Item 1. Business
GENERAL
StanCorp Financial Group, Inc. was incorporated in 1998 in Oregon. As used in this report, the terms “StanCorp,” “Company,” “we,” “us” and “our” refer to StanCorp Financial Group, Inc. and its subsidiaries, unless the context indicates otherwise. Our investor relations website is www.stancorpfinancial.com. We post on our investor relations website our annual reports on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 (“Exchange Act”) as soon as reasonably practicable after they are electronically filed with or furnished to the Securities and Exchange Commission (“SEC”). The filings on our investor relations website are available free of charge. We also make available on our investor relations website our Corporate Governance Guidelines, our Codes of Business Conduct and Ethics (including any waivers granted to executive officers or directors), and the charters of the Audit, Organization & Compensation, and Nominating & Corporate Governance Committees of our Board of Directors. The information contained on our website is not part of, or incorporated by reference in, this annual report on Form 10-K. These documents are also available in print without charge to any person who requests them by writing or telephoning our Shareholder Services Department, StanCorp Financial Group, Inc., 1100 SW Sixth Avenue, Portland, OR 97204, (800) 378-8360.
We are headquartered in Portland, Oregon and are a holding company for our Insurance Services and Asset Management subsidiaries and for subsidiaries included in our Other category. Our insurance businesses offer group and individual disability insurance, group life and accidental death and dismemberment (“AD&D”) insurance, group dental and group vision insurance, and absence management services. Through our insurance subsidiaries, we have the authority to underwrite insurance products in all 50 states as well as the District of Columbia and the U.S. territories of Guam, Puerto Rico and the Virgin Islands. Our asset management businesses offer full-service 401(k) plans, 403(b) plans, 457 plans, defined benefit plans, money purchase pension plans, profit sharing plans and non-qualified deferred compensation products and services. Our asset management businesses also offer investment advisory and management services, origination and servicing of fixed-rate commercial mortgage loans, individual fixed and indexed annuity products, group annuity contracts and retirement plan trust products, and manage certain real estate properties. A subsidiary included in our Other category owns and manages certain real estate properties held for sale from time to time in conjunction with our real estate business.
CORPORATE STRATEGY
Our strategy is to exceed customers’ needs for financial products and services in growing markets where the application of specialized expertise creates potential for superior shareholder returns. Our core purpose is to help people achieve financial well-being and peace of mind with industry-leading expertise. Our vision is to lead the financial services industry in integrity, expertise and customer service. We operate in select financial products and services markets and seek to compete on expertise, differentiation and customer service, while maintaining a strong financial position.
Our long-term strategy includes:
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Maintain strong growth rates in traditional risk acceptance businesses (disability and group life insurance).
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Seek to expand growth opportunities by increasing penetration in markets where we have limited presence.
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Drive the right mix of business to achieve profitable growth.
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Seek to diversify our earnings base by taking advantage of market opportunities, demographic trends and capital synergies.
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Return value to shareholders through strategic uses of capital.
Our ability to accomplish this strategy is dependent on a number of factors, some of which involve risks or uncertainties. See “Competition” and “Key Factors Affecting Results of Operations” below and Item 1A, “Risk Factors,” of this Report.
STANCORP AND SUBSIDIARIES
StanCorp, headquartered in Portland, Oregon, is a holding company and conducts business through wholly-owned operating subsidiaries throughout the United States. Through our subsidiaries, we have the authority to underwrite insurance products in all 50 states as well as the District of Columbia and the U.S. territories of Guam, Puerto Rico and the Virgin Islands.
StanCorp has the following wholly-owned operating subsidiaries: Standard Insurance Company (“Standard”), The Standard Life Insurance Company of New York, Standard Retirement Services, Inc. (“Standard Retirement Services”), StanCorp Equities, Inc. (“StanCorp Equities”), StanCorp Mortgage Investors, LLC (“StanCorp Mortgage Investors”), StanCorp Investment Advisers, Inc. (“StanCorp Investment Advisers”), StanCorp Real Estate, LLC (“StanCorp Real Estate”), Standard Management, Inc. (“Standard Management”), and StanCap Insurance Company, Inc. (“StanCap Insurance Company”).
Standard, our largest subsidiary, underwrites group and individual disability insurance and annuity products, group life and AD&D insurance, and provides group dental and group vision insurance, absence management services and retirement plan products. Founded in 1906, Standard is domiciled in Oregon, licensed in all states except New York, and licensed in the District of Columbia and the U.S. territories of Guam, Puerto Rico and the Virgin Islands.
The Standard Life Insurance Company of New York was organized in 2000 and is licensed to provide group and individual disability insurance, group life and AD&D insurance, group dental insurance and vision insurance in New York.
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The Standard is a service mark of StanCorp and its subsidiaries and is used as a brand mark and marketing name by Standard and The Standard Life Insurance Company of New York.
Standard Retirement Services administers and services our retirement plans group annuity contracts and trust products. Retirement plan products are offered in all 50 states through Standard or Standard Retirement Services.
