Item 1 and “Risk Factors - Debt and Financial Strength Ratings” in Part 1, Item 1A, contained herein for further discussion.
Other Information
Pension and Postretirement Benefit Plans
We sponsor several defined benefit pension and postretirement plans for our employees, including non-qualified pension plans. The U.S. pension plans comprise the majority of our total benefit obligation and pension expense. The value of the benefit obligations is determined based on a set of economic and demographic assumptions that represent our 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. We follow Statements of Financial Accounting Standards No. 87 (SFAS 87), Employers’ Accounting for Pensions, No. 106 (SFAS 106), Employers’ Accounting for Postretirement Benefits Other Than Pensions, No. 132 (SFAS 132), Employers’ Disclosures about Pensions and Other Postretirement Benefits, and No. 158 (SFAS 158), Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R) in our financial reporting and accounting for our pension and postretirement benefit plans.
U.S. Pension and PostRetirement Benefit Plans
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. We use a December 31 measurement date for each plan.
The discount rate is an interest assumption used to convert the benefit payment stream to a present value. We set the discount rate assumption at the measurement date for each of our retirement related benefit plans to reflect the yield of a portfolio of high quality fixed income debt instruments matched against the timing and amounts of projected future benefits. The discount rate used for the net periodic benefit costs for 2007 and 2006 for our U.S. pension plans was 6.10 percent and 5.80 percent, respectively. Using a similar methodology applied to the postretirement plan cash flows, the discount rate used in the net periodic benefit cost for 2007 and 2006 was 5.90 percent and 5.50 percent, respectively.
Lowering the discount rate by 50 basis points would have increased the 2006 pension expense for our U.S. pension plans by $10.7 million and would be expected to result in an $11.2 million increase in our 2007 pension expense.
The long-term rate of return assumption is the best estimate of the average annual assumed return that will be produced from the pension trust assets until current benefits are paid. We use a compound interest method in computing the rate of return on pension plan assets. The long-term rate of return on assets used in the net periodic pension costs for our U.S. qualified defined benefit pension plan for 2007 and 2006 was 8.00 percent. Lowering the expected long-term rate of return on the plan assets by 50 basis points would have increased our 2006 pension
expense by approximately $2.6 million. For 2007, lowering the assumption by 50 basis points would be expected to increase pension expense by approximately $3.5 million.
The market related value equals the fair value of assets, determined as of the measurement date. The assets are not smoothed for purposes of SFAS 87. The expected return on assets, therefore, fully recognizes all asset gains and losses through the measurement date.
Our U.S. pension plans have an unrecognized net actuarial loss and an unrecognized prior service credit which represent the cumulative liability and asset gains and losses and the portion of prior service credits that have not been recognized in pension expense. As of December 31, 2006, the unrecognized net loss for these two items combined was approximately $290.0 million compared to $352.5 million at December 31, 2005. The decrease is due to the decline in the net actuarial loss resulting from an increase in the year end discount rate from 5.80 percent at 2005 to 6.10 percent at 2006 as well as actual asset returns in excess of the 8.0 percent assumed rate of return. Prior to the adoption of SFAS 158, unrecognized actuarial gains or losses and prior service costs or credits were amortized as a component of pension expense but were not reported in companies’ balance sheets. SFAS 158 requires that actuarial gains or losses and prior service costs or credits that have not yet been included in net periodic benefit cost as of the adoption date of SFAS 158 be recognized as components of accumulated other comprehensive income, net of tax. The unrecognized gains or losses will be amortized out of accumulated other comprehensive income and included as a component of the net benefit cost, as they were prior to the adoption of SFAS 158. Our 2006, 2005, and 2004 pension expense includes $19.3 million, $16.4 million, and $13.2 million, respectively, of amortization of the unrecognized net actuarial loss and prior service credit.
We reported U.S. pension expense of $59.6 million, $54.8 million, and $43.6 million in 2006, 2005 and 2004, respectively.
The fair value of plan assets in our U.S. qualified defined benefit pension plan was $658.5 million at December 31, 2006, compared to $515.4 million at year end 2005. In recent years, the moderate increase in assets, coupled with the liability increase due to declining discount rates, has reduced the year end funding level in the plan such that it has a deficit of $151.6 million as of December 31, 2006, compared to $246.1 million as of December 31, 2005. We had no regulatory contribution requirements for 2006 and 2005; however, we elected to make voluntary contributions of $92.0 million and $23.0 million, respectively, to our U.S. qualified defined benefit pension plan. We expect to make a voluntary contribution of approximately $110.0 million in 2007, based on current tax law.
Non-U.S. Pension Plans
Our U.K. operation maintains a separate defined benefit plan for eligible employees. The U.K. defined benefit pension plan (Scheme) was closed to new entrants on December 31, 2002.
The long-term rate of return on asset assumption used in the net periodic pension costs for 2007 and 2006 was 6.8 percent and 6.7 percent, respectively. We elected to set the discount rate assumption at the measurement date for the Scheme to reflect the yield of a portfolio of high quality fixed income debt instruments matched against the timing and amounts of projected future benefits. The discount rate assumptions were 5.10 percent and 4.80 percent as of December 31, 2006 and 2005, respectively.
Pension expense was $7.8 million, $11.7 million, and $11.6 million in 2006, 2005, and 2004, respectively.
The fair value of plan assets in the Scheme was $168.9 million at December 31, 2006, compared to $92.1 million at year end 2005. The Scheme has a deficit of $9.6 million at December 31, 2006, compared to $45.2 million at December 31, 2005. We contribute to the Scheme in accordance with a schedule of contributions which requires that we contribute to the Scheme at the rate of at least 18.20 percent of eligible salaries, sufficient to meet the minimum funding requirement under U.K. legislation. During 2006, we made a voluntary contribution of $44.2 million to reduce the deficit and required contributions of $9.1 million. We anticipate that we will make contributions during 2007 of approximately $9.5 million.
We previously maintained separate defined benefit plans for the employees of our Canadian branch operation. As a result of the sale of the Canadian branch, we froze the Canadian defined benefit pension plans during 2004 and recorded a curtailment loss of $0.7 million. We are currently in the process of terminating the Canadian plans.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are subject to various market risk exposures, including interest rate risk and foreign exchange rate risk. The following discussion regarding our risk management activities includes forward-looking statements that involve risk and uncertainties. Estimates of future performance and economic conditions are reflected assuming certain changes in market rates and prices were to occur (sensitivity analysis). Caution should be used in evaluating our overall market risk from the information presented below, as actual results may differ. We employ various derivative programs to manage these material market risks. See Notes 4 and 5 of the “Notes to Consolidated Financial Statements” for further discussions of the qualitative aspects of market risk, including derivative financial instrument activity.
Interest Rate Risk
Our operations are subject to risk resulting from interest rate fluctuations, primarily long-term U.S. interest rates. Changes in interest rates and individuals’ behavior affect the amount and timing of asset and liability cash flows. We continually model and test asset and liability portfolios to improve interest rate risk management and net yields. Testing the asset and liability portfolios under various interest rate and economic scenarios allows us to choose the most appropriate investment strategy, as well as to prepare for disadvantageous outcomes. This analysis is the precursor to our activities in derivative financial instruments. We use interest rate swaps, interest rate forward contracts, exchange-traded interest rate futures contracts, and options to hedge interest rate risks and to match asset durations and cash flows with corresponding liabilities.
Assuming an immediate increase of 100 basis points in interest rates from year end levels, the net hypothetical decrease in stockholders’ equity related to financial and derivative instruments was estimated to be $1.4 billion and $1.5 billion at December 31, 2006 and 2005, respectively. The fair values of mortgage loans, which are reported in our consolidated balance sheets at amortized cost, would decrease by approximately $50 million and $90 million at December 31, 2006 and 2005, respectively.
At December 31, 2006 and 2005, assuming a 100 basis point decrease in long-term interest rates from year end levels, the fair values of our long-term debt would increase approximately $210 million and $240 million, respectively.
The effect of a change in interest rates on asset prices was determined using a duration implied methodology for corporate bonds, private placement securities, and government and government agency securities whereby the duration of each security was used to estimate the change in price for the security assuming an increase of 100 basis points in interest rates. The effect of a change in interest rates on the mortgage-backed securities is estimated using a mortgage analytic system which takes into account the impact of changing prepayment speeds resulting from a 100 basis point increase in interest rates on the change in price of the mortgage-backed securities. These hypothetical prices were compared to the actual prices for the period to compute the overall change in market value. The changes in the fair values of long-term debt were determined using discounted cash flows analyses. Because we actively manage our investments and liabilities, actual changes could be less than those estimated above.
Foreign Currency Risk
We are also subject to foreign exchange risk arising from our foreign operations and certain investment securities denominated in those local currencies. Foreign operations represented 7.4 percent and 6.4 percent of total assets at December 31, 2006 and 2005, respectively, and 9.7 percent and 9.2 percent of total revenue from continuing operations for 2006 and 2005, respectively. Assuming foreign exchange rates decreased 10 percent from the December 31, 2006 and 2005 levels, stockholders’ equity and net income as of and for the periods then ended would not have been materially affected.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
The Company’s management is responsible for designing, implementing, and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting encompasses the processes and procedures management has established to (i) maintain records that, in reasonable detail, accurately and fairly reflect the Company’s transactions and dispositions of assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles; (iii) provide reasonable assurance that receipts and expenditures are appropriately authorized; and (iv) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.
Management recognizes that there are inherent limitations in the effectiveness of internal control over financial reporting, including the potential for human error or the circumvention or overriding of internal controls. Accordingly, even effective internal control over financial reporting cannot provide absolute assurance with respect to financial statement preparation. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. In addition, any projection of the evaluation of effectiveness to future periods is subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and concluded that, as of December 31, 2006, the Company maintained effective internal control over financial reporting.
The effectiveness of the Company’s internal control over financial reporting and management’s assessment of that effectiveness, as of December 31, 2006, have been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which follows.
REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM,
ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Board of Directors and Stockholders
Unum Group and Subsidiaries
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that Unum Group and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Unum Group and subsidiaries’ management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Unum Group and subsidiaries maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Unum Group and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Unum Group and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006, and our report dated February 26, 2007 expressed an unqualified opinion thereon.
REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Stockholders
Unum Group and Subsidiaries
We have audited the accompanying consolidated balance sheets of Unum Group and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedules listed in the index at Item 15(a). These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Unum Group and subsidiaries at December 31, 2006 and 2005, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, Unum Group changed its method of accounting for defined benefit pension and other postretirement plans as of December 31, 2006 in accordance with Statement of Financial Accounting Standards No. 158 (SFAS 158), Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R).
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Unum Group and subsidiaries’ internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated February 26, 2007 expressed an unqualified opinion thereon.
CONSOLIDATED BALANCE SHEETS
Unum Group and Subsidiaries
See notes to consolidated financial statements.
CONSOLIDATED BALANCE SHEETS - Continued
Unum Group and Subsidiaries
See notes to consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
Unum Group and Subsidiaries
See notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
See notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
See notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 1 - Significant Accounting Policies
Basis of Presentation: The accompanying consolidated financial statements of Unum Group and its subsidiaries (the Company) have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). Such accounting principles differ from statutory accounting principles (see Note 16). Material intercompany transactions have been eliminated.
In January 2007, we entered into a definitive agreement for the sale of our wholly-owned subsidiary, GENEX Services, Inc. (GENEX). During 2004, we completed the sale of our Canadian branch. The financial results of GENEX and the Canadian branch are reported as discontinued operations in the consolidated financial statements for each year presented, as applicable. Except where noted, the information presented in the notes to the consolidated financial statements excludes our discontinued operations. See Note 2 for further discussion.
Description of Business: We are the largest provider of group and individual income protection products in the United States and the United Kingdom. We also provide a complementary portfolio of other insurance products, including long-term care insurance, life insurance, employer- and employee-paid group benefits, and other related services. We market our products primarily to employers interested in providing benefits to their employees.
We have three major business segments: Unum US, Unum UK, and Colonial. Our other segments are the Individual Income Protection - Closed Block segment, the Other segment, and the Corporate segment. Unum US and Unum UK were previously referred to as U.S. Brokerage and Unum Limited. The names were changed in conjunction with our corporate branding initiative. See Note 14 for further discussion of our operating segments.
Use of Estimates: The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in the financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein.
Many factors influence the assumptions upon which reserves for policy and contract benefits are based, including historical trends in our experience and expected deviations from historical experience. Considerable judgment is required to interpret actual historical experience and to assess the future factors that are likely to influence the ultimate cost of settling existing claims. Given that insurance products contain inherent risks and uncertainties, the ultimate liability may be more or less than such estimates indicate.
Investments: Investments are reported in our consolidated balance sheets as follows:
Available-for-Sale Fixed Maturity Securities are reported at fair value.
Mortgage Loans are generally carried at amortized cost less an allowance for probable losses.
Real Estate classified as 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. If investment real estate is determined to be other than temporarily 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 our investment criteria. Real estate held for sale is valued net of a valuation allowance that reduces the carrying value to the lower of cost less accumulated depreciation or fair value less estimated cost to sell. Accumulated depreciation on real estate was $9.5 million and $9.3 million as of December 31, 2006 and 2005, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 1 - Significant Accounting Policies
Policy Loans are presented at unpaid balances directly related to policyholders. Included in policy loans are $3,238.1 million and $3,005.4 million of policy loans ceded to reinsurers at December 31, 2006 and 2005, respectively.
Other Long-term Investments, primarily private equity fund limited partnerships, are generally carried at cost plus our share of changes in the investee’s ownership equity since acquisition.
Short-term Investments are carried at cost.
Fixed maturity securities include bonds and redeemable preferred stocks. Fixed maturity securities not bought and held for the purpose of selling in the near term but for which we do not have the positive intent and ability to hold to maturity are classified as available-for-sale.
Changes in the fair value of available-for-sale fixed maturity securities are reported as a component of other comprehensive income. These amounts are net of income tax and valuation adjustments to reserves for future policy and contract benefits which would have been recorded had the related unrealized gain or loss on these securities been realized.
Realized investment gains and losses, which are reported as a component of revenue in the consolidated statements of operations, are based upon specific identification of the investments sold and do not include amounts allocable to separate accounts. At the time a decline in the value of an investment is determined to be other than temporary, a loss is recorded which is included in realized investment gains and losses.
We discontinue the accrual of investment income on invested assets when collection is uncertain. We recognize investment income on impaired investments when the income is received.
Derivative Financial Instruments: We recognize all of our derivative instruments (including certain derivative instruments embedded in other contracts) as either assets or liabilities in our consolidated balance sheets and measure those instruments at fair value.
