revenue and profitability to be driven by increasing premium income through sales growth and stable persistency while maintaining a focus on high-quality business and the management of expenses. High quality service is viewed as a differentiator for the Colonial segment in the marketplace. The two key drivers for quality service delivery are trained service professionals and effective use of technology. These key drivers will be emphasized by seeking to increase innovation, productivity, and performance through leadership development and technological advances.
Individual Income Protection - Closed Block Segment Operating Results
The Individual Income Protection – Closed Block segment generally consists of those individual income protection policies in force prior to the Company’s substantial changes in product offerings, pricing, distribution, and underwriting. These changes generally occurred during the period 1994 through 1998. A minimal amount of new business continued to be sold subsequent to these changes, but the Company ceased selling new policies in this segment at the beginning of 2004 other than update features contractually allowable on existing policies.
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Shown below are financial results and key performance indicators for the Individual Income Protection – Closed Block segment.
Persistency
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As previously discussed, effective August 8, 2005, the Company recaptured the closed block individual income protection business originally ceded to Centre Life Reinsurance Ltd. in 1996. The underlying operating results of the reinsurance contract, prior to recapture, were reflected in other income. The recapture did not have a material impact on operating income for the segment.
Also as previously discussed, in the first quarter of 2004, the Company restructured its individual income protection – closed block business wherein three of its insurance subsidiaries entered into reinsurance agreements that effectively provide approximately 60 percent reinsurance coverage for the Company’s overall consolidated risk above a specified retention limit. If losses to the reinsurer exceed a specified aggregate limit, any further losses will revert to the Company. These reinsurance transactions were effective as of April 1, 2004. The Company transferred cash equal to $521.6 million of ceded reserves plus an additional $185.8 million in cash for a before-tax prepaid cost of insurance which was deferred and is being amortized into earnings over the expected claim payment period covered under the Company’s retention limit. The amortization of the prepaid cost is expected to be approximately $5.4 million in 2005. Included in the loss for the first nine months of 2004 are the first quarter of 2004 restructuring charges of $282.2 million, $367.1 million, and $207.1 million related to the write-down of deferred policy acquisition costs, value of business acquired, and goodwill, respectively, and the claim reserve charge of $110.6 million, for a total before tax charge of $967.0 million.
The increase in premium income for the third quarter of 2005 relative to the prior year third quarter is due to the recapture of the previously discussed block of business, which on an annual basis will add approximately $185.0 million of premium income to this segment. The premium income increase in the third quarter of 2005 related to this recaptured block was approximately $24.5 million. The decrease in premium income for the first nine months compared to prior year is due to the expected decline in this closed block of business, offset somewhat by premium income on the recaptured business. Net investment income, which in the third quarter includes $12.5 million of investment income related to the $1.6 billion of bonds transferred to the Company in conjunction with the reinsurance recapture, increased slightly in the third quarter of 2005 relative to the third quarter of 2004. This increase was mostly offset by a decline in the level of invested assets, a decline in the portfolio yield rate, and a decline in bond call premiums and prepayments on mortgage-backed securities. Net investment income decreased in the first nine months of 2005 relative to the prior year due to a decline in the portfolio yield rate, a lower level of invested assets during the first eight months of 2005 prior to the recapture, and a decrease in income on mortgage-backed securities. Other income includes the underlying results of certain blocks of reinsured business, including the results of the aforementioned block of business prior to the recapture date.
The benefit ratio for the third quarter of 2005 increased in comparison to the prior year period due primarily to lower claim recoveries in the third quarter and the $23.1 million third quarter of 2005 reserve charge related primarily to the settlement agreement with the California DOI, partially offset by improved claim incidence trends in the third quarter of 2005. The benefit ratio for the first nine months of 2005 increased in comparison to the prior year period, excluding the $23.1 million third quarter of 2005 reserve charge and the $110.6 million claim reserve charge in the first quarter of 2004, due to lower claim recoveries for the nine months of 2005 relative to 2004, partially offset by improved incidence rates.
Operating expenses for the third quarter and first nine months of 2005 include charges of $11.2 million related primarily to the settlement agreement with the California DOI. Excluding those charges, expenses and the operating expense ratio are lower than the prior year periods. Operating expenses also include payment of a judgment in a lawsuit in the second quarter of 2005.
The Company believes that the 2004 restructuring of this closed block of business has strengthened the balance sheet for this segment and minimized the Company’s exposure to potential future adverse morbidity. The Company expects no change in the level of service provided to policyholders of this business as a result of the restructuring. Total revenue, subsequent to a full year’s inclusion of premium and net investment income related to the recaptured block of business, is expected to decline very slowly over time as the Company believes that persistency will remain in the mid-90 percent range. The Company believes that the interest adjusted loss ratio will be relatively flat over
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the long-term, but the segment may experience quarterly volatility. The expense ratio throughout the remainder of 2005 is expected to be consistent with or lower than that reported for 2004.
Other Segment Operating Results
The Other operating segment includes results from disability management services and U.S. Brokerage insured products not actively marketed (with the exception of certain individual income protection products), including individual life and corporate-owned life insurance, reinsurance pools and management operations, group pension, health insurance, and individual annuities. It is expected that operating revenue and income in this segment resulting from the products that are not actively marketed will decline over time as these business lines wind down, and management expects to reinvest the capital supporting these lines of business in the future growth of the U.S. Brokerage, Unum Limited, and Colonial segments.
Disability Management Services
Operating revenue from disability management services, which includes the Company’s wholly-owned subsidiaries GENEX and Options and Choices, Inc., totaled $44.2 million and $133.4 million in the third quarter and first nine months of 2005, respectively, compared to $44.6 million and $133.5 million in the comparable periods of 2004. Operating income totaled $4.9 million in the third quarter of 2005 compared to $4.4 million in the third quarter of 2004 and $11.5 million and $12.2 million for the first nine months of 2005 and 2004, respectively.
During the third quarter of 2005, GENEX acquired Independent Review Services, Inc., a provider of medical diagnostic networks and independent medical examinations, at a price of $3.5 million. This acquisition will broaden GENEX’s product offerings through the addition of medical diagnostic services.