StanCorp Equities is a limited business broker-dealer and member of the Financial Industry Regulatory Authority. As a wholesaler, StanCorp Equities activities are limited to soliciting and supporting third-party broker-dealers and investment advisers that offer or advise their retirement plan clients on using an unregistered group annuity contract or a mutual fund trust platform.
StanCorp Mortgage Investors originates and services fixed-rate commercial mortgage loans for the investment portfolios of our insurance subsidiaries. StanCorp Mortgage Investors also generates additional fee income from the origination and servicing of commercial mortgage loans participated to institutional investors.
StanCorp Investment Advisers is an SEC-registered investment adviser providing performance analysis, fund selection support, model portfolios and other investment advisory and investment management services.
StanCorp Real Estate is a property management company that owns and manages our Hillsboro, Oregon home office properties and other properties held for investment and held for sale. StanCorp Real Estate also manages the Portland, Oregon home office properties.
Standard Management manages certain real estate properties held for sale from time-to-time in conjunction with our real estate business.
StanCap Insurance Company is a pure captive insurance company domiciled in Oregon. Effective September 30, 2014, StanCap Insurance Company entered into a reinsurance agreement with Standard to reinsure Standard’s group life and AD&D insurance business.
MARKET POSITION
Based on the United States insurance industry in-force premium statistics, we have leading market positions with single digit market share in group long term and short term disability insurance, group life insurance and individual disability insurance. These statistics were based on the most recent annual Gen Re insurance industry reports available as of January 2015. The market positions are as follows:
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5th largest provider of group long term disability insurance.
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5th largest provider of group short term disability insurance.
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8th largest provider of group life insurance.
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7th largest provider of individual disability insurance.
FINANCIAL STRENGTH AND CREDIT RATINGS
Financial strength ratings are gauges of our claims paying ability and are an important factor in establishing the competitive position of insurance companies. In addition, ratings are important for maintaining public confidence in our Company and in our ability to market our products. Rating organizations regularly review the financial performance and condition of insurance companies. In addition, credit ratings on our 10-year senior notes (“Senior Notes”) and junior subordinated debentures (“Subordinated Debt”) are tied to our financial strength ratings. A ratings downgrade could increase surrender levels for our annuity products, adversely affect our ability to market our products and increase costs of future debt issuances.
Standard & Poor’s (“S&P”), Moody’s Investors Service, Inc. (“Moody’s”) and A.M. Best Company (“A.M. Best”) provide financial strength ratings on Standard.
The following table sets forth Standard’s financial strength ratings as of January 2015:
(1) Also includes The Standard Life Insurance Company of New York
Debt ratings assess credit quality and the likelihood of issuer default. S&P, Moody’s and A.M. Best provide ratings on StanCorp’s Senior Notes and Subordinated Debt. S&P and A.M. Best also provide issuer credit ratings for both Standard and StanCorp.
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The following table sets forth our debt ratings and issuer credit ratings as of January 2015:
(1) Also includes The Standard Life Insurance Company of New York
We believe our well-managed underwriting and claims operations, high quality invested asset portfolios, enterprise risk management processes and strong capital position will continue to support our ability to meet policyholder obligations. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Asset-Liability and Interest Rate Risk Management” and Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Capital Management.” In addition, we remain well within our financial covenants. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Financing Cash Flows.”
SEGMENTS
We collectively view and operate our businesses as Insurance Services and Asset Management. Insurance Services contains two reportable product segments, Employee Benefits and Individual Disability. Asset Management is a separate reportable segment. Holding company and corporate activities are reported in the Other category. Resources are allocated and performance is evaluated at the segment level.
Total revenues for 2014 excluding losses associated with revenues of $15.2 million from the Other category were $2.79 billion. Revenues from Insurance Services were $2.36 billion or 84.7%, with $2.11 billion or 75.7% in revenues from Employee Benefits and $251.4 million or 9.0% in revenues from Individual Disability. Revenues from Asset Management were $427.2 million or 15.3%. Revenues from the Other category included net capital losses of $14.0 million. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Consolidated Results of Operations-Revenues” and Part II, Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 5-Segments” for segment information regarding revenues, expenses and total assets for the years 2014, 2013 and 2012.
Insurance Services
Insurance Services is comprised of our Employee Benefits and Individual Disability segments, and offers group life and AD&D insurance, group and individual disability insurance, group dental and group vision insurance, and absence management services to individuals and employer groups ranging in size from two lives to 170,000 lives. We have approximately 42,000 group insurance policies in-force, covering approximately 6.1 million employees as of December 31, 2014.
Employee Benefits
Our Employee Benefits products are sold by sales representatives through independent employee benefit brokers and consultants. The sales representatives, who are employees of the Company, are compensated through salary and incentive compensation programs and are located in 39 field offices in principal metropolitan areas of the United States. The field offices also provide sales support and customer service through field administrative staff. Our arrangements with brokers include compensation established at the time of sale (commissions or fees) and, in some situations, also include compensation related to the overall performance of a block of business (performance-related compensation). In most cases, the overall performance of a block of business is measured in terms of volume and persistency (customer retention).