The accounting for changes in the fair value (i.e., gain or loss) of a derivative depends on whether it has been designated and qualifies as part of a hedging relationship, and further, on the type of hedging relationship. To qualify as a hedging instrument, a derivative must pass prescribed effectiveness tests, performed quarterly using both qualitative and quantitative methods. For those derivatives that are designated and qualify as hedging instruments, the derivative is designated, based upon the exposure being hedged, as one of the following:
Fair value hedge. Changes in the fair value of the derivative as well as the offsetting change in fair value on the hedged item attributable to the risk being hedged are recognized in current earnings during the period of change in fair value. The gain or loss on the termination of an effective fair value hedge is recognized in current earnings.
Cash flow hedge. To the extent it is effective, changes in the fair value of the derivative are reported in other comprehensive income and reclassified into earnings in the same period or periods during which the hedged item affects earnings. The ineffective portion of the hedge, if any, is recognized in current earnings during the period of change in fair value. The gain or loss on the termination of an effective cash flow hedge is reported in other comprehensive income and reclassified into earnings in the same period or periods during which the hedged item affects earnings.
Foreign currency exposure hedge. To the extent it is effective, changes in the fair value of the derivative are reported in other comprehensive income as part of the foreign currency translation adjustment and
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 1 - Significant Accounting Policies - Continued
reclassified into earnings in the same period or periods during which remeasurement of the hedged foreign currency asset affects earnings. The ineffective portion of the hedge, if any, is recognized in current earnings during the period of change in fair value. The gain or loss on the termination of an effective foreign currency exposure hedge is reported in other comprehensive income as part of the foreign currency translation adjustment and reclassified into earnings in the same period or periods during which remeasurement of the hedged foreign currency asset affects earnings.
Gains or losses on the termination of ineffective hedges are reported in current earnings. In the event a hedged item is disposed of or the anticipated transaction being hedged is no longer likely to occur, we will terminate the related derivative and recognize the gain or loss on termination in current earnings.
For a derivative not designated as a hedging instrument, the change in fair value is recognized in earnings during the period of change.
Reinsurance Recoverable: We routinely cede reinsurance to other insurance companies. For ceded reinsurance agreements wherein we are not relieved of our legal liability to our policyholders, we report assets and liabilities on a gross basis. Our reinsurance recoverable includes the balances due from reinsurers under the terms of these reinsurance agreements for ceded policy and contract benefits, ceded future policy and contract benefits, and ceded unearned premiums, less ceded policy loans.
Deferred Policy Acquisition Costs: Certain costs of acquiring new business that vary with and are primarily related to the production of new business have been deferred. Such costs include commissions, other agency compensation, certain selection and policy issue expenses, and certain 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. Deferred policy acquisition costs are subject to recoverability testing at the time of policy issue and loss recognition testing subsequent to the year of issue.
Deferred policy acquisition costs related to traditional policies are amortized over the premium paying period of the related policies in proportion to the ratio of the present value of annual expected premium income to the present value of total expected premium income. Such amortization is adjusted annually to reflect the actual policy persistency as compared to the anticipated experience.
Deferred policy acquisition costs related to interest-sensitive policies are amortized over the lives of the policies in relation to the present value of estimated gross profits from surrender charges and mortality, investment, and expense margins. Adjustments are made each year to reflect actual experience for assumptions which deviate significantly compared to anticipated experience.
Loss recognition is generally performed on an annual basis. Insurance contracts are grouped on a basis consistent with our manner of acquiring, servicing, and measuring profitability of the contracts. If loss recognition testing indicates that deferred policy acquisition costs are not recoverable, the deficiency is charged to expense. The assumptions used in loss recognition testing represent management’s best estimates of future experience.
Value of Business Acquired: Value of business acquired represents the present value of future profits recorded in connection with the acquisition of a block of insurance policies. The asset is amortized based upon expected future premium income for traditional insurance policies and estimated future gross profits for interest-sensitive insurance policies, with the accrual of interest added to the unamortized balance at interest rates principally ranging from 5.05 percent to 6.00 percent. The accumulated amortization for value of business acquired was $101.9 million and $83.8 million as of December 31, 2006 and 2005, respectively. We periodically review the carrying amount of value of business acquired using the same methods used to evaluate deferred policy acquisition costs.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 1 - Significant Accounting Policies - Continued
Goodwill: Goodwill is the excess of the amount paid to acquire a business over the fair value of the net assets acquired. The carrying amount of goodwill is reviewed for impairment annually or whenever events or changes in circumstances indicate that the carrying amount might not be recoverable. If the fair value of the operations to which the goodwill relates is less than the carrying amount of the unamortized goodwill, the carrying amount is reduced with a corresponding charge to expense.
Property and Equipment: Property and equipment is reported at cost less accumulated depreciation, which is calculated on the straight-line method over the estimated useful life. The accumulated depreciation for property and equipment was $496.4 million and $443.0 million as of December 31, 2006 and 2005, respectively.
Revenue Recognition: Traditional life and accident and health products are long duration contracts, and premium income is recognized as revenue when due from policyholders. If the contracts are experience rated, the estimated ultimate premium is recognized as revenue over the period of the contract. The estimated ultimate premium, which is revised to reflect current experience, is based on estimated claim costs, expenses, and profit margins.
For interest-sensitive products, the amounts collected from policyholders are considered deposits, and only the deductions during the period for cost of insurance, policy administration, and surrenders are included in revenue. Policyholders’ funds represent funds deposited by contract holders and are not included in revenue.
Policy and Contract Benefits: Policy and contract accrued benefits, principally related to accident and health insurance policies, are based on reported losses and estimates of incurred but not reported losses for traditional life and accident and health products. For interest-sensitive products, benefits are the amounts paid and expected to be paid on insured claims in excess of the policyholders’ policy fund balances.
Policy and Contract Benefits Liabilities: Active life reserves for future policy and contract benefits on traditional life and accident and health products have been provided on the net level premium method. The reserves are calculated based upon assumptions as to interest, withdrawal, morbidity, and mortality that were appropriate at the date of issue. Interest assumptions for active life reserves may be graded downward over a period of years. Withdrawal assumptions are based on our actual experience. Morbidity and mortality assumptions are based upon industry standards adjusted as appropriate to reflect our actual experience. The assumptions vary by plan, year of issue, and policy duration and include a provision for adverse deviation.
Disabled lives reserves for future policy and contract benefits on disability policies are calculated based upon assumptions as to interest and claim resolution rates that are currently appropriate. Claim resolution rate assumptions are based on our actual experience. The interest rate assumptions used for discounting claim reserves are based on projected portfolio yield rates, after consideration for defaults and investment expenses, for the assets supporting the liabilities for the various product lines. The assets for each product line are selected according to the specific investment strategy for that product line to produce asset cash flows that follow timing and amount patterns similar to those of the anticipated liability payments.
Reserves for future policy and contract benefits on group single premium annuities have been provided on a net single premium method. The reserves are calculated based on assumptions as to interest, mortality, and retirement that were appropriate at the date of issue. Mortality assumptions are based upon industry standards adjusted as appropriate to reflect our actual experience. The assumptions vary by year of issue.
Reserves for future policy and contract benefits on interest-sensitive products are principally policyholder account values.
Policyholders’ Funds: Policyholders’ funds represent customer deposits plus interest credited at contract rates. We control interest rate risk by investing in quality assets which have an aggregate duration that closely matches the expected duration of the liabilities.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 1 - Significant Accounting Policies - Continued
Income Tax: Deferred taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial statement purposes and the amounts used for income tax purposes. Deferred taxes have been measured using enacted statutory income tax rates and laws that are currently in effect. A valuation allowance is established for deferred tax assets when it is more likely than not that an amount will not be realized.
Deferred Gain or Loss on Reinsurance: Where applicable, gains or losses on reinsurance transactions are deferred and amortized into earnings based upon expected future premium income for traditional insurance policies and estimated future gross profits for interest-sensitive insurance policies. The deferred gain on reinsurance included in other liabilities in our consolidated balance sheets at December 31, 2006 and 2005 was $181.3 million and $204.2 million, respectively.
Premium Tax Expense: Premium tax expense is included in other operating expenses in the consolidated statements of operations. For the years ended December 31, 2006, 2005, and 2004, premium tax expense was $140.5 million, $137.4 million, and $129.0 million, respectively.
Separate Accounts: The separate account amounts shown in our consolidated balance sheets represent contributions by contract holders to variable-benefits and fixed-benefits pension plans. The contract purchase payments and the assets of the separate accounts are segregated from other funds for both investment and administrative purposes. Contract purchase payments received under variable annuity contracts are subject to deductions for sales and administrative fees. Also, the sponsoring companies of the separate accounts receive management fees based on the net asset values of the separate accounts.
Translation of Foreign Currency: Revenues and expenses of our continuing and discontinued foreign operations are translated at average exchange rates. Assets and liabilities are translated at the rate of exchange on the balance sheet date. The translation gain or loss is generally reported in accumulated other comprehensive income, net of deferred tax.
Accounting for Participating Individual Life Insurance: Participating policies issued by one of our subsidiaries prior to its 1986 conversion from a mutual to a stock life insurance company will remain participating as long as the policies remain in force. A Participation Fund Account (PFA) was established for the benefit of all such individual participating life and annuity policies and contracts. The assets of the PFA provide for the benefit, dividend, and certain expense obligations of the participating individual life insurance policies and annuity contracts. The PFA was $349.8 million and $353.1 million at December 31, 2006 and 2005, respectively, and represented approximately 0.7 percent of consolidated assets and 0.7 percent of consolidated liabilities at December 31, 2006 and 2005.
Reclassifications: Financial results previously reported have been revised for the classification of GENEX as a discontinued operation, as discussed in Note 2.
Accounting Pronouncements Adopted:
Effective January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004) (SFAS 123(R)), Share-Based Payment, which is a revision to Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation. SFAS 123(R) focuses primarily on accounting for transactions in which an entity obtains employee service in exchange for share-based payments. Under SFAS 123(R), share-based awards that do not require future service (i.e., vesting awards) are expensed immediately. Share-based employee awards that require future service are amortized over the relevant service period. We adopted SFAS 123(R) using the modified prospective transition method. In accordance with the modified prospective transition method, the provisions are generally applied only to share-based awards granted subsequent to adoption. The adoption of SFAS 123(R) did not have a material effect on our financial position or results of operations.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 1 - Significant Accounting Policies - Continued
Had we 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:
Effective January 1, 2006, we adopted the provisions of Financial Accounting Standards Board (FASB) Staff Position No. FAS 115-1 (FSP 115-1), The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, which addresses the determination of when an investment is considered impaired, whether the impairment is other than temporary, and the measurement of an impairment loss. FSP 115-1 also includes accounting considerations subsequent to the recognition of other-than-temporary impairment and requires certain disclosures about unrealized losses. The adoption of FSP 115-1 did not have a material effect on our financial position or results of operations.
Effective December 31, 2006, we adopted the provisions of Statement of Financial Accounting Standards No. 158 (SFAS 158), Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R). SFAS 158 requires an employer to recognize the overfunded or underfunded status of a defined benefit pension and other postretirement plans as an asset or liability in its balance sheet and to recognize changes in that funded status through comprehensive income. Also, under SFAS 158, defined benefit pension and other postretirement plan assets and obligations are to be measured as of the date of the employer’s fiscal year-end. The adoption of SFAS 158 resulted in the following adjustments to our balance sheet: a decrease in other assets of $55.0 million, a decrease in deferred income tax of $40.3 million, an increase in other liabilities of $69.4 million, and a decrease in accumulated other comprehensive income of $84.1 million. The adoption of SFAS 158 had no effect on our results of operations.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 1 - Significant Accounting Policies - Continued
Accounting Pronouncements Outstanding:
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 in September 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, 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. We will adopt the provisions of SOP 05-1 effective January 1, 2007. The cumulative effect of applying the provisions of SOP 05-1 will be reported in our first quarter of 2007 financial statements as an adjustment to the opening balance of retained earnings for 2007. We estimate that the cumulative effect adjustment will decrease retained earnings approximately $400.0 million to $450.0 million.
Statement of Financial Accounting Standards No. 155 (SFAS 155), Accounting for Certain Hybrid Financial Instruments, an amendment of Statement of Financial Accounting Standards Nos. 133 (SFAS 133) and 140 (SFAS 140), was issued in February 2006. SFAS 155: (a) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; (b) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133; (c) establishes a requirement to evaluate beneficial interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; (d) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and, (e) eliminates restrictions on a qualifying special-purpose entity’s ability to hold passive derivative financial instruments that pertain to beneficial interests that are or contain a derivative financial instrument. We will adopt the provisions of SFAS 155 effective January 1, 2007. The adoption of SFAS 155 will not have a material effect on our financial position or results of operations.
FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, an interpretation of Statement of Financial Accounting Standard No. 109 (SFAS 109), was issued in June 2006. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS 109. Unlike SFAS 109, FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Additionally, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. We will adopt the provisions of FIN 48 effective January 1, 2007. The cumulative effect of applying the provisions of FIN 48 will be reported in our first quarter of 2007 financial statements as an adjustment to the opening balance of retained earnings for 2007. We estimate that the cumulative effect adjustment will increase retained earnings by up to $25.0 million.
Statement of Financial Accounting Standards No. 157 (SFAS 157), Fair Value Measurements, was issued in September 2006. SFAS 157 defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. We will adopt the provisions of SFAS 157 effective January 1, 2008. The adoption of SFAS 157 will not have a material effect on our financial position or results of operations.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 2 - Discontinued Operations
As discussed in Note 1, in January 2007, we entered into a definitive agreement for the sale of GENEX and expect to close the transaction during the first quarter of 2007, subject to customary closing conditions. The expected gain on the transaction is not material. We have agreed with the buyer, in an arms-length transaction, to continue to purchase certain disability management services for a period of up to five years from the effective date of the sale. Intercompany amounts paid to GENEX for these types of services for the years ended December 31, 2006, 2005, and 2004 were approximately $15.4 million, $15.7 million, and $18.8 million, respectively. The estimated future purchase of these services from the buyer is not material.
GENEX is accounted for as an asset held for sale at December 31, 2006 and is reported as discontinued operations in the accompanying consolidated financial statements. The results of GENEX, which were previously included in the Other segment, are now reported as discontinued operations and excluded from segment results for all periods.
Selected results for GENEX are as follows:
Assets and liabilities for discontinued operations as reported in the accompanying consolidated balance sheets are comprised of the following:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 2 - Discontinued Operations - Continued
During 2003, we entered into an agreement to sell our Canadian branch. In the first quarter of 2004, we recognized a 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. The transaction closed April 30, 2004, and in the second quarter of 2004, we recognized a loss of $113.0 million before tax and $70.9 million after tax on the sale of the branch.
Selected results for the Canadian branch for the period January 1, 2004 through April 30, 2004 are as follows (in millions of dollars, except share data):
Note 3 - Fair Values of Financial Instruments
We use the following methods and assumptions in estimating the fair values of our financial instruments:
Fixed Maturity Securities: Fair values are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services. For private placements, fair values are estimated using internally prepared valuations combining matrix pricing with vendor purchased software programs, including valuations based on estimates of future profitability. Additionally, we obtain prices from independent third-party brokers to establish valuations for certain of these securities. See Note 4 for the amortized cost and fair values of securities by security type and by maturity date.