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Reinsurance Pools and Management
The Company’s reinsurance operations include the reinsurance management operations of Duncanson & Holt, Inc. (D&H) and the risk assumption, which includes reinsurance pool participation; direct reinsurance which includes accident and health (A&H), long-term care (LTC), and long-term disability coverages; and Lloyd’s of London (Lloyd’s) syndicate participations. During the years 1999 through 2001, the Company exited its reinsurance pools and management operations through a combination of a sale, reinsurance, and/or placement of certain components in run-off. During the third quarter and first nine months of 2005, this line of business reported operating losses of $1.1 million and $6.4 million, respectively, compared to $2.0 million and $6.1 million in the comparable periods of 2004.
Individual Life and Corporate-Owned Life
During 2000, the Company reinsured substantially all of the individual life and corporate-owned life insurance blocks of business. The Company ceded approximately $3.3 billion of reserves to the reinsurer. The $388.2 million before-tax gain on these transactions was deferred and is being amortized into income based upon expected future premium income on the traditional insurance policies ceded and estimated future gross profits on the interest-sensitive insurance policies ceded.
Total operating revenue for individual life and corporate-owned life insurance was $9.7 million and $10.0 million in the third quarters of 2005 and 2004, respectively. Operating income for the same periods was $9.3 million and $9.4 million, respectively. For the first nine months of 2005 and 2004, operating revenue was $29.8 million and $30.0 million, respectively, and operating income was $28.3 million and $27.8 million, respectively.
Group pension, health insurance, individual annuities, and other closed lines of business had operating revenue of $27.2 million and $37.3 million in the third quarter of 2005 and 2004, respectively, and operating income (losses) of $0.5 million and $(0.1) million. For the first nine months of 2005 and 2004, operating revenue was $83.8 million and $113.2 million, respectively, and operating income was $3.4 million and $3.2 million. Decreases in operating revenue and income are expected to continue as these lines of business wind down.
Corporate Segment Operating Results
The Corporate segment includes investment income on corporate assets not specifically allocated to a line of business, corporate interest expense, and certain corporate income and expense not allocated to a line of business.
Operating revenue in the Corporate segment was $16.9 million in the third quarter of 2005 compared to $10.4 million in the third quarter of 2004. For the first nine months, operating revenue was $50.9 million in 2005 and $39.6 million in 2004. The increase in revenue for the first nine months was primarily related to higher net investment income resulting from a bond call in the first quarter of 2005 and from interest income on unallocated cash and investments. Included in the first nine months of 2004 revenue is a second quarter $9.4 million curtailment gain related to changes in the Company’s retiree medical plan. See Note 7 of the “Notes to Condensed Consolidated Financial Statements” contained herein in Item 1 for further discussion of the Company’s postretirement benefits.
The Corporate segment reported operating losses of $33.0 million and $44.8 million in the third quarter of 2005 and 2004, respectively, and $109.8 million and $122.2 million for the first nine months of 2005 and 2004. Interest and debt expense was $49.8 million and $155.5 million in the third quarter and first nine months of 2005, respectively, compared to $53.4 million and $154.1 million in the prior year periods.
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During 2003, the Company entered into an agreement to sell its Canadian branch. The transaction closed April 30, 2004, and the Company reported a second quarter of 2004 loss of $113.0 million before tax and $70.9 million after tax on the sale of the branch. The Company also recognized a first quarter of 2004 loss of $0.6 million before tax and $0.4 million after tax to write down the value of bonds in the Canadian branch investment portfolio to market value.
No income or loss was reported for discontinued operations in the third quarter of 2004. For the first nine months of 2004, income from discontinued operations, excluding the 2004 reported loss on the sale and the write-downs, was $10.5 million, net of tax.
See Note 3 of the “Notes to Condensed Consolidated Financial Statements” contained herein in Item 1 for further discussion of the Company’s discontinued operations.
Investments
Overview
Investment activities are an integral part of the Company’s business, and profitability is significantly affected by investment results. Invested assets are segmented into portfolios that support the various product lines. Generally, the investment strategy for the portfolios is to match the effective asset cash flows and durations with related expected liability cash flows and durations to consistently meet the liability funding requirements of the Company’s business. The Company seeks to maximize investment income and total return and to assume credit risk in a prudent and selective manner, subject to constraints of quality, liquidity, diversification, and regulatory considerations. The Company’s overall investment philosophy is to invest in a portfolio of high quality assets that provide investment returns consistent with that assumed in the pricing of its insurance products. Assets are invested predominately in fixed maturity securities, and the portfolio is matched with liabilities so as to eliminate as much as possible the Company’s exposure to changes in the overall level of interest rates.
The Company actively manages its asset and liability cash flow match as well as its asset and liability duration match in order to minimize interest rate risk. Changes in interest rates affect the amount and timing of cash flows. The Company may redistribute its investments within its different lines of business, when necessary, to adjust the cash flow and/or duration of the asset portfolios to better match the cash flow and duration of the liability portfolios. Asset and liability portfolio modeling is updated on a quarterly basis and is used as part of the overall interest rate risk management strategy. Cash flows from the inforce asset and liability portfolios are projected at current interest rate levels and also at levels reflecting an increase and a decrease in interest rates to obtain a range of projected cash flows under the different interest rate scenarios. These results enable the Company to assess the impact of projected changes in cash flows and duration resulting from potential changes in interest rates. Testing the asset and liability portfolios under various interest rate scenarios enables the Company to choose the most appropriate investment strategy as well as to minimize the risk of disadvantageous outcomes. This analysis is a precursor to the Company’s activities in derivative financial instruments, which are used to hedge interest rate risk and to match duration. At September 30, 2005, the weighted average duration of the Company’s policyholder liability portfolio was approximately 8.18 years, and the weighted average duration of the Company’s investment portfolio supporting those policyholder liabilities was approximately 7.65 years.
The Company is able to hold to its investment philosophy throughout credit and interest rate cycles because of its capital position, the fixed nature of its liabilities, and the matching of those liabilities with assets and also because of the experience gained through many years of a consistent investment philosophy. It is the Company’s intent, and has been its practice, to hold investments to maturity to meet liability payments.
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Below is a summary of the Company’s formal investment policy, including the overall quality and diversification objectives.