Group life and AD&D insurance contributed $797.8 million, net of Experience Rated Refunds (“ERRs”), or 39.1% of 2014 premiums for Insurance Services. Group life insurance products provide coverage to insured employees for a specified period and have no cash value (amount of cash available to an insured employee on the surrender of, or withdrawal from, the life insurance policy). Coverage is offered to insured employees and their dependents. AD&D insurance is usually provided in conjunction with group life insurance, and is payable after the accidental death or dismemberment of the insured in an amount based on the face amount of the policy or dismemberment schedule.
Group long term disability insurance contributed $748.6 million, net of ERRs, or 36.6% of 2014 premiums for Insurance Services. Group long term disability insurance provides partial replacement of earnings to insured employees who become disabled for extended periods of time.
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Our basic long term disability insurance product covers disabilities that occur during the policy period at both work and elsewhere. In order to receive long term disability insurance benefits, an employee must be continuously disabled beyond a specified waiting period, which generally ranges from 30 to 180 days. The benefits are usually reduced by other income that the disabled employee receives from sources such as social security disability, workers compensation and sick leave. The benefits may also be subject to certain maximum amounts and benefit periods.
Generally, group long term disability insurance policies offer rate guarantees on premiums for periods from one to three years. While we can prospectively re-price and re-underwrite coverage at the end of these guarantee periods, we must pay benefits with respect to claims incurred during these periods without being able to increase guaranteed premium rates during the same periods.
Group short term disability insurance contributed $217.7 million, net of ERRs, or 10.6% of 2014 premiums for Insurance Services. Our basic short term disability products generally cover only disabilities occurring outside of work. Short term disability insurance generally requires a short waiting period, ranging from one to 30 days, before an insured employee may receive benefits, with maximum benefit periods generally not exceeding 180 days. Group short term disability benefits may also be reduced by other income that the disabled employee receives from sources such as social security disability, workers compensation and sick leave.
Our other insurance premiums include group dental and group vision insurance and contributed $78.7 million, net of ERRs, or 3.9% of 2014 premiums for Insurance Services. Group dental products provide coverage to insured employees and their dependents for preventive, basic and major dental expenses, and also include an option to purchase orthodontia benefits. We offer three dental plans including a traditional plan, a reduced cost plan and a cost containment plan that are differentiated by levels of service and cost. Standard has a strategic marketing alliance with Ameritas Life Insurance Corp. (“Ameritas”), which offers Standard’s policyholders flexible dental coverage options and access to Ameritas’ nationwide preferred provider organization panel of dentists.
Our group vision products provide coverage to insured employees and their dependents for essential eye care services including exams, frames, a variety of lens options and contact lenses. We offer three vision plans that are differentiated by vision-care provider network coverage.
We also offer absence management services that allow employers to outsource administrative services and compliance support for short term disability, federal and state leaves of absence, and other employer-specific leaves of absence.
Individual Disability
Individual Disability contributed $199.1 million or 9.8% of 2014 premiums for Insurance Services. The products include non-cancelable disability coverage that provides insurance at a guaranteed fixed premium rate for the life of the contract, and guaranteed renewable coverage where premium rates are guaranteed for limited periods and are subject to change thereafter. Non-cancelable disability insurance policies represented 77.2% of Individual Disability policies in-force as of December 31, 2014. We also offer a product with features that provide coverage in the event of partial disability or loss of income while caring for a family member with a serious health condition as well as medical and legal specialty protection. In addition, we offer business overhead expense coverage that reimburses covered operating expenses when the insured is disabled, and business equity buy-out coverage that provides payment for the purchase, by other owners or partners, of the insured’s ownership interest in a business in the event of total disability.
Individual Disability products are sold nationally by brokers through master general agents, primarily to physicians, lawyers, executives, other professionals and small business owners. The compensation paid to brokers and master general agents is based primarily on a percentage of premiums. Master general agents are eligible for a bonus based on sales volume of business they have written.
Asset Management
Asset Management offers full-service 401(k) plans, 403(b) plans, 457 plans, defined benefit plans, money purchase pension plans, profit sharing plans and non-qualified deferred compensation products and services. This segment also offers investment advisory and management services, origination and servicing of fixed-rate commercial mortgage loans, individual fixed-rate and indexed annuity products, group annuity contracts and retirement plan trust products.
Retirement plans contributed $214.6 million or 50.2% of 2014 revenues for Asset Management. Recordkeeping services for 401(k), defined benefit plans and governmental 457 plans are provided through an unregistered group annuity contract with third-party brand name mutual funds through a separate account and a stable value investment option managed by Standard. These plan services are also provided through an open architecture (“NAV”) platform offering mutual funds and a stable value investment option managed by Standard. Plans on the NAV platform can choose from any mutual fund that our trading partners are able to trade. We also provide a stable value investment option available on an investment-only basis to retirement plans for which Standard does not provide recordkeeping services. Retirement plan assets under administration were $19.02 billion at December 31, 2014.