Derivatives: Fair values are based on market quotes or pricing models and represent the net amount of cash we would have received or paid if the contracts had been settled or closed as of the last day of the year.
DIG Issue B36 Embedded Derivatives: Fair values are estimated using internal pricing models and represent the hypothetical value of the duration mismatch of assets and liabilities, interest rate risk, and third party credit risk embedded in certain reinsurance agreements we have entered.
Mortgage Loans: Fair values are estimated using discounted cash flow analyses and interest rates currently being offered for similar mortgage loans to borrowers with similar credit ratings and maturities. Mortgage loans with similar characteristics are aggregated for purposes of the calculations.
Policy Loans and Other Long-term Investments: Carrying amounts approximate fair value.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 3 - Fair Values of Financial Instruments - Continued
Policyholders’ Funds: Carrying amounts for deferred annuity products and other policyholders’ funds, which include guaranteed investment contracts (GICs) and supplementary contracts without life contingencies, approximate fair value.
Fair values for insurance contracts other than investment contracts are not required to be disclosed. However, the fair values of liabilities under all insurance contracts are taken into consideration in our overall management of interest rate risk, which minimizes exposure to changing interest rates through the matching of investment maturities with amounts due under insurance contracts.
Long-term Debt: Fair values are obtained from independent pricing services or discounted cash flow analyses based on current incremental borrowing rates for similar types of borrowing arrangements.
The carrying values of financial instruments such as short-term investments, cash and bank deposits, accounts and premiums receivable, accrued investment income, and accounts payable approximate the fair values due to the short-term nature of the instruments. As such, these financial instruments are not included in the following chart.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 4 - Investments
Fixed Maturity Securities
The amortized cost and fair values of securities by security type are shown as follows.
Of the $653.3 million in gross unrealized losses on fixed maturity securities and the derivatives that hedge these securities at December 31, 2006, $592.7 million, or 90.7 percent, are related to investment-grade fixed maturity securities. 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.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 4 - Investments - Continued
The gross unrealized loss on below-investment-grade fixed maturity securities was $60.6 million at December 31, 2006, or 9.3 percent, of the total gross unrealized loss on fixed maturity securities. Generally, below-investment-grade fixed maturity securities are more likely to develop credit concerns.
The following charts indicate the length of time our fixed maturity securities had been in a gross unrealized loss position as of December 31, 2006 and 2005.
As of December 31, 2006, we held 466 individual investment-grade fixed maturity securities and 51 individual below-investment-grade fixed maturity securities that were in an unrealized loss position, of which 181 investment-grade fixed maturity securities and 27 below-investment-grade fixed maturity securities had been in an unrealized loss position continuously for over one year.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 4 - Investments - Continued
As of December 31, 2006, we held three securities with a gross unrealized loss of $10.0 million or greater, as follows:
For those securities with a gross unrealized loss of $10.0 million or greater, further discussed as follows are (a) the factors which we believe resulted in the impairment and (b) the information we considered, both positive and negative, in reaching the conclusion that the impairments were not other than temporary.
•
The first fixed maturity bond of the U.S. government sponsored mortgage funding company was issued by the Federal Home Loan Bank. The bond was rated AAA by Standard & Poor’s Corporation (S&P) as of December 31, 2006, 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 after the purchase of the bond. We believe that the decline in fair value of this security is temporary. The market value of this security will increase if interest rates decline to levels similar to when the bonds were purchased. We believe this is likely to occur over the life of the security. We have the ability to hold this security to the earlier of recovery or maturity.
•
The second 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 S&P as of December 31, 2006, 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 after the purchase of the bond. We believe that the decline in fair value of this security is temporary. The market value of this security will increase if interest rates decline to levels similar to when the bonds were purchased. We believe this is likely to occur over the life of the security. We have the ability to hold this security to the earlier of recovery or maturity.
•
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 carried the AA rating of the issuer, as determined by S&P as of December 31, 2006. 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 if there is 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
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 4 - Investments - Continued
result of the decline in the S&P 500 index after the purchase date of the note. Based on historical long-term returns of the S&P 500 index, we believe 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. We believe that the decline in fair value of the note is temporary. We have the ability to hold this security to the earlier of recovery or maturity.
In determining when a decline in fair value below amortized cost of a fixed maturity security is other than temporary, we evaluate the following factors:
•
The probability of recovering principal and interest.
•
Our ability and intent to retain the security for a sufficient period of time for it to recover.
•
Whether the security is current as to principal and interest payments.
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The significance of the decline in value.
•
The time period during which there has been a significant decline in value.
•
Current and future business prospects and trends of earnings.
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The valuation of the security’s underlying collateral.
•
Relevant industry conditions and trends relative to their historical cycles.
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Market conditions.
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Rating agency actions.
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Bid and offering prices and the level of trading activity.
•
Adverse changes in estimated cash flows for securitized investments.
•
Any other key measures for the related security.
If we determine 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. For those fixed maturity securities with an unrealized loss and on which we have not recorded an impairment write-down, we believe that the decline in fair value below amortized cost is temporary.
The amortized cost and fair values of fixed maturity securities by maturity date are shown as follows. The maturity dates have not been adjusted for possible calls or prepayments.
At December 31, 2006, the total investment in below-investment-grade fixed maturity securities was $2,134.0 million or 5.8 percent of the fair value of invested assets excluding ceded policy loans. The amortized cost of these securities was $2,111.7 million.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 4 - Investments - Continued
We have four special purpose entities which support our investment objectives and which are consolidated under the provisions of Interpretation No. 46 (FIN 46(R)), Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51. These entities are securitized asset trusts and contain specific financial instruments that do not include our common stock or debt. Three of these entities are trusts holding forward contracts to purchase unrelated equity securities. Each of these trusts also holds a defeasance swap contract for highly rated bonds to provide principal protection for the investments. The fair values of the underlying forward and swap contracts equaled $177.3 million as of December 31, 2006, and are reported as fixed maturity securities in the consolidated balance sheets. The fourth entity is a trust containing a highly rated bond for principal protection, unrelated equity securities, and several partnership equity investments. We contributed the bond and partnership investments into the trust at the time it was established. The purpose of this trust was to allow us to maintain our investment in the partnerships while at the same time protecting the principal of the investment. The fair values of the bond, equity securities, and partnerships were $81.0 million, $11.5 million, and $40.3 million, respectively, as of December 31, 2006.
We have a significant investment in, but are not the primary beneficiary of, a special purpose entity which is a collateralized bond obligation asset trust (CBO) in which we hold interests in several of the tranches and for which we act as investment manager of the underlying securities. This special purpose entity does not meet the consolidation requirements of FIN 46(R). We issued the CBO in 1998, and its purpose is to securitize high yield bonds and earn a spread over the cost of the funds from the different tranches issued. The outstanding balance of all tranches at December 31, 2006 was $143.7 million, $91.8 million of which is held by third parties. These third parties have no recourse against us. The total value of the CBO assets was $82.2 million at December 31, 2006. Our maximum exposure to loss for the fixed maturity securities is $18.8 million at December 31, 2006.
At December 31, 2006, we had capital commitments of approximately $13.2 million to fund certain of our private placement fixed maturity securities. The funds are due upon satisfaction of contractual notice from the issuer. These amounts may or may not be funded during the term of the security.
In the normal course of business, we receive collateral from unaffiliated third parties through transactions which include both securities lending and also short-term agreements to purchase securities with the agreement to resell them at a later, specified date. For both types of transactions, we require that a minimum of 102 percent of the fair value of the securities loaned or securities purchased under repurchase agreements be maintained as collateral. Generally, cash is received as collateral under these agreements. In the event that securities are received as collateral, we are not permitted to sell or repledge them. We also pledge our fixed maturity securities as collateral to unaffiliated third parties through transactions including both securities lending and also short-term agreements to sell securities with the agreements to repurchase them at a later, specified date. At December 31, 2006, the carrying value of fixed maturity securities pledged as collateral to third parties was $1,005.7 million.
Mortgage Loans
At December 31, 2006, mortgage loans were collateralized by office buildings (39.6 percent), industrial buildings (29.8 percent), retail stores (16.4 percent), and other properties (14.2 percent). Our mortgage loan portfolio is geographically dispersed within the United States, with the largest concentrations in Pennsylvania (16.3 percent) and California (12.2 percent).
Mortgage loans are impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. At December 31, 2006, impaired mortgage loans totaled $2.8 million. We had no impaired mortgage loans at December 31, 2005.
At December 31, 2006, we had capital commitments of approximately $66.6 million for commercial mortgage loan originations. The funds will be due at closing of the mortgage loans.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 4 - Investments - Continued
Investment Valuation Allowances
At December 31, 2006 and 2005 we had real estate investment allowances totaling $7.6 million. Deductions for allowances released upon disposal or restructuring totaled $1.7 million in 2005. There were no other deductions and no additions in 2006, 2005, and 2004.
At December 31, 2006, the balance in the valuation allowance for mortgage loans was $0.5 million. We had no valuation allowance for mortgage loans at December 31, 2005. Additions to allowances for mortgage loans totaled $0.5 million in 2006. There were no deductions and no other additions in 2006, 2005, and 2004.
There were no other investment valuation allowances at December 31, 2006 and 2005.
Net Investment Income
Sources for net investment income are as follows:
Realized Investment Gain and Loss
Realized investment gains (losses) are as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 4 - Investments - Continued
Other Comprehensive Income
The components of the change in the net unrealized gain on securities and the change in the net gain on cash flow hedges included in other comprehensive income (loss) are as follows:
Note 5 - Derivative Financial Instruments
We use swaps, forwards, futures, and options to hedge interest rate and currency risks and to match assets with our insurance liabilities.
Derivative Risks
The basic types of risks associated with derivatives are market risk (that the value of the derivative will be adversely impacted by changes in the market, primarily the change in interest and exchange rates) and credit risk (that the counterparty will not perform according to the terms of the contract). The market risk of the derivatives should generally offset the market risk associated with the hedged financial instrument or liability.
To help limit the credit exposure of the derivatives, we enter into master netting agreements with our counterparties whereby contracts in a gain position can be offset against contracts in a loss position. We also typically enter into bilateral, cross-collateralization agreements with our counterparties to help limit the credit exposure of the derivatives. These agreements require the counterparty in a loss position to submit acceptable collateral with the other counterparty in the event the net loss position meets or exceeds an agreed upon amount. Our current credit exposure on derivatives, which is limited to the value of those contracts in a net gain position, was $19.9 million at December 31, 2006. The carrying value of fixed maturity securities pledged as collateral to our counterparties was $180.2 million at December 31, 2006.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 5 - Derivative Financial Instruments - Continued
Hedging Activity
The table below summarizes by notional amounts the activity for each category of derivatives.
The following table summarizes the timing of anticipated settlements of interest rate swaps outstanding at December 31, 2006, whereby we receive a fixed rate and pay a variable rate. The weighted average interest rates assume current market conditions.
Our freestanding derivatives all qualify as hedges and have been designated as cash flow hedges. Our significant cash flow hedging programs are described as follows.
We have executed a series of cash flow hedges for certain of our long-term product portfolios using forward starting interest rate swaps and forward contracts. The purpose of these hedges is to lock in the reinvestment rates on future anticipated cash flows through the year 2013 and protect us from the potential adverse impact of declining interest rates on the associated policy reserves. We plan on terminating these forward interest rate swaps and forward contracts at the time the projected cash flows are used to purchase fixed income securities. As of December 31, 2006 and 2005, we had $2,125.0 million and $2,700.0 million, respectively, notional amount of the forward starting interest rate swaps outstanding under this program. We did not have any forward contracts outstanding under this program as of December 31, 2006 or 2005.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 5 - Derivative Financial Instruments - Continued
As of December 31, 2006 and 2005, we had $658.4 million and $690.4 million, respectively, notional amount of open current and forward foreign currency swaps to hedge fixed income foreign dollar denominated securities.
As of December 31, 2006 and 2005, we had $367.8 million and $400.0 million, respectively, notional amount of currency swaps and $216.3 million notional amount of forward currency contracts to hedge the foreign currency risk associated with the U.S. dollar denominated debt issued by one of our U.K. subsidiaries.
We have invested in certain structured fixed maturity securities that contain embedded derivatives with a notional amount of $176.6 million as of December 31, 2006 and 2005. These embedded derivatives represent forward contracts and are accounted for as cash flow hedges. The purpose of these forward contracts is to hedge the risk of changes in cash flows related to the anticipated purchase of certain equity securities in the years 2020 through 2022.
We have entered into an interest rate swap with a notional amount of $60.0 million as of December 31, 2006 and 2005 whereby we receive a fixed rate of interest and pay a variable rate of interest. The purpose of this swap is to hedge the variable cash flows associated with a floating rate security we own. The variable rate we pay on the swap is offset by the amount we receive on the variable rate security.
As of December 31, 2006 and 2005, we had $170.0 million and $348.0 million, respectively, notional amount of open options on forward interest rate swaps to lock in a reinvestment rate floor for the reinvestment of cash flows, through the year 2007, from renewals on policies with a one to two year minimum premium rate guarantee.
As of December 31, 2005, we had $15.2 million notional amount of a foreign currency forward contract to hedge the variability of functional currency cash flows associated with the anticipated receipt of foreign currency proceeds from the settlement of a bankruptcy claim related to a fixed maturity security we owned. We terminated this derivative in 2006, for cash, at the time the bankruptcy claim proceeds were received.
During 2004 and 2003, we entered into certain foreign currency forward contracts whereby we agreed to pay our counterparty a specific Canadian dollar denominated notional amount in exchange for a specific U.S. dollar denominated notional amount. These cash flow hedges were used to eliminate the variability of functional currency cash flows associated with the proceeds from the sale of our Canadian branch. We terminated these currency forwards, for cash, at the time of the closing of the sale of the branch in 2004 and recognized a gain of $2.4 million which was reported as a component of the loss from discontinued operations.
We also have 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, we recognized $(5.3) million, $(7.9) million, and $88.6 million of net realized investment gains (losses) during 2006, 2005, and 2004, respectively. One of the reinsurance contracts for which DIG Issue B36 was applicable was recaptured during 2005. Prior to recapture, we included in other assets a deposit asset for the applicable reinsurance contract. At the time of recapture, the receivable in the deposit asset was settled, the derivative was terminated, and the assets were recorded using the market value of $1,621.7 million that existed on that date. The difference in the book value transferred out of the deposit asset account, which was $1,472.7 million, and the market value recorded equaled the embedded derivative market value component of $149.0 million. The time value component of $9.4 million was recognized as a realized investment loss. The fair value of the embedded derivative related to the remaining applicable reinsurance contract was $(11.5) million as of December 31, 2006.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 5 - Derivative Financial Instruments - Continued
During 2006, we completed a program to reset the interest rates of several receive fixed, pay variable forward starting interest rate swaps by terminating various existing swaps and adding new swaps at current market interest rates and identical cash flow dates. This allowed us to increase our utilization of cash flows as well as reduce our credit exposure to our counterparties. Under this program, we added and terminated swaps with a notional amount of $1,515.0 million each, resulting in a gain of $136.4 million which we reported in other comprehensive income (loss). The anticipated cash flows hedged by these derivatives are still probable, and the gains from the terminated swaps along with the replacement swaps continue to be highly effective cash flow hedges. These terminations and the associated gain are included in the hedging activity discussed in the following paragraph.