Rating
Internal Limit
Investment Results
Net investment income was $547.2 million in the third quarter of 2005 and $1,623.4 million in the first nine months of 2005, up 3.8 percent and 1.8 percent relative to the comparable prior year amounts. The increase was due primarily to growth in invested assets and an increase in bond call premiums, offset by a lower yield due to the low interest rate environment and the investment of new cash at lower rates and also due to a decline in the level of prepayments on mortgage-backed securities. The third quarter and first nine months of 2005 also includes net investment income of $12.5 million related to the $1.6 billion of bonds transferred to the Company in conjunction with the third quarter of 2005 recapture of a ceded closed block of individual income protection business. The overall yield in the portfolio was 6.86 percent as of September 30, 2005, and the weighted average credit rating was A2. The overall yield in the portfolio was 6.95 percent as of September 30, 2004 and 6.93 percent at the end of 2004. In the current low interest rate market, the Company expects that the portfolio yield will continue to gradually decline until the market rates on new purchases increase above the level of the overall yield.
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The Company reported before-tax realized investment gains and losses during the third quarter and first nine months of 2005 and 2004 as shown in the following chart. Impairment losses were recognized as a result of management’s determination that the value of certain fixed maturity and equity securities had other than temporarily declined during the applicable reporting period, as well as the result of further declines in the values of fixed maturity and equity securities that had initially been written down in a prior period. The value of the securities was determined to have other than temporarily declined or to have further declined from the initial impairment based on the factors discussed herein in “Critical Accounting Policies.” Additional investment losses may occur during the remainder of 2005.
The Company also reports changes in the fair values of certain embedded derivatives as realized investment gains and losses, as required under the provisions of Statement of Financial Accounting Standards No. 133 Implementation Issue B36 (DIG Issue B36), Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments That Incorporate Credit Risk Exposure That Are Unrelated or Only Partially Related to the Creditworthiness of the Obligor Under Those Instruments. The change in the fair values of these embedded derivatives resulted in a before tax loss of $73.3 million in the third quarter of 2005 due primarily to the increase in interest rates as of September 30, 2005 relative to June 30, 2005. For the first nine months of 2005, the change in fair values of the embedded derivatives was minimal, reflecting interest rate levels on mid-term and longer-term maturities that were, on average, fairly consistent at September 30, 2005 with the level of rates existing at December 31, 2004. The third quarter and first nine months realized loss on these embedded derivatives also includes recognition of a $9.4 million before tax loss related to the time value component of the embedded derivative in the reinsurance contract that was recaptured in the third quarter of 2005. Interest rates generally decreased during the third quarter and first nine months of 2004, resulting in an increase in the fair value of these embedded derivatives during that time period.
Gross Realized Investment Gain from Sales
Gross Realized Investment Loss
Write-downs
Sales
Change in Fair Value of DIG Issue B36 Derivatives
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Realized Investment Losses during the First Nine Months of 2005 from Other than Temporary Impairments
Approximately 66 percent of the first nine months of 2005 other than temporary impairment losses occurred in the transportation industry. Circumstances surrounding larger other than temporary impairment losses are as follows:
Realized Investment Losses during the First Nine Months of 2004 from Other than Temporary Impairments
Approximately 54 percent of the first nine months of 2004 other than temporary impairment losses in continuing operations occurred in the transportation and financial institutions industries. Circumstances surrounding larger other than temporary impairment losses are as follows:
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Realized Investment Losses during the First Nine Months of 2005 from Sale of Fixed Maturity Securities
In the third quarter and first nine months of 2005, the Company realized a loss of $17.8 million and $54.6 million, respectively, on the sale of fixed maturity securities. The securities sold during the third quarter of 2005 had a book value of $190.9 million and a fair value of $173.1 million at the time of sale and represented 21 different issuers. For the first nine months, the securities sold had a book value of $667.3 million and a fair value of $612.7 million at the time of sale and represented 51 issuers. Circumstances surrounding larger realized investment losses from sale of securities are as follows:
Realized Investment Losses during the First Nine Months of 2004 from Sale of Fixed Maturity Securities
For the third quarter and first nine months of 2004, the Company realized a loss of $10.2 million and $44.9 million, respectively, on the sale of fixed maturity securities in its continuing operations. The securities sold during the third quarter of 2004 had a book value of $81.4 million and a fair value of $71.2 million at the time of sale and represented 16 different issuers. For the first nine months, the securities sold had a book value of $423.8 million and a fair value of $378.9 million at the time of sale and represented 52 different issuers. Circumstances surrounding larger realized investment losses from sale of securities are as follows:
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Asset Distribution
The following table provides the distribution of invested assets for the periods indicated. Ceded policy loans of $2.9 billion as of September 30, 2005 and December 31, 2004, which are reported on a gross basis in the condensed consolidated statements of financial condition contained herein in Item 1, are excluded from the table below. The investment income on these ceded policy loans is not included in income.
Investment-Grade Fixed Maturity Securities
Below-Investment-Grade Fixed Maturity Securities
Other Invested Assets
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Fixed Maturity Securities
Fixed maturity securities at September 30, 2005, included $34.4 billion, or 99.6 percent, of bonds and derivative instruments and $126.4 million, or 0.4 percent, of redeemable preferred stocks. The following table shows the fair value composition by internal industry classification of the fixed maturity bond portfolio and the associated unrealized gains and losses.
Fixed Maturity Bonds – By Industry Classification
As of September 30, 2005
Classification
Basic Industry
Canadian
Capital Goods
Communications
Consumer Cyclical
Consumer Non-Cyclical
Derivative Instruments
Energy (Oil & Gas)
Financial Institutions
Mortgage/Asset Backed
Sovereigns
Technology
Transportation
U.S. Government Agencies and Municipalities
Utilities
The following table is a distribution of the maturity dates for fixed maturity bonds in an unrealized loss position at September 30, 2005.
Fixed Maturity Bonds – By Maturity
Due in 1 year or less
Due after 1 year up to 5 years
Due after 5 years up to 10 years
Due after 10 years
Subtotal
Mortgage/Asset Backed Securities
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Of the $397.6 million in gross unrealized losses at September 30, 2005, $307.7 million, or 77.4 percent, are related to investment-grade fixed maturity bonds. The following table shows the length of time the Company’s investment-grade fixed maturity bonds had been in a gross unrealized loss position as of September 30, 2005.