Mutual funds offered through the group annuity separate account as of December 31, 2014 are limited to those funds that have been evaluated through a due diligence process. Representative fund companies are: Dodge & Cox, Federated Investors Funds, Harbor Funds, Oppenheimer Funds, T. Rowe Price Funds and Vanguard Funds. Funds offered in our group annuity retirement plans are regularly evaluated for performance, expense ratios, risk statistics, style consistency, industry diversification and management through the investment advisory service we provide to our customers. Funds are added and removed as part of this evaluation process.
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StanCorp Investment Advisers provides fund performance analysis and selection support to 87.0% of our group annuity plan sponsors. All group annuity contracts are distributed through StanCorp Equities.
Services for 403(b) and non-qualified deferred compensation plans are available on the NAV platform.
Our target market for retirement plans is primarily small to mid-size businesses. Our retirement plans products and services are sold primarily through registered investment advisors, brokers, employee benefit consultants and other distributors served by our sales representatives throughout the United States. These distributors are usually compensated based on a percentage of the deposits or assets under administration. Compensation is disclosed to the customer by either Standard or Standard Retirement Services. Most of our retirement plan customers receive financial, record keeping and administrative services, although the option is available to receive only financial and record keeping services or financial services only.
The primary sources of revenue for the retirement plans business include plan administration fees, asset-based fees and investment income on general account assets under administration, a portion of which is credited to policyholders. In addition, premiums and benefits to policyholders reflect the conversion of retirement plan assets into life-contingent annuities, which is an option that can be selected by plan participants at the time of retirement.
The Standard earned a total of 24 Best in Class awards in PlanSponsor Magazine’s 2014 Defined Contribution Survey. All of the Best in Class awards were in the less than $5 million and $5 million to $25 million in plan assets categories.
Individual annuities contributed $164.7 million or 38.6% of 2014 revenues for Asset Management. The individual annuity products sold are primarily fixed-rate and indexed deferred annuities. We also sell immediate annuities. Our target market for annuities is any individual seeking conservative investments to meet their retirement or other financial goals.
The fixed-rate annuity product portfolio includes deferred annuities with initial interest rate guarantees ranging from one to ten years and a full array of single premium immediate annuity income payment options. We also offer an indexed annuity product and invest in over-the-counter call-spread options to hedge account value growth linked to the performance of the S&P 500 index.
Fixed and indexed annuities are distributed through independent producers and financial institutions, including banks, credit unions and broker dealer organizations. This is accomplished through a network of national marketing organizations (“NMOs”) who attract, train and support financial institutions, brokers and producers on our behalf. The NMOs, financial institutions, brokers and independent producers are compensated based on a percentage of premiums and deposits related to annuity sales. NMOs are also eligible for a bonus based on the volume of annuity business sold by the financial institutions and producers they support.
Most of our annuity business deposits are not recorded as premiums, but rather are recorded as liabilities. Individual fixed-rate annuity deposits earn investment income, a portion of which is credited to policyholders. Annuity premiums consist of premiums on life-contingent annuities, which are a small portion of total sales.
Our other financial services businesses include our investment advisory, real estate management and commercial mortgage loan origination businesses. These businesses contributed $47.9 million or 11.2% of 2014 revenues for Asset Management.
Our investment advisory business, StanCorp Investment Advisers, provides performance analysis, fund selection support, model portfolios and other investment advisory and investment management services.
StanCorp Mortgage Investors underwrites, originates and services fixed-rate commercial mortgage loans, generally between $250,000 and $5 million per loan for the investment portfolios of our insurance subsidiaries. It also generates additional fee income from the origination and servicing of commercial mortgage loans participated to institutional investors. The target market for commercial mortgage loans is small retail, industrial and office properties located throughout the continental United States.
Other
We report our holding company and corporate activities in the Other category. This category includes return on capital not allocated to the product segments, holding company expenses, operations of certain unallocated subsidiaries, interest on debt, unallocated expenses, net capital gains and losses primarily related to the impairment or the disposition of our invested assets and adjustments made in consolidation.
COMPETITION
Competition for the sale of our products comes primarily from other insurers and financial services companies such as banks, broker-dealers, mutual funds, and managed care providers for employer groups, individual consumers and distributors. Some competitors have greater financial resources, offer a broader array of products and have higher financial strength ratings. Pricing is competitive in the markets we serve. We seek to compete on expertise and do not seek to compete primarily on price. While we believe our products and services provide superior value to our customers, a significant price difference between our products and those of some of our competitors may result in periods of declining new sales, reduced persistency, declining premium levels and increased sales force attrition. See “Key Factors Affecting Results of Operations-Pricing.”