During the years ended December 31, 2006, 2005, and 2004, we recognized net gains of $183.6 million, $120.7 million, and $29.1 million, respectively, on the termination of cash flow hedges and reported $183.6 million, $121.0 million, and $29.2 million, respectively, in other comprehensive income. During the years ended December 31, 2005 and 2004 we reported net losses of $0.3 million and $0.1 million, respectively, as a component of realized investment gains and losses. We amortized $30.0 million, $21.8 million, and $20.7 million of net deferred gains into net investment income during 2006, 2005, and 2004, respectively. The estimated amount of net deferred gains to be amortized into operating earnings during 2007 is $27.2 million.
The notional amount of derivatives outstanding under the hedge programs was $3,774.1 million at December 31, 2006. For the year ended December 31, 2006, there was no material ineffectiveness related to our derivative holdings, and there was no component of the derivative instruments’ gain or loss excluded from the assessment of hedge effectiveness. Additionally, there were no gains or losses reclassified into earnings as a result of the discontinuance of cash flow hedges due to the improbability of the original forecasted transactions occurring as anticipated.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 6 - Acquisitions and Dispositions
Acquisitions
During 2005 and 2004 GENEX acquired Independent Review Services, Inc., a provider of medical diagnostic networks and independent medical examinations, at a price of $3.5 million and Integrated Benefits Management, a provider of case management services, at a price of $0.7 million, respectively. These companies will be included with the disposition of GENEX.
During 2004, we 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 us. We also became a multi-national pooling partner for Swiss Life Insurance & Pension Company with respect to business written in the United Kingdom. The amount attributable to value of business acquired in conjunction with this transaction was $15.4 million.
A reconciliation of value of business acquired is as follows:
During 2004, we recognized an impairment of $367.1 million for the remaining balance of the individual income protection - closed block value of business acquired. The impairment related to the restructuring of this business and the resulting modification of our reporting segments. See Note 14 for further discussion.
The estimated net amortization of value of business acquired for each of the next five years is $8.2 million in each of the years 2007 and 2008, $9.2 million in 2009, and $9.4 million in each of the years 2010 and 2011.
Dispositions
In January 2007, we entered into a definitive agreement for the sale of GENEX. See Note 2 for further discussion.
During 2005, we completed the sale of Unum UK’s Netherlands branch. The gain on the sale was $5.7 million before tax and $4.0 million after tax.
During 2004, we completed the sale of our Canadian branch. See Note 2 for further discussion.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 7 - Liability for Unpaid Claims and Claim Adjustment Expenses
Changes in the liability for unpaid claims and claim adjustment expenses are as follows:
The majority of the net balances are related to disability claims with long-tail payouts on which interest earned on assets backing liabilities is an integral part of pricing and reserving. Interest accrued on prior year reserves has been calculated on the opening reserve balance less one-half year’s cash payments at our average reserve discount rate used during 2006, 2005, and 2004.
We entered into settlement agreements with various state insurance regulators in the fourth quarter of 2004 and with the California Department of Insurance (DOI) in the third quarter of 2005. In connection with these settlement agreements, we increased our income protection claim reserves $84.5 million in 2004 and $52.7 million in 2005. During 2006, we further increased our income protection claim reserves $396.4 million to reflect our revised estimate for costs associated with the claim reassessment process. “Incurred Related to Prior Years - Incurred” includes $396.4 million, $52.7 million, and $84.5 million in 2006, 2005, and 2004, respectively, for these reserve charges. “Paid Related to Prior Years” includes $154.9 million and $16.1 million in 2006 and 2005, respectively, for these reserve charges. There were no payments related to prior years in 2004 for these reserve charges. See Note 15 for further discussion of the settlement agreements and the claim reassessment process.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 7 - Liability for Unpaid Claims and Claim Adjustment Expenses - Continued
In 2004, we completed an analysis of the assumptions related to our 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, we lowered the claim reserve discount rate to reflect the segmentation of the investment portfolio between the individual income protection - recently issued business and the individual income protection - closed block business, the duration of the assets and the related policy liabilities. Based on the analysis, in 2004 we increased our individual income protection - closed block claim reserves by $110.6 million to reflect our current estimate of future benefit obligations. “Incurred Related to Prior Years - Incurred” includes $237.4 million in 2004 for the reserve strengthening, reinsurance, and other related adjustments associated with the restructuring.
A reconciliation of policy and contract benefits and reserves for future policy and contract benefits as reported in the consolidated balance sheets to the liability for unpaid claims and claim adjustment expenses is as follows:
The unrealized adjustment to reserves for future policy and contract benefits reflects the changes that would be necessary to policyholder liabilities if the unrealized investment gains and losses related to the available-for-sale securities had been realized. Changes in these adjustments are reported as a component of other comprehensive income.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 8 - Income Tax
Total income tax expense (benefit) was allocated as follows:
A reconciliation of the income tax expense (benefit) attributable to income (loss) from continuing operations before income tax, computed at U.S. federal statutory tax rates, to the income tax expense (benefit) as included in the consolidated statements of operations, is as follows.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 8 - Income Tax - Continued
The net deferred income tax liability consists of the following:
Under the Life Insurance Company Tax Act of 1959, U.S. stock life insurance companies were required to maintain a policyholders’ surplus account containing the accumulated portion of income which had not been subjected to income tax in the year earned. The Deficit Reduction Act of 1984 required that no future amounts be added after 1983 to the policyholders’ surplus account and that any future distributions to shareholders from the account would become subject to federal income tax at the general corporate federal income tax rate then in effect. During 2004, the Homeland Investment Act of 2004 was enacted. The Homeland Investment Act of 2004 provided, in part, that distributions from policyholders’ surplus accounts during 2005 and 2006 would not be taxed.
The amount of the policyholders’ surplus accounts of our U.S. insurance subsidiaries at December 31, 2004, was approximately $228.8 million. Distributions made during 2005 by these life insurance subsidiaries, including dividend distributions, were deemed to occur first from the policyholders’ surplus accounts. As a result, our U.S. life insurance subsidiaries distributed as dividends the remaining balance of their policyholders’ surplus account to the holding company during 2005. This resulted in the elimination of a future potential tax of approximately $80.1 million which had not previously been provided for in current or deferred taxes because we considered the conditions under which such a tax would be paid to be remote.
The Homeland Investment Act of 2004 also provided a deduction of 85 percent of certain foreign earnings that were repatriated during 2005, up to a maximum of $500.0 million. For the portion of unremitted foreign earnings of our non-U.S. operations that had been considered to be permanently reinvested, we had not previously provided U.S. income taxes. During the fourth quarter of 2005, we repatriated $454.8 million in unremitted foreign earnings from our U.K. subsidiary. We recorded current taxes payable of approximately $15.3 million on those previously unremitted foreign earnings and recorded a tax benefit of approximately $18.6 million as a result of the reversal of the deferred tax liability related to the unremitted earnings. We consider the remaining amounts of unremitted earnings as permanently invested in our foreign subsidiaries, and we have therefore not provided taxes on those amounts.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 8 - Income Tax - Continued
Our consolidated statements of operations include the following amounts of income subject to foreign taxation, including the results of the Canadian branch discontinued operations, and the related foreign income tax expense (benefit):
During the fourth quarter of 2006, we reversed income tax liabilities of approximately $91.9 million related primarily to group relief benefits obtained from the use of net operating losses in a foreign jurisdiction in which our businesses operate as the result of final determinations on those years. Included also in fourth quarter 2006 operating results is income of $2.6 million before tax and approximately $3.9 million after tax attributable to the receipt of interest and tax refunds on prior year tax items in excess of what was previously provided.
During the first quarter of 2005, the Internal Revenue Service (IRS) completed its examination of tax years 1999 through 2001 and issued its revenue agent’s report (RAR) in April 2005. Income tax liabilities of approximately $32.0 million that related 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. We are contesting several issues raised in the 1999 through 2001 tax years and expect to resolve these through the IRS appeals process.
During 2005, we also recognized $3.0 million of income before tax and $2.0 million after tax as a result of refunds received from the IRS during the year. Additionally, we recognized an income tax benefit of approximately $10.8 million in connection with the finalization of income tax reviews of our U.K. subsidiaries.
During 2004, we obtained a judgment in refund litigation for tax year 1984, and as a result we were entitled to a refund of tax plus interest for 1984 and for tax years subsequent to 1984 in which the IRS took inconsistent positions on the deductibility of the insurance tax reserves that were the subject of the litigation and for which we paid tax based on the IRS’ positions. As a result of the judgment, results from operations were increased by $14.0 million before tax and $26.2 million after tax.
Also during 2004, we recognized tax benefits from settlements of IRS examinations of tax years 1996 through 1998. Under the settlements, we resolved issues raised by the IRS pertaining to the calculation of insurance tax reserves and the deductibility of losses on notional principal contracts. Tax benefits of $33.1 million are included in 2004 results from operations attributable to the effect of prior year tax settlements.
We are under continuous examination by the IRS and other tax authorities in areas wherein we have significant business operations. The current IRS examination covers the tax years 2002 through 2004.
We believe sufficient provision has been made for proposed and potential adjustments for years under examination and at appeals and for years yet to be examined. We do not believe that any such future adjustment will have a material adverse effect on our financial position, liquidity, or results of operations, although the resolution of income tax matters could impact our results of operations for a particular period.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 8 - Income Tax - Continued
We will adopt FIN 48 effective January 1, 2007. FIN 48 prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. We are continuing to evaluate the effect of FIN 48 on our financial statements but estimate that the cumulative effect adjustment at adoption on January 1, 2007 will increase retained earnings by up to $25.0 million. This estimate is subject to revision as we complete our analysis.
As of December 31, 2006, we had net operating loss carryforwards in the U.S. of approximately $135.1 million. The majority of the net operating loss carryforwards will expire in 2023. As of December 31, 2006, we had net operating loss carryforwards in foreign jurisdictions of $6.4 million for which a full valuation allowance has been established because in our judgment, we will most likely not realize a tax benefit for these losses. The $0.1 million change from 2005 in the valuation allowance is due to fluctuations in foreign exchange rates.
Total income taxes paid during 2006, 2005, and 2004 were $129.2 million, $93.4 million, and $91.5 million, respectively.
Note 9 - Debt
Long-term debt consists of the following:
The 7.25% notes due 2032 are redeemable at Unum Group’s option on or after June 25, 2007. The adjustable conversion-rate equity security units, the 5.997% notes due 2008, and the junior subordinated debt securities due 2038 are callable under limited, specified circumstances. The remaining callable debt may be redeemed, in whole or in part, at any time. Collateralized debt, which consists of the senior secured notes, ranks highest in priority, followed by unsecured notes, which consists of adjustable conversion-rate equity security units, notes, and medium-term notes, followed by junior subordinated debt securities. The aggregate contractual principal maturities are $175.0 million in 2008, $300.0 million in 2009, $325.0 million in 2011, and $1,860.0 million in 2012 and thereafter.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 9 - Debt - Continued
In November 2006, Tailwind Holdings, LLC (Tailwind Holdings), a wholly-owned subsidiary of Unum Group, issued $130.0 million of floating rate, insured, senior, secured notes due 2036 (the notes) in a private offering. The notes bear interest at a floating rate equal to the London Interbank Offered Rate (LIBOR) plus 0.35%. Tailwind Holdings contributed the $130.0 million proceeds from the issuance of the notes, to Tailwind Reinsurance Company (Tailwind Re), the sole subsidiary of Tailwind Holdings, as a capital contribution. Tailwind Re deposited the funds in a funding sub account. No further deposits will be made into the funding sub account.
Tailwind Re has reinsured a quota share portion of Unum Life Insurance Company of America’s (Unum America) liability with respect to certain specified long-term disability claims incurred between January 1, 1999 and December 31, 2001 that were in payment status on January 1, 2006 (reinsured claims). Assets held in the funding sub account will not be available to fund payments of principal or interest on the notes, but will be held solely to satisfy any obligations of Tailwind Re to Unum America under the Reinsurance Agreement.
Tailwind Holdings’ ability to meet its obligations to pay principal, interest, and other amounts due on the notes will be dependent principally on its receipt of dividends from Tailwind Re. The ability of Tailwind Re to pay dividends to Tailwind Holdings will depend on its satisfaction of applicable regulatory requirements and on the performance of the reinsured claims.
Recourse for the payment of principal, interest, and other amounts due on the notes is limited to the collateral and the other assets, if any, of Tailwind Holdings. The collateral consists of a first priority, perfected security interest in (a) the debt service coverage account (DSCA) that is required to be maintained in accordance with the indenture pursuant to which the notes were issued (the indenture), (b) the capital stock of Tailwind Re and the dividends and distributions on such capital stock, and (c) Tailwind Holdings’ rights under the transaction documents related to the notes to which Tailwind Holdings is a party. None of Unum Group, Unum America, Tailwind Re, or any other affiliate of Tailwind Holdings is an obligor or guarantor on the notes.
Tailwind Holdings is required to repay a portion of the outstanding principal under the notes at par on the scheduled payment dates of each year in an amount equal to the lesser of (i) a specified targeted amortization amount as defined in the indenture and (ii) the amount of the remaining available funds in the DSCA minus an amount equal to the minimum balance that is required to be maintained in the DSCA under the indenture, provided that Tailwind Holdings has sufficient funds available to pay its other expenses, including the payment of interest on the notes, and to retain the required balance in the DSCA.
In June 2006, pursuant to a cash tender offer, we purchased $50.0 million of our outstanding 7.405% junior subordinated debt securities due 2038 and $250.0 million aggregate principal amount of our outstanding 7.625% notes due 2011. The cost of the cash tender offer decreased 2006 income by $17.8 million before tax, or $11.6 million after tax.
In November 2005, UnumProvident Finance Company plc, a wholly-owned subsidiary of Unum Group, issued $400.0 million of 6.85% senior debentures due November 15, 2015 in a private offering and received net proceeds of $399.6 million. These debentures are fully and unconditionally guaranteed by Unum Group. In December 2006, $32.0 million of these debentures were redeemed. The cost related to this redemption decreased 2006 income by $2.7 million before tax, or $1.9 million after tax.