Unrealized Loss on Investment-Grade Fixed Maturity Bonds
Length of Time in Unrealized Loss Position
<= 90 days
> 90 <= 180 days
> 180 <= 270 days
> 270 <= 1 year
> 1 year <= 2 years
> 2 years <= 3 years
> 3 years
Totals
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The following table shows the length of time the Company’s below-investment-grade fixed maturity bonds had been in a gross unrealized loss position as of September 30, 2005. The fair value and gross unrealized losses are categorized by the relationship of the current fair value to amortized cost for those securities on September 30, 2005. The fair value to amortized cost relationships are not necessarily indicative of the fair value to amortized cost relationships for the securities throughout the entire time that the securities have been in an unrealized loss position nor are they necessarily indicative of the relationships subsequent to September 30, 2005.
Unrealized Loss on Below-Investment-Grade Fixed Maturity Bonds
Gross
Unrealized Loss
fair value < 100% >= 70% of amortized cost
fair value < 70% >= 40% of amortized cost
> 270 <=1 year
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As of September 30, 2005, the Company held 3 securities with a gross unrealized loss of $10 million or greater, as shown in the chart below.
Gross Unrealized Losses on Fixed Maturity Bonds
$10.0 Million or Greater
Fixed Maturity Bonds
U.S. Government Sponsored Mortgage Funding Company
Principal Protected Equity Linked Note
Below-Investment-Grade
U.S. Based Automobile Manufacturer
Unrealized losses on investment-grade fixed maturity securities principally relate to changes in interest rates or changes in market or sector credit spreads which occurred subsequent to the acquisition of the securities. These changes are generally temporary and are not recognized as realized investment losses unless the securities are sold, a decision is made that it is unlikely that the Company will hold the securities until recovery, or the securities become other than temporarily impaired. Generally, below-investment-grade fixed maturity securities are more likely to develop credit concerns. As previously discussed under “Critical Accounting Policies” contained herein, in determining whether a decline in fair value below amortized cost of a fixed maturity security is other than temporary, the Company utilizes a formal, well-defined, and disciplined process to monitor and evaluate its fixed income investment portfolio. The process results in a thorough evaluation of problem investments and the recording of realized losses on a timely basis for investments determined to have an other than temporary impairment.
For those fixed maturity securities with an unrealized loss and on which the Company has not recorded an impairment loss, the Company believes that the decline in fair value below amortized cost is temporary. The Company has the ability to hold its securities to the earlier of recovery or maturity and intends to hold all of its fixed maturity investments until maturity to meet its liability obligations. If information becomes available that changes the Company’s assessment as to whether the Company will receive contractual payments related to a fixed maturity security and the security is also not projected to recover in value, the related security is generally sold. The Company may also in certain circumstances sell a security in an unrealized loss position because of changes in tax laws, when a merger or the disposition of a segment or product line results in positions outside of the Company’s investment guidelines, due to changes in regulatory or capital requirements, due to unexpected changes in liquidity needs, or to take advantage of tender offers that recover up to or beyond the cost of the investment.
For those securities with a gross unrealized loss of $10.0 million or greater, further discussed as follows are (a) the factors which the Company believes resulted in the impairment and (b) the information the Company considered, both positive and negative, in reaching the conclusion that the impairments were not other than temporary.
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The fixed maturity bond of the U.S. government sponsored mortgage funding company was issued by the Federal Home Loan Mortgage Corporation. The bond was rated AAA by Standard & Poor’s Corporation (S&P) as of September 30, 2005, with no negative outlook by rating agencies or in analysts’ reports. The change in the market value of this security relates to changes in interest rates subsequent to the purchase of the bond. The Company believes that the decline in fair value of this security is temporary. The Company has the ability to hold this security to the earlier of recovery or maturity and intends to hold its fixed maturity investments until maturity to meet its liability obligations.
The principal protected equity linked note is a zero coupon bond, issued by a large, well capitalized Fortune 500 financial services company, the return of which is linked to a Vanguard S&P 500 index mutual fund. This bond matures on August 24, 2020 and carries the A+ rating of the issuer, as determined by S&P as of September 30, 2005. This note has an embedded derivative contract and substitutes highly rated bonds in place of the underlying S&P 500 index mutual fund to provide principal protection in the event of a significant decline in the equities market. The note derives its value from the underlying S&P 500 index mutual fund. The reduction in the market value of this note was the result of the decline in the S&P 500 index subsequent to the purchase date of the note. Based on historical long-term returns of the S&P 500 index, the Company believes that the value of the underlying S&P 500 index mutual fund will equate to or exceed the par value of the security at maturity. The Company therefore believes that the decline in fair value of the note is temporary. The Company has the ability to hold this security to the earlier of recovery or maturity and intends to hold its fixed maturity investments until maturity to meet its liability obligations.
The fixed maturity bonds of the U.S. based automobile manufacturer are securities issued by the manufacturer and its captive finance subsidiary. The reduction in market value of these securities was primarily due to a decline in profitability and cash flow due to the competitive environment, loss of market share, high cost of raw materials, and rising employee healthcare and pension costs. The automotive company and the finance subsidiary both have substantial liquidity, and the finance subsidiary has approximately $25 billion in unused capacity in its credit facilities. Furthermore, the finance subsidiary has approximately $88 billion of assets maturing within two years compared to only $46 billion of finance-related debt maturing in the same period. These securities have been in an unrealized loss position for less than 270 days, and the Company believes that the decline in fair value of these securities is temporary. The Company has the ability to hold these securities to the earlier of recovery or maturity and intends to hold its fixed maturity investments until maturity to meet its liability obligations.