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KEY FACTORS AFFECTING RESULTS OF OPERATIONS
Insurance Services represented approximately 77%, 77% and 74% of total income before income taxes, excluding the Other category, for the years ended December 31, 2014, 2013 and 2012, respectively. In addition to competition, four primary factors can have a critical impact on the financial results of Insurance Services operations: pricing; claims experience; wage, employment and benefit levels; and interest rates.
Asset Management represented approximately 23%, 23% and 26% of total income before income taxes, excluding the Other category, for the years ended December 31, 2014, 2013 and 2012, respectively. The financial results of Asset Management are primarily impacted by wage, employment and benefit levels, interest rates and equity and bond market performance.
Pricing. One of the key components of our pricing decisions for many of our insurance products is the investment return available to us. In periods of decreasing or low interest rates, the returns available to us from our primary investments, fixed maturity securities-available-for-sale (“fixed maturity securities”) and commercial mortgage loans, decline. This may require us to increase the price of some of our products in order to maintain our targeted returns. If our competitors do not make similar adjustments to their product pricing or if they have a higher return on investments, our products may be more expensive than those offered by competitors. Alternatively, in periods when interest rates are increasing, we may be able to reduce premium rates, and therefore reduce pricing pressure to customers. We believe that our practice of maintaining a disciplined approach to product pricing that considers investment returns provides the best long-term pricing strategy, higher levels of persistency, and therefore, the best long-term financial success for our company.
Claims Experience. The predominant factors affecting claims experience are incidence, represented by the number of claims, and severity, represented by the length of time a disability claim is paid and the size of the claim. We have a large and diversified insurance business. However, claims experience can fluctuate widely, particularly from quarter to quarter.
Wage, Employment and Benefit Levels. In our insurance businesses, premium rates are partly based on total salaries covered. The rate of wage and employment growth can influence organic growth of premiums. In addition, economic conditions can impact demand for the Employee Benefits products we offer and can increase competition for market share as overall market growth declines. Due to the customer mix of our group insurance business with approximately half of our group long term disability and group life insurance premiums coming from the state and local public sector and education industries, the timing and impact of changes to the wage and employment environment on our results may differ from trends in the general economy.
In our asset management businesses, the growth in wages and employment levels affects the level of new deposits for the retirement plans we administer, which affects the amount of administrative fees we earn.
Interest Rates. Our financial results are sensitive to changing interest rates. Changes in interest rates affect product pricing for our insurance businesses because premiums must be invested to provide a return sufficient to meet the future claims of policyholders. Therefore, we closely monitor changes in interest rates and make changes to our pricing, as appropriate. Interest rates also affect the discount rates we use to establish reserves.
For those products in our asset accumulation businesses where deposits are invested in securities managed by us, achieving adequate interest rates is important to meet customer obligations, including our annuity obligations.
Equity and Bond Market Performance. Changes in equity and bond market performance affect the value of the assets under administration for our retirement plans business, which is a primary driver of administrative fees we earn.
RISK MANAGEMENT
We manage our risk associated with our businesses through the following practices:
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Sound product design and underwriting.
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Effective claims management.
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Pricing discipline.
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Broad diversification of risk by customer industry, geography, size and occupation.
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Maintenance of a strong financial position.
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Maintenance of reinsurance and risk pool arrangements.
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Sufficient alignment of assets and liabilities to meet financial obligations.
Diversification of Products
We achieve earnings diversification by offering multiple insurance products such as group life and AD&D insurance, group and individual disability insurance, group dental and group vision insurance, and absence management services. In addition, we diversify our earnings base through our asset management businesses, which include products such as full-service retirement plans, money purchase pension plans, defined benefit plans, non-qualified deferred compensation products, investment advisory and management services, origination and servicing of fixed-rate commercial mortgage loans, individual fixed and indexed annuity products, group annuity contracts and retirement plan trust products. These products have differing price, market and risk characteristics. Our strategy is to diversify our earnings base and take advantage of market opportunities, demographic trends and capital synergies.
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Diversification by Customer Industry, Geography and Size
We seek to diversify risk by customer industry, geography and size measured by the number of insured employees in each of our business segments. Approximately half of our group long term disability and group life insurance premiums come from the state and local public sector and education industries in which we have expertise and a competitive advantage.
The following tables set forth in-force premium distribution by customer industry, geography and size for group long term disability and group life insurance products:
Reinsurance
In order to limit our losses from large claim exposures, we enter into reinsurance agreements with other insurance companies. We review our retention limits based on customer size and experience. The maximum retention limit for group life and AD&D is $750,000 per individual. Our maximum retention limit for group disability insurance is $15,000 of monthly benefit per individual. Our maximum retention limit for individual disability insurance is $7,500 of monthly benefit per individual.
Standard maintains a strategic marketing alliance with Ameritas that offers Standard’s policyholders flexible dental coverage options and access to Ameritas’ nationwide preferred provider organization panel of dentists. As part of this alliance, Standard and Ameritas entered into a reinsurance agreement. In 2014, the agreement provided for 26.1% of the net dental premiums written by Standard and the risk associated with this premium to be ceded to Ameritas.