In May 2004, Unum Group issued 12.0 million 8.25% adjustable conversion-rate equity security units (units) in a private offering for $300.0 million. We 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 Unum Group’s common stock on May 15, 2007 and which entitles
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 9 - Debt - Continued
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 Unum Group due May 15, 2009 with a principal amount of $1,000, on which we 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, we 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 balance sheets, and the related purchase contract issuance costs reduced additional paid-in capital by $27.6 million. The scheduled remarketing of the senior note element of these units occurred in February 2007, as stipulated by the terms of the original offering, and we reset the interest rate on $300.0 million of senior notes due May 15, 2009 to 5.859%. We purchased $150.0 million of the senior notes in the remarketing which were subsequently retired.
In May 2003, Unum Group issued 23.0 million 8.25% adjustable conversion-rate equity security units (units) in a public offering for $575.0 million. Each unit had a stated amount of $25 and initially consisted of (a) a contract pursuant to which the holder agreed to purchase, for $25, shares of Unum Group’s common stock on May 15, 2006 and which entitled the holder to contract adjustment payments at the annual rate of 2.25 percent, payable quarterly, and (b) a 1/40, or 2.5 percent, ownership interest in a senior note issued by Unum Group due May 15, 2008 with a principal amount of $1,000, on which we paid interest at the initial annual rate of 6.00 percent, payable quarterly. The scheduled remarketing of the senior note element of these units occurred in February 2006, as stipulated by the terms of the original offering, and we reset the interest rate on $575.0 million of senior notes due May 15, 2008 to 5.997%. We purchased $400.0 million of the senior notes in the remarketing which were subsequently retired. The associated write-off of deferred debt costs decreased 2006 income by $5.3 million before tax, or $3.4 million after tax. Upon settlement of the common stock purchase contract in May 2006, we received proceeds of approximately $575.0 million and issued 43.3 million shares of common stock.
In 1998, Provident Financing Trust I (the trust) issued $300.0 million of 7.405% capital securities in a public offering. These capital securities, which mature on March 15, 2038, are fully and unconditionally guaranteed by Unum Group, have a liquidation value of $1,000 per capital security, and have a mandatory redemption feature under certain circumstances. Unum Group issued 7.405% junior subordinated deferrable interest debentures which mature on March 15, 2038, to the trust in connection with the capital securities offering. The sole assets of the trust are the junior subordinated debt securities.
Unum Group has a shelf registration, which became effective in 2005, with the Securities and Exchange Commission 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 finance trusts up to an aggregate of $1.0 billion. If utilized, the shelf registration will enable us 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 our capital needs. At December 31, 2006, we had $1.0 billion remaining on our shelf registration.
Interest paid on short-term and long-term debt and related securities during 2006, 2005, and 2004 was $200.7 million, $210.7 million, and $205.2 million, respectively.
Note 10 - Pensions and Other Postretirement Benefits
We sponsor several defined benefit pension and postretirement plans for our employees, including non-qualified pension plans. The U.S. plans comprise the majority of our total benefit obligation and benefit cost. We maintain a separate defined benefit plan for eligible employees in our U.K. operation. We previously maintained separate defined benefit plans for the employees of our Canadian branch operation. As a result of the sale of the Canadian
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 10 - Pensions and Other Postretirement Benefits - Continued
branch, we froze the Canadian defined benefit pension plans during 2004 and are currently in the process of terminating these plans.
The following tables provide the changes in the benefit obligation and fair value of plan assets and statements of the funded status of the plans. We use a December 31 measurement date for each plan.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 10 - Pensions and Other Postretirement Benefits - Continued
The amounts recognized in the consolidated balance sheets for our pension and postretirement benefit plans at December 31, 2006 are as follows:
The weighted average assumptions used in the measurement of our pension and postretirement benefit obligations as of December 31 are as follows:
The weighted average assumptions used to determine net periodic benefit cost for years ended December 31 are as follows:
We currently set the discount rate assumption annually for each of our pension-related benefit plans at the measurement date to reflect the yield of a portfolio of high quality long-term fixed income securities matched against the projected cash flows for future benefits.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 10 - Pensions and Other Postretirement Benefits - Continued
For measurement purposes at December 31, 2006 and 2005, the annual rate of increase in the per capita cost of covered postretirement health care benefits assumed for the next calendar year was 9.00 percent for benefits payable to retirees prior to Medicare eligibility and 9.80 percent for benefits payable to Medicare eligible retirees. The rate was assumed to change gradually to 5.00 percent by the end of the fifth year and remain at that level thereafter.
A one percent increase or decrease in the assumed health care cost trend rate at December 31, 2006 would have increased (decreased) the service cost and interest cost by $0.7 million and $(0.6) million, respectively, and the postretirement benefit obligation by $7.6 million and $(6.8) million, respectively.
The medical and dental premium used to determine the per retiree employer subsidy are capped. If the cap is not reached by the year 2015, the caps are then set equal to the year 2015 premium. Certain of the current retirees and all future retirees are subject to the cap.
The following table provides the components of the net periodic benefit cost for the plans described above for the years ended December 31.
The net actuarial loss, prior service credit, and transition asset included in accumulated other comprehensive income and expected to be recognized in net periodic pension cost during 2007 is $20.6 million, $(3.1) million, and $(0.1) million, respectively, before tax, and $13.3 million, $(2.0) million, and $(0.1) million, respectively, after tax. The prior service credit expected to be recognized in net periodic cost for postretirement plans during 2007 is $(3.8) million before tax and $(2.5) million after tax.
The following table provides expected benefit payments, which reflect expected future service, as appropriate.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 10 - Pensions and Other Postretirement Benefits - Continued
Our funded pension plans’ weighted average asset allocations, by asset category, are as follows:
To determine the net periodic pension cost for our U.S. qualified defined benefit pension plan for the year 2006, an 8.0 percent long-term expected rate of return assumption was used. The long-term rate of return assumption is an estimate, based on statistical analysis, of the average annual assumed return that will be produced from the pension trust assets until current benefits are paid. The investment portfolio during 2006 contained a diversified blend of large cap, mid cap, and small cap domestic equity securities, international equity securities, convertible securities, and investment-grade and below-investment-grade fixed income securities. Our expectations for the future investment returns of these asset categories were based on a combination of historical market performance and evaluations of investment forecasts obtained from external consultants and economists. The methodology underlying the return assumption included the various elements of the expected return for each asset class such as long-term rates of return, volatility of returns, and the correlation of returns between various asset classes. The expected return for the total portfolio was calculated based on the plan’s strategic asset allocation. Investment risk is measured and monitored on an ongoing basis through annual liability measurements, periodic asset/liability studies, and quarterly investment portfolio reviews. Risk tolerance is established through consideration of plan liabilities, plan funded status, and corporate financial condition. The plan prohibits the use of derivative instruments.
The funding policy for our U.S. qualified defined benefit plan is to contribute annually an amount at least equal to the minimum annual contribution required under the Employee Retirement Income Security Act and other applicable laws, but generally not greater than the maximum amount that can be deducted for federal income tax purposes. We had no regulatory contribution requirements for 2006 and 2005; however, we elected to make voluntary contributions of $92.0 million and $23.0 million, respectively. We expect to make a voluntary contribution of approximately $110.0 million to our U.S. qualified defined benefit pension plan in 2007, based on current pension funding law. The funding policy for the U.S. non-qualified defined benefit pension plan and postretirement plan is to contribute the amount of the benefit payments made during the year.
Our U.K. operation maintains a separate defined benefit plan (Scheme) for eligible employees. The Scheme assets are invested in pooled funds, with a 54 percent global equity securities allocation. The remainder of the assets is predominantly invested in fixed interest bonds and index linked bonds. The long-term rate of return assumption is the best estimate of the average annual assumed return that will be produced from the Scheme assets until current benefits are paid. We are required to contribute to the Scheme at the rate of at least 18.20 percent of eligible salaries sufficient to meet the minimum funding requirement under U.K. legislation. We made contributions of $53.3 million and $8.8 million in 2006 and 2005, respectively. We expect to make contributions of $9.5 million during 2007.
We also maintain a reserve for life insurance benefits payable to certain former retirees covered under the postretirement welfare plan. The expected return assumption for this reserve was 5.75 percent, which was based on full investment in fixed income securities with an average book yield of 6.39 percent and 6.56 percent for 2006 and 2005, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 10 - Pensions and Other Postretirement Benefits - Continued
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 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. During 2005 we confirmed that all of our retiree medical plans qualify for a government subsidy under the Medicare Act and chose to defer coordination with the new prescription drug benefit until 2007. This change is reflected in the net periodic benefit cost.
Note 11 - Stockholders’ Equity and Earnings Per Common Share
Common Stock
Dividends paid per common share were $0.30 for each of the years ended December 31, 2006, 2005, and 2004.
During 2006, we settled the purchase contract element of the adjustable conversion-rate equity security units issued in 2003 by issuing 43.3 million shares of Unum Group common stock. See Note 9 for further discussion.
Preferred Stock
Unum Group 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.
Earnings Per Common Share
Net income (loss) per common share is determined as follows:
We use the treasury stock method to account for the effect of the purchase contract element of the units, outstanding stock options, and other dilutive securities on the number of weighted average common shares, assuming dilution. Under this method, the purchase contract element of the units, as described in Note 9, and outstanding stock options, as described in Note 12, will have a dilutive effect only when the average market price of Unum Group’s common
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 11 - Stockholders’ Equity and Earnings Per Common Share - Continued
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 units issued in 2004 have a threshold appreciation price of $16.95 per share. The units issued in 2003 had a threshold appreciation price of $13.27. The outstanding stock options have exercise prices ranging from $12.23 to $58.56.
In computing earnings per common 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 common share assuming dilution if the results would be antidilutive, such as when a net loss from continuing operations is reported. For the year ended December 31, 2004, approximately 5.6 million issuable shares related to the purchase contract element of the units and approximately 1.4 million issuable common shares for the assumed exercises of stock options and other dilutive securities were not used in the calculation of earnings per common share due to the antidilutive effect when a net loss from continuing operations is reported.
Options to purchase approximately 8.2 million, 12.1 million, and 14.4 million shares of common stock for the years ended December 31, 2006, 2005, and 2004, respectively, were outstanding but were not included in the computation of earnings per common share, assuming dilution, because the exercise prices of the options were greater than the average market price of Unum Group’s common stock. The purchase contract elements of the units issued in 2004 were also excluded from the computation for the year ended December 31, 2004 because the threshold appreciation price was greater than the average market price of Unum Group’s common stock.
Note 12 - Stock-Based Compensation
Stock Plans
We previously had a broad-based stock plan of 2002 under which there were up to 2,390,000 shares of common stock available for stock option awards to our employees, officers, consultants, and brokers, excluding certain senior officers and directors. Prior to terminating the plan in February 2004 for purposes of any further grants, we granted 2,007,375 shares in the form of stock options with a maximum term of ten years after the date of grant and generally with a three year vesting period.
Under the broad-based stock plan of 2001, up to 2,000,000 shares of common stock are available for stock option awards to our employees, officers, consultants, and brokers, excluding certain senior officers and directors. The stock options have a maximum term of ten years after the date of grant and generally vest after three years. At December 31, 2006, 550,990 shares were available for future grants.
Under the stock plan of 1999, up to 17,500,000 shares of common stock are available for awards to our employees, officers, brokers, and directors. Awards may be in the form of stock options, stock appreciation rights, stock awards, dividend equivalent awards, or any other right or interest relating to stock. Stock options have a maximum term of ten years after the date of grant and generally vest after three years. The number of shares available to be issued as stock awards under the stock plan of 1999 is limited to 6,125,000 shares. At December 31, 2006, 6,366,710 shares were available for future grants under the stock plan of 1999.
For the stock plan of 1999, the broad-based stock plan of 2001, and the broad-based stock plan of 2002, the exercise price for stock options issued cannot be less than the fair market value of the underlying common stock as of the grant date.
We issue new shares of common stock for nonvested stock grants, exercise of stock options, and purchase of employee stock purchase plan (ESPP) shares.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 12 - Stock-Based Compensation - Continued
Expense for the stock plans described above, included in compensation expense in the consolidated statements of operations, is as follows:
Cash received under all share-based payment arrangements for the years ended December 31, 2006, 2005, and 2004 was $5.0 million, $18.1 million, and $5.7 million, respectively.
Nonvested Stock Awards
Nonvested share activity is summarized as follows:
Stock awards vest over a two to five year service period, beginning at the date of grant, and the compensation cost is recognized ratably during the vesting period. Compensation cost for stock awards subject to accelerated vesting upon retirement is recognized over the implicit service period for awards issued subsequent to 2005 and over the explicit service period (subject to acceleration upon actual retirement) for awards issued prior to 2006. We pay cash dividend equivalents on outstanding nonvested stock awards. Dividend equivalents paid on nonvested stock awards are charged to expense when paid. At December 31, 2006, we had $12.7 million of unrecognized compensation cost related to nonvested stock awards that will be recognized over a weighted average period of 1.0 year. Prior to adoption of SFAS 123(R), this amount was reported as additional paid-in capital and deferred compensation, a contra equity account. The value of this contra equity account at the adoption of SFAS 123(R) was $13.8 million. The weighted average grant date fair values per share for nonvested stock awards granted during 2006, 2005, and 2004 were $20.95, $17.43, and $15.14, respectively.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 12 - Stock-Based Compensation - Continued
Stock Options
Stock option activity is summarized as follows:
All outstanding stock options were exercisable as of December 31, 2006, with a remaining weighted average contractual life of 2.7 years. No stock options were granted during 2006, 2005, and 2004.
ESPP
Substantially all of our employees are eligible to participate in an ESPP. Under the plan, up to 3,460,000 shares of common stock are authorized for issuance, of which 1,725,941 remain available for issuance at December 31, 2006. Stock may be purchased at the end of each financial quarter at a purchase price of 85 percent of the lower of its beginning or end of quarter market prices. We sold 148,833 shares, 154,395 shares, and 205,172 shares to employees with a weighted average exercise price of $18.99, $15.38, and $12.88 and a weighted average grant date fair value of $3.90, $3.29, and $2.65, during the years 2006, 2005, and 2004, respectively.
Note 13 - Reinsurance
In the normal course of business, we assume reinsurance from and cede reinsurance to other insurance companies. The primary purpose of ceded reinsurance is to limit losses from large exposures. However, if the assuming reinsurer is unable to meet its obligations, we remain contingently liable. We evaluate the financial condition of reinsurers and monitor concentration of credit risk to minimize this exposure. We may also require assets in trust, letters of credit, or other acceptable collateral to support reinsurance recoverable balances.
The reinsurance recoverable at December 31, 2006 relates to 85 companies. Thirteen major companies account for approximately 91 percent of the reinsurance recoverable at December 31, 2006, and are all companies rated A or better by A.M. Best Company or are fully securitized by letters of credit or investment-grade fixed maturity securities held in trust. Virtually all of the remaining nine percent of the reinsurance recoverable relates to business reinsured either with companies rated A- or better by A.M. Best Company, with overseas entities with equivalent ratings or backed by letters of credit or trust agreements, or through reinsurance arrangements wherein we retain the assets in our general account. Less than one percent of the reinsurance recoverable is held by companies either rated below A- by A.M. Best Company or not rated.