The Company’s investment in mortgage-backed and asset-backed securities was approximately $4.3 billion and $3.8 billion on an amortized cost basis at September 30, 2005 and December 31, 2004, respectively. At September 30, 2005, the mortgage-backed securities had an average life of 7.3 years and effective duration of 4.2 years. The mortgage-backed and asset-backed securities are valued on a monthly basis using valuations supplied by the brokerage firms that are dealers in these securities. The primary risk involved in investing in mortgage-backed securities is the uncertainty of the timing of cash flows from the underlying loans due to prepayment of principal with the possibility of reinvesting the funds in a lower interest rate environment. The Company uses models which incorporate economic variables and possible future interest rate scenarios to predict future prepayment rates. The Company has not invested in mortgage-backed derivatives, such as interest-only, principal-only or residuals, where market values can be highly volatile relative to changes in interest rates.
As of September 30, 2005, the Company’s exposure to below-investment-grade fixed maturity securities was $2,301.1 million, approximately 6.4 percent of the fair value of invested assets excluding ceded policy loans, compared to 6.4 percent at the end of 2004. Below-investment-grade bonds are inherently more risky than investment-grade bonds since the risk of default by the issuer, by definition and as exhibited by bond rating, is higher. Also, the secondary market for certain below-investment-grade issues can be highly illiquid. Additional downgrades may occur during 2005, but the Company does not anticipate any liquidity problem caused by its investments in below-investment-grade securities, nor does it expect these investments to adversely affect its ability to hold its other investments to maturity.
The Company has a significant interest in, but is not the primary beneficiary of, a special purpose entity which is a collateralized bond obligation asset trust in which the Company holds interests in several of the tranches and for which the Company acts as investment manager of the underlying securities. The Company’s investment in this entity was reported at fair value with fixed maturity securities in the condensed consolidated statements of financial condition. The fair value of this investment was derived from the fair value of the underlying assets. The fair value
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and amortized cost of this investment was $23.0 million and $22.3 million, respectively, at September 30, 2005, and $25.6 million and $24.8 million, respectively, at December 31, 2004.
Mortgage Loans and Real Estate
The Company’s mortgage loan portfolio was $661.1 million and $498.2 million on an amortized cost basis at September 30, 2005 and December 31, 2004, respectively. The Company believes its mortgage loan portfolio is well diversified geographically and among property types. The incidence of problem mortgage loans and foreclosure activity remains low, and management expects the level of delinquencies and problem loans to remain low in the future. The Company had no restructured or delinquent mortgage loans at September 30, 2005 or December 31, 2004.
The Company expects that during the remainder of 2005 it will invest in additional commercial mortgage loans. This will allow the Company to leverage its operational structure currently in place for its existing mortgage loan portfolio and to utilize an additional investment category in its portfolio strategies.
Real estate was $18.2 million and $27.4 million at September 30, 2005 and December 31, 2004, respectively. Investment real estate is carried at cost less accumulated depreciation. Real estate acquired through foreclosure is valued at fair value at the date of foreclosure and may be classified as investment real estate if it meets the Company’s investment criteria. If investment real estate is determined to be permanently impaired, the carrying amount of the asset is reduced to fair value. Occasionally, investment real estate is reclassified to real estate held for sale when it no longer meets the Company’s investment criteria. Real estate held for sale, which is valued net of a valuation allowance that reduces the carrying value to the lower of cost or fair value less estimated cost to sell, amounted to $6.7 million at September 30, 2005 and $6.2 million at December 31, 2004.
The Company uses a comprehensive rating system to evaluate the investment and credit risk of each mortgage loan and to identify specific properties for inspection and reevaluation. The Company establishes an investment valuation allowance for mortgage loans based on a review of individual loans and the overall loan portfolio, considering the value of the underlying collateral. Investment valuation allowances for real estate held for sale are established based on a review of specific assets. If a decline in value of a mortgage loan or real estate investment is considered to be other than temporary or if the asset is deemed permanently impaired, the investment is reduced to estimated net realizable value, and the reduction is recognized as a realized investment loss. Management monitors the risk associated with these invested asset portfolios and regularly reviews and adjusts the investment valuation allowance. At September 30, 2005, the balance in the valuation allowances for real estate was $7.6 million. No valuation allowance was held for mortgage loans at September 30, 2005.
Derivatives
The Company uses derivative financial instruments to manage duration, increase yield on cash flows expected from current holdings and future premium income, and manage currency risk. Historically, the Company has utilized interest rate futures contracts, current and forward interest rate swaps and options on forward interest rate swaps, current and forward currency swaps, interest rate forward contracts, forward treasury locks, currency forward contracts, and forward contracts on specific fixed income securities. All of these freestanding derivative transactions are hedging in nature and not speculative. Positions under the Company’s hedging programs for derivative activity that were open during the first nine months of 2005 involved current and forward interest rate swaps, current and forward currency swaps, forward treasury locks, currency forward contracts, and options on forward interest rate swaps.
Almost all hedging transactions are associated with the individual and group long-term care and the individual and group income protection product portfolios. All other product portfolios are periodically reviewed to determine if hedging strategies would be appropriate for risk management purposes.
During the third quarters of 2005 and 2004, the Company recognized net gains of $52.7 million and $5.0 million, respectively, on the termination of cash flow hedges and reported $52.7 million and $5.1 million, respectively, in other comprehensive income. During the third quarter of 2004, the Company reported $(0.1) million as a component of realized investment gains and losses. During the first nine months of 2005 and 2004, the Company recognized net gains of $85.9 million and $24.6 million, respectively, on the termination of cash flow hedges and
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reported $86.2 million and $24.7 million, respectively, in other comprehensive income and $(0.3) million and $(0.1) million, respectively, as a component of realized investment gains and losses. The Company amortized $5.9 million and $5.1 million of net deferred gains into net investment income during the third quarter of 2005 and 2004, respectively, and $15.9 million and $15.4 million during the first nine months of 2005 and 2004, respectively.
The Company’s current credit exposure on derivatives, which is limited to the value of those contracts in a net gain position, was $35.5 million at September 30, 2005. Additions and terminations, in notional amounts, to the Company’s hedging programs during the third quarter of 2005 were $224.5 million and $521.6 million, respectively, and terminations were $63.6 million in the third quarter of 2004. Additions and terminations include roll activity, which is the closing out of an old contract and initiation of a new one when a contract is about to mature but the need for it still exists. The notional amount of derivatives outstanding under the hedge programs was $4,332.1 million at September 30, 2005 and $4,795.9 million at December 31, 2004.