Standard participates in a reinsurance and third-party administration arrangement with Northwestern Mutual Life Insurance Company (“Northwestern Mutual”) under which Northwestern Mutual group long term and short term disability products are sold using Northwestern Mutual’s agency distribution system. Generally, Standard assumes 60% of the risk, and receives 60% of the premiums for the policies issued. If Standard were to become unable to meet its obligations, Northwestern Mutual would retain the reinsured liabilities. Therefore, in accordance with an agreement with Northwestern Mutual, Standard established a trust for the benefit of Northwestern Mutual with the market value of the assets in the trust equal to Northwestern Mutual’s reinsurance receivable from Standard. The market value of the assets required to be maintained in the trust was $241.1 million at December 31, 2014. Premiums assumed by Standard for the Northwestern Mutual business accounted for approximately 3% of our total premiums for
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each of the three years 2014, 2013 and 2012. In addition to assuming risk, Standard provides product design, pricing, underwriting, legal support, claims management and other administrative services under the arrangement.
Effective September 30, 2014, StanCap Insurance Company entered into a reinsurance agreement with Standard to reinsure Standard’s group life and AD&D business. This reinsurance agreement between StanCap Insurance Company and Standard replaced the yearly renewable term group life reinsurance agreement with Canada Life Assurance Company, which was terminated effective September 30, 2014. The intercompany transactions between Standard and StanCap Insurance Company are eliminated in consolidation.
We also maintain reinsurance coverage for certain catastrophe losses related to group life and AD&D, with partial coverage of nuclear, biological and chemical acts of terrorism and are part of a catastrophe reinsurance pool with other reinsurance companies. We are part of a catastrophe reinsurance pool with other insurance companies. This pool spreads catastrophe losses from group life and AD&D over 18 participating members. Our annual fee to participate in the pool was less than $30,000 for 2014. As a member of the pool, we are exposed to maximum potential losses experienced by other participating members of up to $104.6 million for a single event for losses submitted by a single company and a maximum of $261.5 million for a single event for losses submitted by multiple companies. Our percentage share of losses experienced by pool members will change over time as it is a function of our group life and AD&D in-force relative to the total group life and AD&D in-force for all pool participants. The catastrophe reinsurance pool does not exclude war or nuclear, biological and chemical acts of terrorism. Through a combination of this agreement and our participation in a catastrophe reinsurance pool discussed below, we have coverage of up to $484.7 million per event. In February 2015, we were notified of the termination of the catastrophe reinsurance pool effective June 2015. We are exploring our options in the market for catastrophe reinsurance coverage.
The Terrorism Risk Insurance Act of 2002 (“TRIA”), which has been extended through 2020, provides for federal government assistance to property and casualty insurers in the event of material losses due to terrorist acts on behalf of a foreign person or foreign interest. Due to the concentration of risk present in group life insurance and the fact that group life insurance is not covered under TRIA, an occurrence of a significant catastrophe or a change in the on-going nature and availability of reinsurance and catastrophe reinsurance could have a material effect on us.
Asset-Liability and Interest Rate Risk Management
See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Asset-Liability and Interest Rate Risk Management.”
INVESTMENTS
Investment management is an integral part of our business. Investments are maintained to ensure that asset types and maturities are appropriate for our policy reserves and other liabilities so that we can meet our obligations to policyholders under a wide variety of economic conditions. A substantial portion of our insurance subsidiaries’ future policy benefits and claims result from long term disability insurance reserves that have proven to be very stable over time, and annuity products on which interest rates can be adjusted periodically, subject to minimum interest rate guarantees. Policyholders or claimants may not withdraw funds from the large block of disability reserves. Instead, claim payments are issued monthly over periods that may extend for many years. Holding these stable long-term reserves makes it possible to allocate a significant portion of invested assets to long-term fixed-rate investments, including commercial mortgage loans. StanCorp Mortgage Investors’ market niche for small fixed-rate commercial mortgage loans allows us to enhance the yield on the overall investment portfolio beyond that available through fixed maturity securities with an equivalent risk profile. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Investing Cash Flows” and Part II, Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 10-Investments.”
REGULATION
State and Federal Laws and Regulations
Our insurance products are regulated by the jurisdictions in which we sell our products including all 50 states, the District of Columbia, the U.S. territories of Guam, Puerto Rico and the Virgin Islands. The insurance industry in the United States is subject to extensive regulation. Such regulation relates to, among other things, terms and provisions of insurance policies, market conduct practices, maintenance of capital and payment of distributions, and financial reporting on a statutory basis of accounting.
As registered investment advisers, StanCorp Investment Advisers is subject to regulation under the Investment Advisers Act of 1940. This Act establishes, among other things, recordkeeping and reporting requirements, disclosure requirements, limitations on transactions between the adviser’s account and an advisory client’s account, limitations on transactions between the accounts of advisory clients and general anti-fraud provisions.