Reinsurance activity is accounted for on a basis consistent with the terms of the reinsurance contracts and the accounting used for the original policies issued. Premium income and benefits and change in reserves for future benefits are presented in the consolidated statements of operations net of reinsurance ceded.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 13 - Reinsurance - Continued
Reinsurance data is as follows:
During the third quarter of 2005, we recaptured a closed block of individual income protection business, with approximately $1.6 billion in invested assets and $185.0 million of annual premium. Before the recapture, the underlying operating results of the reinsurance contract were reflected in other income. The recapture did not have a material effect on operating results for the Individual Income Protection - Closed Block segment.
During 2004, we restructured our individual income protection - closed block business wherein three of our insurance subsidiaries entered into reinsurance agreements to reinsure approximately 66.7 percent of potential future losses that occur above a specified retention limit. The reinsurance agreements effectively provide approximately 60 percent reinsurance coverage for our overall consolidated risk above a specified 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 is now estimated to grow to approximately $2.4 billion over time, after which any further losses will revert to us. These reinsurance transactions were effective as of April 1, 2004. We 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 our retention limit.
Note 14 - Segment Information
Our reporting segments are comprised of the following: Unum US, Unum UK, Colonial, Individual Income Protection - Closed Block, Other, and Corporate.
The Unum US segment includes our U.S. group long-term and short-term income protection insurance, group life and accidental death and dismemberment products, and supplemental and voluntary lines of business, comprised of individual income protection - recently issued, group and individual long-term care, and brokerage voluntary workplace benefits products. These products are marketed through our field sales personnel who work in conjunction with independent brokers and consultants. For the sale of individual income protection and individual long-term care products, we use a distribution model which provides independent brokers and consultants with the option of direct access to a sales support center centrally located in our corporate offices.
The Unum UK segment includes group long-term income protection, group life, and individual income protection products sold primarily in the United Kingdom through field sales personnel and independent brokers and consultants.
The Colonial segment includes insurance for income protection products, life products, and cancer and critical illness products issued and marketed primarily to employees at the workplace through an agency sales force and brokers.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 14 - Segment Information - Continued
The Individual Income Protection - Closed Block segment generally consists of those individual income protection policies that were designed to be distributed to individuals in a non-workplace setting and which were primarily in force prior to the substantial changes in product offerings, pricing, distribution, and underwriting which generally occurred during the period 1994 through 1998. A minimal amount of new business continued to be sold subsequent to these changes, but we ceased selling new policies in this segment at the beginning of 2004 other than update features contractually allowable on existing policies.
The Other segment, includes results from Unum US insured products not actively marketed (with the exception of the individual income protection products in the Individual Income Protection - Closed Block segment), including individual life and corporate-owned life insurance, reinsurance pools and management operations, group pension, health insurance, and individual annuities.
The Corporate segment consists of revenue earned on corporate assets not specifically allocated to a line of business, interest expense on corporate debt, and certain corporate income and expense not allocated to a line of business.
In conjunction with the restructuring of the individual income protection - closed block business during 2004, as discussed in Notes 7 and 13, we at that time modified our 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 our financial restructuring and separation of this business from the lines of business which still 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 us 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. Also as part of the restructuring, we increased our claim reserves for the closed block of individual income protection business $110.6 million before tax. The impairment charges and reserve strengthening, which total $967.0 million before tax, are reported in the Individual Income Protection - Closed Block segment. The after-tax charge of $701.0 million is included in the net loss reported for the year ended December 31, 2004. See Note 7 for further discussion regarding 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 our consolidated statements of operations prepared in accordance with GAAP due to the exclusion of before tax realized investment gains and losses. We measure 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 we believe that this performance measure is a better indicator of the ongoing businesses and the underlying trends in the businesses. Our investment focus is on investment income to support our 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 depend on market conditions and do not necessarily relate to decisions regarding the underlying business of our segments.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 14 - Segment Information - Continued
Premium income by major line of business within each of our segments is presented as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 14 - Segment Information - Continued
Selected operating statement data by segment is presented as follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 14 - Segment Information - Continued
The following table provides the changes in deferred policy acquisition costs by segment:
A reconciliation of total operating revenue and operating income (loss) by segment to revenue and net income (loss) as reported in the consolidated statements of operations follows:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 14 - Segment Information - Continued
Assets by segment are as follows:
We report goodwill in our Unum US segment and in our Unum UK segment, which are the segments expected to benefit from the originating business combinations. Stockholders’ equity is allocated to the operating segments on the basis of an internal allocation formula that reflects the volume and risk components of each operating segment’s business and aligns allocated equity with our target capital levels for regulatory and rating agency purposes. We modify this formula periodically to recognize changes in the views of capital requirements.
Note 15 - Commitments and Contingent Liabilities
Commitments
We have noncancelable lease obligations on certain office space and equipment. As of December 31, 2006, the aggregate net minimum lease payments were $106.8 million payable as follows: $32.1 million in 2007, $23.1 million in 2008, $16.1 million in 2009, $10.1 million in 2010, $6.9 million in 2011, and $18.5 million thereafter. Rental expense for the years ended December 31, 2006, 2005, and 2004 was $35.8 million, $33.9 million, and $37.9 million, respectively.
Contingent Liabilities
We are a defendant in a number of litigation matters. In some of these matters, no specified amount is sought. In others, very large or indeterminate amounts, including punitive and treble damages, are asserted. There is a wide variation of pleading practice permitted in the United States courts with respect to requests for monetary damages, including some courts in which no specified amount is required and others which allow the plaintiff to state only that the amount sought is sufficient to invoke the jurisdiction of that court. Further, some jurisdictions permit plaintiffs to allege damages well in excess of reasonably possible verdicts. Based on our extensive experience and that of others in the industry with respect to litigating or resolving claims through settlement over an extended period of time, we believe that the monetary damages asserted in a lawsuit or claim bear little relation to the merits of the case, or the likely disposition value. Therefore, the specific monetary relief sought is not stated.
The lawsuits described below are for the most part in very preliminary stages. The outcome of the matters is uncertain, and we are unable to estimate a range of reasonably possible losses. Unless indicated otherwise, 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 our consolidated results of operations in a period, encourage other litigation, harm the Company’s reputation and goodwill, and limit our ability to write new business, particularly if the adverse outcomes negatively impact certain of our debt and financial strength ratings.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 15 - Commitments and Contingent Liabilities - Continued
Claims Handling Matters
Multidistrict Litigation
On September 2, 2003, the Judicial Panel on the Multidistrict Litigation entered an order transferring more than twenty putative class actions and derivative suits, described below, filed in various courts against the Company, several of its subsidiaries, and some of our officers, to the U.S. District Court for the Eastern District of Tennessee for coordinated or consolidated pretrial proceedings. The defendants strongly deny the allegations in each of these actions and will vigorously defend the substantive and procedural aspects of the litigations, except as noted below with respect to settlement discussions in the Plan Beneficiary Class Actions.
Shareholder Derivative Actions
On November 22, 2002, the first of five purported shareholder derivative actions was filed in the Tennessee Chancery Court. Between December 27, 2002 and March 11, 2003, four additional purported derivative actions were filed in state and federal courts in Tennessee. The defendants removed each of the actions that were filed in Tennessee state court to the U.S. District Court for the Eastern District of Tennessee.
Each of these actions purports to be brought on behalf of the Company against certain current and past members of our 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 breached their duties of good faith and loyalty by establishing or permitting to be established an unlawful policy of denying legitimate disability claims and improper financial reporting, and that certain defendants engaged in insider trading.
The district court consolidated these actions under the caption In re UnumProvident Corporation Derivative Actions. The plaintiffs then filed a single consolidated amended complaint. We deny the allegations of the complaint and will vigorously contest them.
Federal Securities Law Class Actions
On February 12, 2003, the first of six virtually identical putative securities class actions was filed in the U.S. District Court for the Eastern District of Tennessee. 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.
The Lead Plaintiff filed a consolidated amended complaint on behalf of a putative class of purchasers of UnumProvident stock between March 30, 2000 and April 24, 2003. The amended complaint alleges, among other things, that we issued misleading financial statements, improperly accounted for certain impaired investments, failed to properly estimate our 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.
A motion to dismiss was filed, and the court ultimately issued a Memorandum and Order denying in part, and granting in part, the motion. The court granted the motion with respect to Lead Plaintiff’s claims concerning our investments and denied the motion challenging the other alleged misstatements. Discovery, which had been stayed in this action pursuant to the Private Securities Litigation Reform Act of 1995, has now begun.
Policyholder Class Actions
On July 15, 2002, Rombeiro v. Unum Life Insurance Company of America, et al., was filed in the Superior Court of California and subsequently was removed to federal court, alleging that the plaintiff was wrongfully denied disability benefits under a group long-term disability plan. On January 21, 2003, an Amended Complaint was filed
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 15 - Commitments and Contingent Liabilities - Continued
on behalf of a putative class of individuals that were denied or terminated from benefits under group long-term disability plans, seeking 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 similar relief.
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 alleged 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 the Employee Retirement Income Security Act (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 multidistrict litigation. 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 and appointed a lead plaintiff. A consolidated amended complaint was filed on February 20, 2004. Several motions remain pending before the court in this matter.
On April 30, 2003, a separate putative class action, Taylor v. UnumProvident Corporation, et al., was filed in the Tennessee Circuit Court and subsequently removed to federal court. The complaint alleges claims against UnumProvident and certain subsidiaries on behalf of a putative class of long-term disability insurance policyholders 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, seeking equitable and monetary relief. Plaintiff alleges that the defendants violated various state laws by engaging in unfair claim practices and improperly denying claims.
The court subsequently granted in part our motion for summary judgment in Taylor, dismissing plaintiff’s request for equitable relief on her breach of contract claim and dismissing any claim plaintiff may make for punitive damages under the Tennessee Consumer Protection Act. The former claim is the principal claim upon which class certification is sought. The court reserved ruling on the remainder of the pending motion for summary judgment pending further mediation of the Taylor and ERISA Benefit actions.
Court ordered mediation has concluded with the settlement of all individual claims brought by six of the fifteen named plaintiffs in the ERISA Benefit Denial Actions. A seventh plaintiff has subsequently resolved her claims through the process established under the regulatory settlement agreements.
Plan Beneficiary Class Actions
On April 29, 2003, the first of two identical putative class actions, Gee v. UnumProvident Corporation, et al., was filed in the Eastern District of Tennessee on behalf of participants and beneficiaries of UnumProvident’s 401(k) Retirement Plan (Plan), and the actions were later consolidated.
On January 9, 2004, plaintiffs filed a consolidated amended complaint against us, several of our officers and directors, and several alleged Plan fiduciaries on behalf of a putative class of individuals that held our Company’s stock in their 401(k) retirement accounts subsequent to November 17, 1999. Plaintiffs allege that the defendants violated ERISA by making misrepresentations and omissions regarding investment in our Company’s stock and by acting imprudently in failing to take action to protect participants from losses sustained from investments in the Plan’s UnumProvident Stock Fund.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 15 - Commitments and Contingent Liabilities - Continued
The parties are currently engaged in settlement discussions supervised by a Court appointed mediator. The parties have reached an agreement in principle for resolution of the matter, the net cost of which is immaterial to the Company. The agreement is subject to further negotiations on a number of points, including attorneys’ fees, the preparation of a definitive written agreement, and Court approval of any final agreement.
Examinations and Investigations
In the fourth quarter of 2004, certain of our insurance subsidiaries entered into settlement agreements with state insurance regulators upon conclusion of a multistate market conduct examination led by Maine, Massachusetts, and Tennessee relating to disability claims handling practices. A total of 48 states and the District of Columbia were parties to the settlement agreements, which provide for changes in certain claims handling procedures, a claim reassessment process available to certain claimants whose claims were denied or closed during certain periods and who choose to participate, changes in governance to increase oversight of the claims handling and reassessment process, and contingent fines for non-compliance. In addition, the U.S. Department of Labor (DOL), which had been conducting an inquiry relating to certain ERISA plans, was a party to the settlement agreements, and the Office of the New York Attorney General (NYAG), which had engaged in its own investigation of our claims handling practices, notified us that it was in support of the settlement and was, therefore, closing its investigation on this issue.
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 settlement agreements also provide for a contingent fine of up to $145.0 million on our U.S. insurance subsidiaries in the event that we fail to satisfactorily meet the performance standards in the settlement agreements relating to the examinations referred to above. The parties to the agreements have subsequently agreed to extend the reassessment process until December 31, 2007, and we expect to conclude the claim reassessment process by that time. The examinations will commence before or after that date. We believe that due to the changes we have made to our claims operations to enhance our oversight functions, it is not probable that we will fail to meet the performance standards in the agreements when these examinations are concluded.
In October 2005, certain of our 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 2004 multistate settlement agreements. As part of the settlement with the California DOI, we agreed to change certain practices and policy provisions related to our California business. The settlement also incorporates claims handling practices previously covered by the multistate settlement agreements and includes certain additional claim handling changes. Under the terms of the settlement, we changed certain provisions specific to California disability policies, and we received approval from the California DOI for the use of new individual and group disability policy forms. Following the California settlement, we also 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, we are 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.
As of the end of 2006, we had completed our review of approximately 55 percent of the total claims expected to be reassessed under the multistate and California settlement agreements and had information on an additional 15 percent for which we had not yet finalized our review. Based on current information, we believe that our ultimate claim reassessment costs could be lower or higher by approximately $90.0 million relative to the best estimate upon which our accruals are currently based. The estimate of the lower and upper end of the range of reasonably possible
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 15 - Commitments and Contingent Liabilities - Continued
additional costs is much less certain than our best estimate and uses assumptions, among the range of reasonably possible outcomes, which are more favorable to us at the lower end of the cost range and less favorable to us at the upper end of the range. We continue to monitor our claim reassessment experience and review the adequacy of the associated reserves on a quarterly basis. Unfavorable experience relative to our revised assumptions could result in additional claim reassessment costs above our current accrual and in excess of our reasonably possible range.
On March 29, 2006 we received a subpoena from the Securities and Exchange Commission (SEC) seeking information regarding certain reinsurance transactions and transactions regarding “Non Traditional Products” entered into after January 1, 2002. We are cooperating fully with the SEC in its investigation.
These and 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 reinsurance, changes in governance and other oversight procedures, fines, and other administrative action.
Such results, singly or in combination, could injure our reputation, cause negative publicity, adversely affect our debt and financial strength ratings, or impair our ability to sell or retain insurance policies, thereby adversely affecting our business, and potentially materially adversely affecting our consolidated results of operations in a period, depending on the results of operations for the particular period. Determination by regulatory authorities that the Company or its insurance subsidiaries have engaged in improper conduct could also adversely affect our defense of various lawsuits described herein.