As of September 30, 2005 and December 31, 2004 the Company had $684.7 million and $707.3 million, respectively, notional amount of open current and forward foreign currency swaps to hedge fixed income Canadian dollar denominated securities the Company retained after the sale of the Canadian branch.
As of September 30, 2005 and December 31, 2004 the Company had $511.0 million notional amount of open options on forward interest rate swaps under the hedging program used to lock in a reinvestment rate floor for the reinvestment of cash flows from renewals on policies with a one to two year minimum premium rate guarantee.
The Company also has embedded derivatives in modified coinsurance contracts recognized under DIG Issue B36. The derivatives recognized under DIG Issue B36 are not designated as hedging instruments, and the change in fair value is reported as a realized investment gain or loss during the period of change. Due to the change in fair value of these embedded derivatives, the Company recognized $73.3 million and $8.7 million of net realized investment losses during the third quarter and first nine months of 2005, respectively, and $83.8 million and $49.4 million of net realized investment gains during the third quarter and first nine months of 2004, respectively.
Non-current Investments
The Company’s exposure to non-current investments totaled $60.4 million at September 30, 2005, or 0.2 percent of invested assets excluding ceded policy loans, compared to $91.5 million at December 31, 2004. Non-current investments are those investments for which principal and/or interest payments are more than thirty days past due. At September 30, 2005 these investments, which are subject to the same review and monitoring procedures in place for other investments in determining when a decline in fair value is other than temporary, consisted of fixed maturity securities for which before-tax impairment losses of approximately $106.8 million had been recorded life-to-date. The amortized cost of these investments was $41.5 million. Approximately $58.9 million of the fixed maturity securities, on a fair value basis, had principal and/or interest payments past due for a period greater than one year.
The Company has an investment program wherein it simultaneously enters into repurchase agreement transactions and reverse repurchase agreement transactions with the same party. The Company nets the related receivables and payables in the condensed consolidated statements of financial condition as these transactions meet the requirements for the right of offset. As of September 30, 2005, the Company had $559.3 million face value of these agreements in an open position that were offset. The Company also uses the repurchase agreement market as a source of short-term financing. The Company had no contracts for this purpose outstanding at September 30, 2005.
Liquidity and Capital Resources
The Company’s liquidity requirements are met primarily by cash flows provided from operations, principally in its insurance subsidiaries. Premium and investment income, as well as maturities and sales of invested assets, provide the primary sources of cash. Debt and/or securities offerings provide an additional source of liquidity. Cash is applied to the payment of policy benefits, costs of acquiring new business (principally commissions), operating expenses, and taxes, as well as purchases of new investments. The Company has established an investment strategy that management believes will provide for adequate cash flows from operations.
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The Company’s policy benefits are primarily in the form of claim payments, and the Company therefore has minimal exposure to the policy withdrawal risk associated with deposit products such as individual life policies or annuities. The Company’s cash flows from operations could be negatively impacted by a decrease in demand for the Company’s insurance products or an increase in the incidence of new claims or the duration of existing claims. Cash flow could also be negatively impacted by a deterioration in the credit market whereby the Company’s ability to liquidate its positions in certain of its fixed maturity securities would be impacted such that the Company might not be able to dispose of these investments in a timely manner. The Company believes its cash resources are sufficient to meet its liquidity requirements for the next twelve months.
Consolidated Cash Flows
Operating Cash Flows
Net cash provided by operating activities was $946.5 million for the nine months ended September 30, 2005, compared to $303.8 million for the comparable period of 2004. Included in the operating cash flows for the first nine months of 2004 is a cash disbursement of $707.4 million made in conjunction with the reinsurance of the Company’s individual income protection – closed block of business. Operating cash flows are primarily attributable to the receipt of premium and investment income, offset by payments of claims, commissions, expenses, and income taxes. Premium income growth is dependent not only on new sales, but on renewals of existing business, renewal price increases, and stable persistency. Investment income growth is dependent on the growth in the underlying assets supporting the Company’s insurance reserves and on the level of portfolio yield rates. Increases in commissions and operating expenses are attributable primarily to new sales growth and the first year acquisition expenses associated with new business. The level of paid claims is due partially to the growth and aging of the block of business and also to the general economy, as previously discussed in the operating results by segment.
The income tax adjustment to reconcile net income (loss) to net cash provided by operating activities increased $173.3 million in the first nine months of 2005 compared to the prior year first nine months primarily as a result of the income tax benefit related to the previously mentioned first quarter of 2004 restructuring charges associated with the individual income protection – closed block segment.
Investing Cash Flows
Investing cash inflows consist primarily of the proceeds from the sales and maturities of investments. Investing cash outflows consist primarily of payments for purchases of investments. Net cash used in investing activities was $706.0 million and $502.1 million for the nine months ended September 30, 2005 and 2004, respectively. The Company generated $577.7 million less in proceeds from maturities of available-for-sale securities in the first nine months of 2005 than in the comparable period of 2004, primarily due to a decrease in principal prepayments on mortgage-backed securities and bond calls. The Company utilized short-term investments during the nine months ended September 30, 2004 in anticipation of the cash to be transferred in conjunction with the reinsurance transaction related to the individual income protection – closed block restructuring.
During the third quarter of 2005, the Company had cash inflows of $8.8 million related to the sale of Unum Limited’s Netherlands branch and cash outflows of $3.5 million related to the GENEX acquisition of Independent Review Services, Inc.
During the first nine months of 2004, the Company had cash inflows of $18.8 million in conjunction with the sale of its Japanese operations. In conjunction with the second quarter 2004 disposition of the Canadian branch the Company transferred fixed maturity securities with a fair value and book value of approximately $1,099.4 million and $957.7 million, respectively, and cash of $31.7 million. While no cash was exchanged in the previously discussed first quarter of 2004 Swiss Life transaction, the Company assumed reserves of approximately $279.6 million and received fixed maturity securities of approximately $259.0 million and other miscellaneous assets of approximately $5.2 million, for a net purchase price of $15.4 million. During the second quarter of 2004, the Company had cash outflows of $0.7 million to acquire Integrated Benefits Management.