StanCorp Equities is registered as a limited business broker-dealer under the Exchange Act and is subject to federal and state regulation, including but not limited to the Financial Industry Regulation Authority.
Violation of applicable laws and regulations can result in legal or administrative proceedings, which can result in fines, penalties, cease and desist orders or suspension or expulsion of our license to sell insurance in a particular state.
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Capital Requirement-Risk-Based Capital
The National Association of Insurance Commissioners uses Risk-Based Capital (“RBC”) to aid in the assessment of the statutory capital and surplus of life and health insurers. RBC employs a risk-based formula that applies prescribed factors to the various risk elements inherent in an insurer’s business to arrive at minimum capital requirements in proportion to the amount of risk assumed by the insurer. The RBC model determines an appropriate Company Action Level RBC based on our business and assets. Capital and surplus below the Company Action Level RBC would require us to prepare and submit an RBC plan to the commissioner of the state of domicile outlining the capital level we plan on maintaining. Capital and surplus below the Authorized Control Level RBC, which is 50% of the Company Action Level RBC, is the capital and surplus level at which the state of domicile is authorized to take whatever regulatory actions it considers necessary to protect the best interests of the policyholders and creditors of the insurer.
At December 31, 2014, the capital and surplus of our statutory insurance subsidiaries was approximately 445% of the Company Action Level RBC required by regulators, which was approximately 890% of the Authorized Control Level RBC required by our states of domicile. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Capital Management.”
EMPLOYEES
At December 31, 2014, StanCorp and its subsidiaries had 2,803 full-time equivalent employees, 79% of which were located in Portland, Oregon and the surrounding metropolitan area. At December 31, 2014, none of our employees were represented by unions.
Item 1A.
Item 1A. Risk Factors
FORWARD-LOOKING STATEMENTS
From time to time StanCorp or its representatives make written or oral statements, including some of the statements contained or incorporated by reference in this Annual Report on Form 10-K and in other reports, filings with the Securities and Exchange Commission (“SEC”), press releases, conferences or otherwise, that are other than purely historical information. These statements, including estimates, projections, expected operating results, statements related to business plans, strategies, objectives and the assumptions upon which those statements are based, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements also include, without limitation, any statement that includes words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,” “seeks,” “will be,” “will continue,” “will likely result” and similar expressions that are predictive in nature or that depend on or refer to future events or conditions. Our forward-looking statements are not guarantees of future performance and involve uncertainties that are difficult to predict. They involve risks and uncertainties, which may cause actual results to differ materially from the forward-looking statements. The risks and uncertainties are detailed in reports filed by StanCorp with the SEC, including Forms 8-K, 10-Q and 10-K, which may include, but are not limited to, the factors listed in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Forward-Looking Statements” of this Form 10-K.
As a provider of financial products and services, our actual results of operations may vary significantly in response to economic trends, interest rates, investment performance, claims experience, operating expenses and pricing. Given these uncertainties or circumstances, investors are cautioned not to place undue reliance on forward-looking statements as a predictor of future results. We assume no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
RISK FACTORS
Risk factors that may affect our business are as follows:
•
Our reserves for future policy benefits and claims related to our current and future business may prove to be inadequate-For certain of our product lines, we establish and carry, as a liability, actuarially determined reserves to meet our obligations for future policy benefits and claims. These reserves do not represent an exact calculation of our future benefit liabilities but instead are estimates based on assumptions, which can be materially affected by changes in the economy, changes in social perceptions about work ethics, emerging medical perceptions regarding physiological or psychological causes of disability, emerging or changing health issues and changes in industry regulation. Claims experience on our products can fluctuate widely from period to period. If actual events vary materially from our assumptions used when establishing the reserves to meet our obligations for future policy benefits and claims, we may be required to increase our reserves, which could have a material adverse effect on our business, financial position, results of operations or cash flows.
•
Differences between actual claims experience and underwriting and reserving assumptions may adversely affect our financial results-Our long term disability insurance products provide coverage for claims incurred during the policy period. Generally, group policies offer rate guarantees for periods from one to three years. While we can prospectively re-price and re-underwrite coverages at the end of these guarantee periods, we must pay benefits with respect to claims incurred during these periods without being able to increase guaranteed premium rates during these periods. Longer duration
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claims, in addition to a higher volume of claims than we expect, expose us to the possibility that we may pay benefits in excess of the amount that we anticipated when the policy was underwritten. The profitability of our long term disability insurance products is thus subject to volatility resulting from the difference between our actual claims experience and our assumptions at the time of underwriting.
•
We are exposed to concentration risk on our group life insurance business-Due to the nature of group life insurance coverage, we are subject to geographical concentration risk from the occurrence of a catastrophe.