Other Claim Litigation
We and our insurance company subsidiaries, as part of our 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 these 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 our general claim litigation, we maintain reserves based on experience to satisfy judgments and settlements in the normal course. We expect that the ultimate liability, if any, with respect to general claim litigation, after consideration of the reserves maintained, will not be material to our consolidated financial condition. 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 our consolidated results of operations in a period, depending on the results of operations for the particular period. We are unable to estimate a range of reasonably possible punitive losses.
From time to time class action allegations are pursued 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, we monitor these cases closely and defend ourselves appropriately where these allegations are made.
Broker Compensation, Quoting Process, and Related Matters
Examinations and Investigations
In June 2004, we received a subpoena from the NYAG requesting documents and information relating to compensation arrangements between insurance brokers or intermediaries and us and our subsidiaries.
On November 1, 2006, we entered into a settlement agreement with the NYAG in the form of an assurance of discontinuance that provides for a national restitution fund of $15.5 million and a fine of $1.9 million, the costs of which were recorded in the third quarter of 2006. That restitution fund should be fully distributed by year end 2007.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 15 - Commitments and Contingent Liabilities - Continued
Since October 2004, we and/or our insurance subsidiaries have received subpoenas or information requests from the NYAG, a Federal Grand Jury in San Diego, the District Attorney for the County of San Diego, insurance departments, and/or other state regulatory or investigatory agencies of at least seven additional states including Connecticut, Florida, Maine, Massachusetts, North Carolina, South Carolina, and Tennessee.
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 arrangements with brokers, particularly with regard to Universal Life Resources, Inc. We have cooperated fully with these investigations.
With respect to the states listed, other than Florida and other than those with whom settlements have been reached, we have not received any further inquiries in the past 12 months and consider those investigations to be dormant.
We have also had discussions with the DOL regarding compliance with ERISA, relating to our interactions with insurance brokers and to regulations concerning insurance information provided by us 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 us concerning these issues, both generally and specifically in connection with certain brokers, including Universal Life Resources, Inc. We are cooperating fully with the DOL’s investigation.
Broker-Related Litigation
We and certain of our subsidiaries, along with many other insurance brokers and insurers, have been named as defendants in a series of putative class actions that have been transferred to the U.S. 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. The plaintiffs in MDL No. 1663 filed a consolidated amended complaint in August 2005, which alleges, among other things, that the defendants violated federal and state antitrust laws, RICO, ERISA, and various state common law requirements by engaging in alleged bid rigging and customer allocation and by paying undisclosed compensation to insurance brokers to steer business to defendant insurers. Defendants filed a motion to dismiss the complaint on November 29, 2005. Various motions remain pending before the court. Rulings on these motions may be delayed pending a motion related to the potential recusal of the district court judge hearing the case.
We are a defendant in an action styled, Palm Tree Computers Systems, Inc. v. ACE USA, et al., which was filed in the Florida state Circuit Court on February 16, 2005. The complaint contains allegations similar to those made in the multidistrict litigation referred to above. The case was removed to federal court and, on October 20, 2005, the case was transferred to the District of New Jersey multidistrict litigation. A motion to remand the case to the state court in Florida remains pending, but no further action has been taken in the case subsequent to the transfer.
On December 21, 2004, a putative derivative action styled Leonard v. UnumProvident Corporation, et al., was filed in Tennessee Chancery Court against us and various members of our board of directors alleging claims on behalf of us against the 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. A motion to dismiss the complaint remains pending. The defendants strongly deny the allegations in the complaint and will vigorously defend both the substantive and procedural aspects of the litigation.
We deny the allegations in these matters and intend to vigorously contest them.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 15 - Commitments and Contingent Liabilities - Continued
Miscellaneous Matters
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 violations of the False Claims Act by us and our GENEX subsidiary. In accordance with 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 declined to prosecute the case and the case became a matter of public record on December 23, 2004. The complaint alleges that we defrauded the government by inducing and or assisting disability claimants to apply for disability benefits from the Social Security Administration (SSA) when we allegedly knew that the claimants were not disabled under SSA criteria. A motion to dismiss the complaint was unsuccessful. We intend to vigorously defend the action.
In certain of our 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 our subsidiaries acted either as pool managers or underwriting agents, as pool members, or as reinsurers. We or our 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 us 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 our consolidated financial position or results of operations in a period, depending on our results of operations for the particular period.
Note 16 - Statutory Financial Information
Statutory Net Income, Capital and Surplus, and Dividends
Statutory net income for U.S. life insurance companies is reported in conformity with statutory accounting principles prescribed by the National Association of Insurance Commissioners (NAIC) and adopted by applicable domiciliary state laws. For the years ended December 31, 2006, 2005, and 2004, our U.S. insurance subsidiaries’ statutory combined net income, excluding Tailwind Re, was $307.4 million, $641.8 million, and $607.6 million, respectively, and statutory combined net gain from operations was $371.5 million, $650.0 million, and $662.1 million, respectively. Statutory capital and surplus, excluding Tailwind Re, was $4,232.0 million and $4,270.2 million at December 31, 2006 and 2005, respectively. Tailwind Re, our South Carolina domiciled special purpose financial captive insurance subsidiary, had statutory net income and statutory net gain from operations of $14.1 million for the year ended December 31, 2006. Statutory capital and surplus for Tailwind Re at December 31, 2006 was $136.2 million.
Restrictions under applicable state insurance laws limit the amount of ordinary dividends that can be paid to a parent company from its insurance subsidiaries without prior approval by regulatory authorities. For life insurance companies domiciled in the United States, that limitation typically 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 a parent 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, $506.2 million is available for the payment of ordinary dividends from our U.S. insurance subsidiaries, excluding Tailwind Re, during 2007. The ability of Tailwind Re to pay dividends to its parent, Tailwind Holdings, a wholly-owned subsidiary of Unum Group, will depend on its satisfaction of applicable regulatory requirements and on the performance of the block of claims reinsured by Tailwind Re.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 16 - Statutory Financial Information - Continued
We also have the ability to draw a dividend from our United Kingdom insurance subsidiary, Unum Limited. Such dividends are limited based on insurance company legislation in the United Kingdom, which requires a minimum solvency margin. The amount available under current law for payment of dividends from Unum Limited during 2007 is approximately $200.2 million. Regulatory restrictions do not limit the amount of dividends available for distribution from our non-insurance subsidiaries.
Deposits
At December 31, 2006, our U.S. insurance subsidiaries had on deposit with U.S. regulatory authorities securities with a book value of $271.6 million held for the protection of policyholders. Additionally, securities with a book value of $29.5 million were on deposit with Canadian regulatory authorities at December 31, 2006.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 17 - Quarterly Results of Operations (Unaudited)
The following is a summary of our unaudited quarterly results of operations for 2006 and 2005:
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - Continued
Unum Group and Subsidiaries
Note 17 - Quarterly Results of Operations (Unaudited) - Continued
Items affecting the comparability of our financial results by quarter are as follows:
•
The fourth quarter of 2006 includes an income tax benefit of $91.9 million primarily as the result of group relief benefits obtained from the use of net operating losses in a foreign jurisdiction in which our businesses operate.
•
The third and first quarters of 2006 include claim reassessment charges of $325.4 million and $86.0 million before tax, respectively, and $211.5 million and $55.9 million after tax, respectively.
•
The third quarter of 2006 includes broker compensation settlement expenses of $18.5 million before tax and $12.7 million after tax.
•
The third quarter of 2005 includes claim reassessment charges of $75.0 million before tax and $51.6 million after tax.
•
The third and first quarters of 2005 include income tax benefits of $10.8 million and $32.0 million, respectively, related to the reduction of income tax liabilities.
See Notes 8, 9, and 15 for further discussion of the above items.
Financial results previously reported were revised in the preceding table for the classification of GENEX, our disability management services business, as a discontinued operation, as discussed in Notes 1 and 2. Premium income, net investment income, net realized investment gain (loss), and net income (loss) did not change as a result of the classification. The financial results for GENEX, which prior to the fourth quarter of 2006 were included in our results from continuing operations, are presented below. The financial results for the fourth quarter of 2006 are also presented for comparative purposes.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report. Based on that evaluation, these officers concluded that our disclosure controls and procedures were effective.
Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended. We assessed the effectiveness of our internal control over financial reporting, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and concluded that, as of December 31, 2006, we maintained effective internal control over financial reporting, as stated in our report which is included herein in Item 8.
The effectiveness of our internal control over financial reporting and our assessment of that effectiveness, as of December 31, 2006, have been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is included herein in Item 8.
In the ordinary course of business, our internal control over financial reporting changes as we modify and enhance our processes and information technology systems to meet changing needs and increase our efficiency. Any significant changes in internal controls are evaluated prior to implementation to help maintain the continued effectiveness of our internal control. While changes have occurred in our internal controls during the quarter ended December 31, 2006, there were no changes that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS OF THE REGISTRANT, AND CORPORATE GOVERNANCE
Directors
The information required by this Item with respect to a code of ethics for senior financial officers is included under the caption “Code of Business Practices and Ethics” in the Registrant’s Proxy Statement for the 2007 Annual Meeting of Stockholders and is incorporated herein by reference.
The information required by this Item with respect to directors is included under the captions “Election of Directors,” “Nominees for Election for Terms Expiring in 2009,” and “Continuing Directors” in the Registrant’s Proxy Statement for the 2007 Annual Meeting of Stockholders and is incorporated herein by reference.
The information required by this Item with respect to the audit committee and an audit committee financial expert is included under the caption “Audit Committee” in the Registrant’s Proxy Statement for the 2007 Annual Meeting of Stockholders and is incorporated herein by reference.
The information required by this Item with respect to compliance with Section 16(a) of the Exchange Act is included under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the Registrant’s Proxy Statement for the 2007 Annual Meeting of Stockholders and is incorporated herein by reference.
The information required by this Item with respect to executive officers of the registrant is incorporated by reference to “Executive Officers of the Registrant” contained herein in Item 1.
Code of Ethics
Our internet website address is www.unum.com. We have adopted corporate governance guidelines, a code of business practices and ethics, and charters for our board of directors’ audit, human capital, governance, finance, and regulatory compliance committees in accordance with NYSE requirements. These documents are available free of charge on the website and in print at the request of any stockholder from the Office of the Corporate Secretary, 1 Fountain Square, Chattanooga, Tennessee, 37402, or by calling toll-free 1-800-718-8824. Within the time period required by the Securities and Exchange Commission and the New York Stock Exchange, we will post on our website any amendment to the “Code of Business Practices and Ethics” and any waiver applicable to any executive officer, director, or senior financial officer (as defined in the Code).
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item is included under the captions “Compensation of Directors,” “Report of the Board Human Capital Committee on Executive Compensation,” “Compensation Discussion and Analysis,” and “Executive Compensation” in the Registrant’s Proxy Statement for the 2007 Annual Meeting of Stockholders and is incorporated herein by reference.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Equity Compensation Plan Information
The following table gives information as of December 31, 2006 about the common stock that may be issued under all of our existing equity compensation plans. The table does not include information with respect to shares subject to outstanding options granted under equity compensation plans assumed by us in connection with mergers and acquisitions of the companies that originally granted those options (see footnote 5).
(1) Includes the following plans: (a) Stock Plan of 1994, (b) Non-Employee Director Compensation Plan of 1998, (c) Stock Plan of 1999 and (d) Amended and Restated Management Incentive Compensation Plan of 1994. The number includes 12,744 performance shares granted under the Amended and Restated Management Incentive Compensation Plan of 1994.
(2) Includes shares under the following plans: (a) Stock Plan of 1999, (b) Non-Employee Director Compensation Plan of 1998, (c) Amended and Restated Management Incentive Compensation Plan of 1998, and (d) UnumProvident Employee Stock Purchase Plan.
(3) Includes the following plans: (a) Provident Companies, Inc. Employee Stock Option Plan of 1998, (b) UnumProvident Corporation Employee Stock Option Plan, (c) UnumProvident Corporation Broad Based Stock Plan of 2001, and (d) UnumProvident Corporation Broad Based Stock Plan of 2002.
(4) Includes the following plans: (a) UnumProvident Corporation Broad Based Stock Plan of 2001, (b) UnumProvident Corporation Broad Based Stock Plan of 2002, (c) Unum Limited Savings-Related Share Option Scheme 2000, (d) UnumProvident Corporation Stock Award Recognition Plan of 2002, and (e) UnumProvident Corporation Non-Employee Director Compensation Plan of 2004.
(5) The table does not include information for the following equity compensation plans assumed by the Company in connection with the merger of the company that originally established those plans: the UNUM Corporation 1990 Long-Term Incentive Plan, the UNUM Corporation 1998 Goals Plan, and the UNUM Corporation 1996 Long-Term Incentive Compensation Plan. As of December 31, 2006, a total of 1,081,664 shares of the Company’s common stock were issuable upon exercise of outstanding options under those assumed plans. The weighted average exercise price of those outstanding options is $45.16 per share. No additional options may be granted under those assumed plans.
Below is a brief description of the equity compensation plans not approved by stockholders:
Provident Companies, Inc. Employee Stock Option Plan of 1998
This plan provided for the award of stock options to employees not eligible for awards under another incentive compensation plan and, therefore, excluded all officers of the Company from participation. One hundred options and fifty options were granted respectively to each full time and part-time employee participant. The total number of options available for grant under this plan was 255,500. The plan terminated December 31, 1998. The plan was administered by the Human Capital Committee of the Board of Directors (Human Capital Committee). The stock options issued under the plan are non-qualified for U.S. tax purposes. The exercise price of options awarded under this plan was the fair market value of the stock on the date of grant. There are provisions for early vesting and/or early termination of the options in the event of retirement, death, disability, and termination of employment. The options outstanding as of June 30, 1999 vested in accordance with the provision of this plan effective with the merger of Unum Corporation with Provident Companies, Inc. There are provisions for adjustments to the number of shares available for grants, number of shares subject to outstanding grants, and the exercise price of outstanding grants in the event of stock splits, stock dividends, or other recapitalization.
UnumProvident Corporation Employee Stock Option Plan (1999)
This plan provided for the award of stock options to employees not eligible for awards under the other stock plans of the Company or at or below a position level as determined by the Human Capital Committee, and therefore excluded all officers of the Company from participation. One hundred and fifty options and seventy-five options were granted respectively to each full time and part-time employee participant. The total number of options available for grant under this plan was 3,500,000. This plan was terminated in February 2002. This plan was administered by the Human Capital Committee. The stock options issued under the plan are non-qualified for U.S. tax purposes. The exercise price of options awarded under this plan was the fair market value of the stock on the date of grant. There are provisions for early vesting and/or early termination of the options in the event of retirement, death, disability, and termination of employment. The plan also provides for acceleration of vesting if there is a change in control, subject to certain limitations, and in other circumstances at the Committee’s discretion. There are provisions for adjustments to the number of shares available for grants, number of shares subject to outstanding grants, and the exercise price of outstanding grants in the event of stock splits, stock dividends, or other recapitalization.