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Financing Cash Flows
Financing cash flows consist primarily of borrowings and repayments of debt, issuance or repurchase of common stock, and dividends paid to stockholders. Net cash used by financing activities was $305.5 million for the first nine months of 2005 compared to $209.0 million provided for the same period in 2004. During the first nine months of 2005, the Company repaid $227.0 million of maturing debt. During the first nine months of 2004, the Company received proceeds of $300.0 million from the May 2004 issuance of adjustable conversion-rate equity security units.
Cash Available from Subsidiaries
The Company is dependent upon payments from its subsidiaries to pay dividends to its stockholders, to pay its debt obligations, and to pay its expenses. These payments by the Company’s insurance and non-insurance subsidiaries may take the form of interest payments on amounts loaned to such subsidiaries by the Company, operating and investment management fees, and/or dividends.
Restrictions under applicable state insurance laws limit the amount of ordinary dividends that can be paid to the Company from its insurance subsidiaries in any 12-month period without prior approval by regulatory authorities. For life insurance companies domiciled in the United States, that limitation equals, depending on the state of domicile, either ten percent of an insurer’s statutory surplus with respect to policyholders as of the preceding year end or the statutory net gain from operations, excluding realized investment gains and losses, of the preceding year.
The payment of ordinary dividends to the Company from its insurance subsidiaries is further limited to the amount of statutory surplus as it relates to policyholders. Based on the restrictions under current law, during 2005, $663.3 million is available for the payment of ordinary dividends to the Company from its domestic insurance subsidiaries.
The Company also has the ability to draw a dividend from its United Kingdom-based affiliate, Unum Limited. Such dividends are limited in amount, based on insurance company law in the United Kingdom, which requires a minimum solvency margin. Approximately $152.5 million is available for the payment of dividends from Unum Limited during 2005.
The ability of the Company to continue to receive dividends from its insurance subsidiaries without regulatory approval will be dependent upon the level of earnings of its insurance subsidiaries as calculated under law. In addition to regulatory restrictions, the amount of dividends that will be paid by insurance subsidiaries will depend on additional factors, such as risk-based capital ratios, funding growth objectives at an affiliate level, and maintaining appropriate capital adequacy ratios to support the ratings desired by the Company. Insurance regulatory restrictions do not limit the amount of dividends available for distribution to the Company from its non-insurance subsidiaries except where the non-insurance subsidiaries are held directly or indirectly by an insurance subsidiary and only indirectly by the Company.
Debt
At September 30, 2005, the Company had long-term debt, including the adjustable conversion-rate equity security units and the junior subordinated debt securities, totaling $2,862.0 million. At September 30, 2005, the debt to total capital ratio was 32.5 percent compared to 35.2 percent at December 31, 2004. The debt to total capital ratio, when calculated allowing no equity credit for the Company’s junior subordinated debt securities and 50 percent equity credit for the Company’s adjustable conversion-rate equity security units, was 27.5 percent at September 30, 2005, compared to 30.2 percent at December 31, 2004.
During the fourth quarter of 2005, the Company intends to issue up to $400.0 million of senior debentures in a private offering as part of its repatriation plan, as previously discussed. In order to maintain its current debt to capital ratio, the Company intends to reduce its current outstanding debt by an amount equal to the debt issuance during the first quarter of 2006 by participating in the remarketing of its mandatory convertible securities in February 2006.
During the fourth quarter of 2004, the Company filed with the Securities and Exchange Commission a shelf registration to allow the Company to issue various types of securities, including common stock, preferred stock, debt securities, depository shares, stock purchase contracts, units and warrants, or preferred securities of wholly-owned
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finance trusts up to an aggregate of $1.0 billion. The shelf registration, which was declared effective February 7, 2005, will enable the Company to raise funds from the offering of any individual security covered by the shelf registration as well as any combination thereof, subject to market conditions and the Company’s capital needs.
See “Debt” in Item 7 of the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2004, for further discussion.
Commitments
With respect to the Company’s commitments, see the discussion in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2004. During the first nine months of 2005, there were no substantive changes to the Company’s commitments.
During the fourth quarter of 2005, the Company gave notification that it would terminate its arrangement, effective April 1, 2006, with an outside party wherein the Company is provided computer data processing services and related functions. As a result of terminating this arrangement, the Company will incur termination fees of approximately $9.2 million before tax and $6.0 million after tax and will record this charge in the fourth quarter of 2005. This change is expected to provide a significantly less costly infrastructure agreement with a new third party provider of mainframe, help desk, and other operational information technology services. Application development is not part of this new agreement, and the Company will retain all aspects of application development services.
Ratings
A.M. Best Company (AM Best), Fitch Ratings (Fitch), Moody’s Investors Service (Moody’s), and Standard & Poor’s Corporation (S&P) are among the third parties that provide the Company assessments of its overall financial position. Ratings from these agencies for financial strength are available for the individual U.S. domiciled insurance company subsidiaries. Financial strength ratings are based primarily on U.S. statutory financial information for the individual U.S. domiciled insurance companies. Debt ratings for the Company are based primarily on consolidated financial information prepared using generally accepted accounting principles. Both financial strength ratings and debt ratings incorporate qualitative analyses by rating agencies on an ongoing basis. The Company competes based in part on the financial strength ratings provided by rating agencies. A downgrade of the Company’s financial strength ratings can be expected to adversely affect the Company. A downgrade of the financial strength ratings could, among other things, adversely affect the Company’s relationships with distributors of its products and services and retention of its sales force, negatively impact persistency and new sales, particularly large case group sales and individual sales, and generally adversely affect the Company’s ability to compete. Downgrades in the Company’s debt ratings can be expected to adversely affect the Company’s ability to raise capital or its cost of capital.
In November 2004, AM Best reaffirmed the Company’s ratings and commented that it would be closely monitoring the Company’s operations as to the impact of the multistate market conduct regulatory settlement. In this regard it noted that California conducted a separate examination and that there could be fines or remediation costs in addition to the charge announced by the Company in connection with the multistate settlement. AM Best stated that the maintenance of the Company’s current ratings reflected the agency’s expectation that several key financial and operational measures would be maintained.
These measures are as follows:
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In June 2005 and again in October 2005, AM Best reaffirmed the existing financial strength rating of the Company and maintained a negative outlook. AM Best anticipates that the negative outlook will remain in effect until there is more clarity with regards to the ultimate cost of the multistate market conduct regulatory settlement agreements and the California settlement agreement and further improvement is exhibited in the financial flexibility of the parent company. The Company believes that its results for September 30, 2005 are generally in compliance with each of these measures.
In the first quarter of 2004, the ratings from Fitch were placed under review for a possible downgrade due to concerns expressed about the Company’s fourth quarter of 2003 reserve strengthening for group income protection and the profitability for this line of business. In May 2004 and again in November 2004, Fitch reaffirmed all of the Company’s ratings but kept the ratings under review pending Fitch’s completion of an analysis of the Company’s reserves. In February 2005, Fitch completed its analysis, citing the material progress the Company has made in strengthening risk based capital levels, resolving the multi-state market conduct examination, and improving GAAP and statutory earnings. Fitch reaffirmed all of the Company’s ratings and revised the outlook to stable. In October 2005, Fitch again reaffirmed all of the ratings of the Company following the announcement of the settlement agreement with the California DOI.
In May 2004, Moody’s downgraded the Company’s senior debt credit ratings to Ba1 from Baa3 and the financial strength ratings on the Company’s insurance company subsidiaries to Baa1 from A3. The ratings outlook is “negative”. This action concluded the ratings review Moody’s initiated in February 2004. Moody’s indicated that the primary driver in the rating action was concern about the execution risk associated with the Company’s strategic plans to restore profitability to its core U.S. group long-term income protection business. Moody’s also noted that the Company had made considerable progress in improving its capital position throughout 2003. The change in the senior debt rating to Ba1 represents a below-investment-grade rating. In November 2004, Moody’s placed the Company’s senior debt credit ratings and the financial strength ratings of the Company’s insurance company subsidiaries on review for possible downgrade due to the heightened event risk associated with the issues concerning broker compensation in the employee benefit market. In April 2005, Moody’s confirmed the Company’s senior debt credit ratings and the financial strength ratings of the Company’s insurance subsidiaries while maintaining a negative outlook. This rating action concluded the review for possible downgrade that began in November 2004. In October 2005, Moody’s again reaffirmed the ratings of the Company following the announcement of the settlement agreement with the California DOI.
Also in May 2004, S&P downgraded the Company’s counterparty credit rating and senior debt rating to BB+ from BBB- while at the same time lowering the counterparty credit and financial strength ratings on the Company’s insurance company subsidiaries to BBB+ from A-, all with a “stable” outlook, citing concerns about the consistency of risk controls and valuation practices, which S&P believes have led to reserve charges and asset impairments in the past several quarters and have also contributed to marginal operating performance in the Company’s U.S. group income protection business. The outlook reflects the effects of strengthened capital adequacy, improved investment risk, and corrective measures taken by the Company to limit the downside on the closed block of individual income protection business and to improve profitability on its U.S. group income protection insurance. The change in the senior debt rating to BB+ represents a below-investment-grade rating. In October 2005, S&P reaffirmed all of the ratings of the Company following the announcement of the settlement agreement with the California DOI.
The Company maintains an ongoing dialogue with these rating agencies to inform them of progress it is making regarding its strategic objectives and financial plans, as well as other issues which could impact the Company. There can be no assurance that further downgrades by these or other ratings agencies will not occur.
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The table below reflects, as of the date of this filing, the senior debt ratings for the Company and the financial strength ratings for the U.S. domiciled insurance company subsidiaries.
AM Best
Fitch
Moody’s
S&P
Senior Debt
U.S. Insurance Subsidiaries
Provident Life & Accident
Provident Life & Casualty
Unum Life of America
First Unum Life
Colonial Life & Accident
Paul Revere Life
Paul Revere Variable
These ratings are not directed toward the holders of the Company’s securities and are not recommendations to buy, sell, or hold such securities. Each rating is subject to revision or withdrawal at any time by the assigning rating organization, and each rating should be evaluated independently of any other rating.
See “Risk Factors – Debt and Financial Strength Ratings” in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2004, for further discussion.
Other Information
Pension and Postretirement Benefit Plans
The Company maintains separate U.S. and foreign pension plans and a U.S. post-retirement benefit plan. The U.S. pension plans comprise the majority of the total benefit obligation and pension expense for the Company. The value of the benefit obligations is determined based on a set of economic and demographic assumptions that represent the Company’s best estimate of future expected experience. These assumptions are reviewed annually. Two of the economic assumptions, the discount rate and the long-term rate of return, are adjusted accordingly based on key external indices. The assumptions chosen for U.S. pension plans and the U.S. postretirement plan use consistent methodology but reflect the differences in the plan obligations. The Company follows Statements of Financial Accounting Standards No. 87, Employer’s Accounting for Pensions (SFAS 87), No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions(SFAS 106), and No. 132, Employers’ Disclosures about Pensions and Other Postretirement Benefits (SFAS 132) in its financial reporting and accounting for its pension and post-retirement benefit plans. See the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2004, and Note 7 of the “Notes to Condensed Consolidated Financial Statements” contained herein in Item 1 for further information.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is subject to various market risk exposures including interest rate risk and foreign exchange rate risk. With respect to the Company’s exposure to market risk, see the discussion under “Investments” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained herein in Item 2 and in Part II, Item 7A of the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2004. During the first nine months of 2005, there was no substantive change to the Company’s market risk or the management of such risk.
ITEM 4. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
As of September 30, 2005, an evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2005.
Internal Control over Financial Reporting
There has been no change in the Company’s internal control over financial reporting, as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended, during the quarter ended September 30, 2005 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting. In the ordinary course of business, the Company routinely enhances its information technology systems through upgrades to current systems or the implementation of new systems. These changes did not materially affect the Company’s internal control over financial reporting nor are they expected to.
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PART II
ITEM 1. LEGAL PROCEEDINGS
Refer to Part I, Item 1, Note 11 of the “Notes to Condensed Consolidated Financial Statements” for information on legal proceedings.
ITEM 6. EXHIBITS
Index to Exhibits
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SIGNATURES
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.
(Registrant)
/s/ Thomas R. Watjen
/s/ Robert C. Greving
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