UnumProvident Corporation Broad Based Stock Plan of 2001
This plan provides for the grant of stock options to employees, officers, consultants, producers (as defined in the plan) and directors of the Company. The plan specifically prohibits the granting of any options under the plan to members of the Company’s Board of Directors and to any “officer” of the Company as defined in Rule 16a-1(f) under the 1934 Act or such other definition of the term “officer” as the New York Stock Exchange may subsequently adopt for purposes of its “broad-based” requirements of Rule 312.03 of NYSE Listed Company Manual. No awards have been made under the plan to employees above the level of Vice President. The total number of options available for grant under this plan was 2,000,000. The stock options are non-qualified for U.S. tax purposes. The exercise price of options awarded under this plan is the fair market value of the stock on the date of grant. The term of any option issued under the plan cannot exceed ten years. There are provisions for early vesting and/or early termination of the options in the event of retirement, death, disability, and termination of employment. The plan also provides for acceleration of vesting if there is a change in control, subject to certain limitations, and in other circumstances at the Committee’s discretion. The plan includes provisions for adjustments to the number of shares available for grants, number of shares subject to outstanding grants, and the exercise price of outstanding grants in the event of stock splits, stock dividends, or other recapitalization.
UnumProvident Corporation Broad Based Stock Plan of 2002
This plan provides for the grant of stock options to employees, officers, consultants, producers (as defined in the plan), and directors of the Company. The plan specifically prohibits the granting of any options under the plan to members of the Company’s Board of Directors and to any “officer” of the Company as defined in Rule 16a-1(f) under the 1934 Act or such other definition of the term “officer” as the New York Stock Exchange may subsequently adopt for purposes of its “broad-based” requirements of Rule 312.03 of NYSE Listed Company Manual. No awards have been made under the plan to employees above the level of Vice President. The total number of options available for grant under this plan was 2,390,000. The plan was terminated in February 2004. The stock options are non-qualified for U.S. tax purposes. The exercise price of options awarded under this plan is the fair market value of the stock on the date of grant. The term of any option issued under the plan cannot exceed ten years. There are provisions for early vesting and/or early termination of the options in the event of retirement, death, disability, and termination of employment. The plan also provides for acceleration of vesting if there is a change in control, subject to certain limitations, and in other circumstances at the Committee’s discretion. The plan includes provisions for adjustments to the number of shares available for grants, number of shares subject to outstanding grants, and the exercise price of outstanding grants in the event of stock splits, stock dividends, or other recapitalization.
UnumProvident Corporation Stock Award Recognition Plan of 2002
This plan provides for the grant of stock awards to employees of the Company who are at or below the level of Vice President and who are not officers, directors, or otherwise considered to be affiliates of the Company within the meaning of Rule 144 of the Securities Act of 1933. The plan is administered by the Chief Executive Officer. The total number of shares available for grant under this plan was 25,000. Stock awarded under the plan may be subject to restrictions. There are provisions for early vesting and/or early termination of restrictions in the event of retirement, death, disability, and termination of employment. The plan also provides for restrictions on awards to lapse if there is a change in control, subject to certain limitations, and in other circumstances at the CEO’s discretion. The plan includes provisions for adjustments to the number of shares available for grants and the number of shares subject to outstanding grants in the event of stock splits, stock dividends, or other recapitalization.
Unum Limited Savings-Related Share Option Plan 2000
This plan of the Company’s subsidiary, Unum Limited, in the United Kingdom allows employees of Unum Limited to acquire options for shares of the Company’s common stock by making an election to purchase stock at a price of at least 80% of the market value of the stock on the date prior to the date the invitation to apply for the option is made or, if greater, the nominal value of a share (the Acquisition Price). The total number of options available for grant under this plan was 200,000. The maximum contribution per month per employee is £150. Contributions are made for a three year period at the end of which the employee can elect to receive cash plus interest or purchase shares at the Acquisition Price. The directors of Unum Limited are the administrators of the plan. There are provisions for early expiration of options in the event of termination of employment and acceleration of vesting and expiration due to death, disability, or retirement. The plan also provides for acceleration of vesting upon a change of control, reconstruction, or voluntary winding up of the Company. The plan includes provisions for adjustments to the number of shares available for grants, and the number of shares subject to outstanding grants in the event of capitalization, consolidation sub-division or reduction, or other variation of the share capital of the Company.
UNUM Corporation 1998 Goals Stock Option Plan
This plan which was assumed by the Company pursuant to the merger, provided for the grant in 1995 of three hundred options to employees below the level of Vice President. Employees who were hired in 1996 and 1997 automatically received two hundred and one hundred options respectively. The vesting of the options was contingent on meeting specified “1998 Goals,” long-term goals established at the time the plan was adopted. The Chief Executive Officer was the administrator of the plan. The total number of options available for grant under this plan was 3,000,000. No new grants could be made under the plan after 1997. The exercise price of options awarded under this plan was the fair market value of the stock on the date of grant. There are provisions for early vesting and/or early termination of the options in the event of retirement, death, disability, and termination of employment. The plan also provides for acceleration of vesting if there is a change in control. The plan includes provisions for adjustments to the number of shares available for grants, number of shares subject to outstanding grants, and the exercise price of outstanding grants in the event of stock splits, stock dividends, or other recapitalization.
UnumProvident Corporation Amended and Restated Non-Employee Director Compensation Plan of 2004
This plan provides for the payment of compensation to the non-employee directors who serve on the Company’s Board. Non-employee directors receive an annual retainer of $80,000, the chairs of the standing committees receive an additional retainer of $7,500, and all directors receive $2,000 for each meeting attended in person and $500 for each conference call meeting of the Board and of the committees on which they participate, including special committees. Under the plan, directors make an irrevocable election each year to receive all or a portion of their retainers and meeting fees in either cash or deferred share rights. A deferred share right is a right to receive one share of common stock on the earlier of (i) the director’s termination of service as a director of the Company, or (ii) another designated date at least three years after the date of the deferral election. The number of deferred share rights granted is calculated as the number of whole shares equal to (i) the dollar amount of the annual retainer and/or fees that the director elects to have paid in deferred share rights, divided by (ii) the fair market value per share on the grant date. The aggregate number of shares which can be issued under the plan is 500,000. The plan is administered by the Human Capital Committee. The plan includes provisions restricting the transferability of the deferred share rights, provisions for adjustments to the number of shares available for grants, and the number of shares subject to outstanding grants in the event of recapitalization, reclassification, stock split, reverse stock split, reorganization, merger, consolidation, or other similar corporate transaction. There are stock ownership guidelines for participants under the plan.
Other information required by Item 12 is included under the captions, “Beneficial Ownership of Company Securities,” and “Security Ownership of Directors and Officers” of the Registrant’s Proxy Statement for the 2007 Annual Meeting of Stockholders and is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
The information required by this Item with respect to certain relationships and related transactions and director independence is included under the captions “Determination of Independence of Directors” and “Independence of Directors” in the Registrant’s Proxy Statement for the 2007 Annual Meeting of Stockholders and is incorporated by reference herein.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Audit Fees
The aggregate fees and expenses related to professional services rendered by Ernst & Young LLP for the fiscal year audit of our annual financial statements and internal control over financial reporting, the interim reviews of the financial statements included in our quarterly reports on Form 10-Q, and services provided in connection with statutory and regulatory filings were $7,460,931 and $7,423,203, respectively, for fiscal years 2006 and 2005.
Audit Related Fees
The aggregate fees and expenses related to professional services rendered by Ernst & Young LLP for audit related services, comprised primarily of accounting consultations, SAS 70 reviews, and audit related services for our employee benefit plans, for fiscal years 2006 and 2005 were $753,136 and $687,088, respectively.
Tax Fees
The aggregate fees and expenses related to professional services rendered by Ernst & Young LLP for tax planning during fiscal years 2006 and 2005 were $84,156 and $440,078, respectively.
Audit Committee Pre-approval Policies
The audit committee of our board of directors is directly responsible for the appointment, compensation, retention, and oversight of the independent auditors. As part of its responsibility, the audit committee has adopted a policy that requires advance approval of all audit, audit-related, tax services, and other services performed by the independent auditor. The policy provides for setting pre-approval limits for specifically defined audit and non-audit services. In pre-approving the services, the audit committee considers whether such services are consistent with SEC rules on auditor independence. Specific approval by the audit committee will be required if fees for any particular service or aggregate fees for services of a similar nature exceed the pre-approved limits. The audit committee has delegated to the chair of the audit committee authority to approve permitted services provided that the chair reports any decisions to the committee at its next scheduled meeting.
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SCHEDULE I-SUMMARY OF INVESTMENTS -
OTHER THAN INVESTMENTS IN RELATED PARTIES
Unum Group and Subsidiaries
* Difference between cost and carrying value results from certain valuation allowances and other temporary declines in value.
SCHEDULE II-CONDENSED FINANCIAL INFORMATION OF REGISTRANT
Unum Group (Parent Company)
BALANCE SHEETS
See notes to condensed financial information.
SCHEDULE II-CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued)
Unum Group (Parent Company)
STATEMENTS OF OPERATIONS
See notes to condensed financial information.
SCHEDULE II-CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued)
Unum Group (Parent Company)
STATEMENTS OF CASH FLOWS
See notes to condensed financial information.
SCHEDULE II-CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued)
Unum Group (Parent Company)
NOTES TO CONDENSED FINANCIAL INFORMATION
Note 1 - Basis of Presentation
The accompanying condensed financial statements should be read in conjunction with the consolidated financial statements and notes thereto of Unum Group and Subsidiaries.
Note 2 - Surplus Notes of Subsidiaries
Outstanding surplus debentures issued by insurance subsidiaries to Unum Group (Parent Company) totaled $100.0 million and $250.0 million at December 31, 2006 and 2005, respectively. A $100.0 million surplus debenture due in 2027 was held at December 31, 2006 and 2005. At December 31, 2005, Unum Group also held a $150.0 million surplus debenture which was redeemed at maturity in December 2006. Semi-annual interest payments are conditional upon approval by the insurance departments of the subsidiaries’ states of domicile. The weighted average interest rate for surplus notes of subsidiaries was 8.2 percent in 2006 and 8.4 percent in 2005 and 2004.
Note 3 - Debt
Long-term debt consists of the following:
The 7.25% notes due 2032 are redeemable at our option on or after June 25, 2007. The adjustable conversion-rate equity security units, the 5.997% notes due 2008, and the junior subordinated debt securities due 2038 are callable under limited, specified circumstances. The remaining callable debt may be redeemed, in whole or in part, at any time. The aggregate contractual principal maturities are $175.0 million in 2008, $300.0 million in 2009, $325.0 million in 2011, and $1,362.0 million in 2012 and thereafter.
The scheduled remarketing of the senior note element of the adjustable conversion-rate equity security units (units) issued in May 2004 occurred in February 2007, as stipulated by the terms of the original offering, and we reset the interest rate on $300.0 million of senior notes due May 15, 2009 to 5.859%. We purchased $150.0 million of the senior notes in the remarketing which were subsequently retired.
The scheduled remarketing of the senior note element of the units issued in May 2003 occurred in February 2006, as stipulated by the terms of the original offering, and we reset the interest rate on $575.0 million of senior notes due May 15, 2008 to 5.997%. We purchased $400.0 million of the senior notes in the remarketing which were subsequently retired.
SCHEDULE II-CONDENSED FINANCIAL INFORMATION OF REGISTRANT (Continued)
Unum Group (Parent Company)
NOTES TO CONDENSED FINANCIAL INFORMATION - CONTINUED
In June 2006, pursuant to a cash tender offer, we purchased $50.0 million of our outstanding 7.405% junior subordinated debt securities due 2038 and $250.0 million aggregate principal amount of our outstanding 7.625% notes due 2011.
In 1998, Provident Financing Trust I (the trust) issued $300.0 million of 7.405% capital securities in a public offering. These capital securities, which mature on March 15, 2038, are fully and unconditionally guaranteed by us, have a liquidation value of $1,000 per capital security, and have a mandatory redemption feature under certain circumstances. We issued 7.405% junior subordinated deferrable interest debentures which mature on March 15, 2038, to the trust in connection with the capital securities offering. The sole assets of the trust are the junior subordinated debt securities.
Note 4 - Guarantees
In November 2005, UnumProvident Finance Company plc, a wholly owned subsidiary, issued $400.0 million of 6.85% senior debentures due November 15, 2015 in a private offering. We fully and unconditionally guarantee these debentures. In December 2006, $32.0 million of these debentures were redeemed by UnumProvident Finance Company plc.
In connection with the debt issuance, UnumProvident Finance Company plc entered into several foreign currency interest rate swaps and a foreign currency forward contract. We have guaranteed the counterparty will receive required periodic settlement payments and are required to post collateral in the event the contracts are in a net loss position. At December 31, 2006, the notional amount of the foreign currency interest rate swaps outstanding was $367.8 million, and the notional amount of the foreign currency forward contract was $216.3 million. See Note 5 of the “Notes to Consolidated Financial Statements” contained herein in Item 8 for further discussion.
SCHEDULE III-SUPPLEMENTARY INSURANCE INFORMATION
Unum Group and Subsidiaries
SCHEDULE III-SUPPLEMENTARY INSURANCE INFORMATION
Unum Group and Subsidiaries
(continued from preceding page)
(1) Net investment income is allocated based upon segmentation. Each segment has its own specifically identified assets and receives the investment income generated by those assets.
(2) Includes commissions, interest and debt expense, cost related to early retirement of debt, deferral of policy acquisition costs, amortization of value of business acquired, compensation expense, and other operating expenses. Included for 2004 are charges related to the 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. Where not directly attributable to a segment, expenses are generally allocated based on activity levels, time information, and usage statistics. Prior year amounts have been restated to exclude discontinued operations.
(3) Excludes life insurance.
SCHEDULE IV-REINSURANCE
Unum Group and Subsidiaries
SCHEDULE V-VALUATION AND QUALIFYING ACCOUNTS
Unum Group and Subsidiaries
(1) Deductions include amounts deemed to reduce exposure of probable losses, amounts applied to specific loans at time of sale/foreclosure, and amounts deemed uncollectible.
Prior year amounts have been restated to exclude discontinued operations.
INDEX TO EXHIBITS
Certain instruments defining the rights of holders of long-term debt securities of Unum Group and its subsidiaries are omitted pursuant to Item 601(b)(4)(iii) of Regulation S-K. Unum Group hereby undertakes to furnish to the Securities and Exchange Commission, upon request, copies of any such instruments.
* Management contract or compensatory plan required to be filed as an exhibit to this form pursuant to Item 15(c) of Form 10-K.