•
We may be exposed to disintermediation risk during periods of increasing interest rates-In periods of increasing interest rates, withdrawals of group and individual annuity contracts may increase as policyholders seek investments with higher perceived returns. This process, referred to as disintermediation, may lead to net cash outflows. These outflows may require investment assets to be sold at a time when the prices of those assets are adversely affected by the increase in interest rates, which may result in realized investment losses. A significant portion of our investment portfolio consists of commercial mortgage loans, which are relatively illiquid, thus increasing our liquidity risk in the event of disintermediation during a period of rising interest rates.
•
Our profitability may be adversely affected by declining or low interest rates-During periods of declining or low interest rates, annuity products may be relatively more attractive investments, resulting in increases in the percentage of policies remaining in-force from year to year during a period when our new investments carry lower returns. During these periods, actual returns on our investments could prove inadequate for us to meet contractually guaranteed minimum payments to holders of our annuity products. In addition, the profitability of our life and disability insurance products can be affected by declining or low interest rates. A factor in pricing our insurance products is prevailing interest rates. Longer duration claims and premium rate guarantees can expose us to interest rate risk when portfolio yields are less than those assumed when pricing these products. Commercial mortgage loans and fixed maturity securities-available-for-sale (“fixed maturity securities”) in our investment portfolio are more likely to be prepaid or redeemed as borrowers seek to borrow at lower interest rates, and we may be required to reinvest those funds in lower interest-bearing investments.
•
Our investment portfolio is subject to risks of market value fluctuations, defaults, delinquencies and liquidity-Our general account investments primarily consist of fixed maturity securities and commercial mortgage loans. The fair values of our investments vary with changing economic and market conditions and interest rates. In addition, we are subject to default risk on our fixed maturity securities portfolio and its corresponding impact on credit spreads. Our commercial mortgage loan portfolio is subject to delinquency, default and borrower concentration risks. Related declines in market activity due to overall declining values of fixed maturity securities may result in our fixed maturity securities portfolio becoming less liquid. In addition, our commercial mortgage loans are relatively illiquid and the demand for our real estate acquired in satisfaction of debt through foreclosure or acceptance of deeds in lieu of foreclosure on commercial mortgage loans (“Real Estate Owned”) may remain low due to macroeconomic conditions. We may have difficulty selling our fixed maturity securities, commercial mortgage loans and Real Estate Owned at attractive prices, in a timely manner, or both if we require significant amounts of cash on short notice. Declines in the value of our invested assets could also affect our ability to pledge collateral as required.
•
Our business is subject to significant competition-Each of our business segments faces competition from other insurers and financial services companies, such as banks, broker-dealers, mutual funds, and managed care providers for employer groups, individual consumers and distributors. Since many of our competitors have greater financial resources, offer a broader array of products and, with respect to other insurers, may have higher financial strength ratings than we do, the possibility exists that any one of our business segments could be adversely affected by competition, which in turn could have a material adverse effect on our business, financial position, results of operations or cash flows.
•
A downgrade in our financial strength ratings may negatively affect our business-Financial strength ratings, which are an indicator of our claims paying ability, are an important factor in establishing the competitive position of insurance companies. Ratings are important to maintaining public confidence in our company and in our ability to market our products. Rating organizations regularly review the financial performance and condition of insurance companies, including our company. A ratings downgrade could increase our surrender levels for our annuity products, could adversely affect our ability to market our products, could increase costs of future debt issuances, and could thereby have a material adverse effect on our business, financial position, results of operations or cash flows.
•
Our profitability may be affected by changes in state and federal regulation-Our business is subject to comprehensive regulation and supervision throughout the United States including rules and regulations relating to income taxes and accounting principles generally accepted in the U.S. While we cannot predict the impact of potential or future state or federal legislation or regulation on our business, future laws and regulations, or the interpretation thereof, could have a material adverse effect on our business, financial position, results of operations or cash flows.
•
Our deferred tax assets include net operating losses (“NOLs”), which depend on future taxable income to be realized and may be limited or impaired by future ownership changes-Our deferred tax assets include federal, state and local NOLs. Certain of our subsidiaries as a group have generated losses in recent years. NOLs can be available to reduce income
10 STANCORP FINANCIAL GROUP, INC.
taxes that might otherwise be incurred on future taxable income. There can be no assurance that we will generate the future taxable income necessary to utilize our NOLs. Furthermore, the availability of these losses to be utilized in the future can become limited if certain changes in company structure or income levels occur. In such a circumstance, we may be unable to utilize the losses even if the Company generates future taxable income.
•
Our business is subject to litigation risk-In the normal course of business, we are a plaintiff or defendant in actions arising out of our insurance business and investment operations. We are from time to time involved in various governmental and administrative proceedings. While the outcome of any pending or future litigation cannot be predicted, as of the date hereof, we do not believe that any pending litigation will have a material adverse effect on our results of operations or financial condition. However, no assurances can be given that such litigation would not materially and adversely affect our business, financial position, results of operations or cash flows.
•
We may be exposed to environmental liability from our commercial mortgage loan and real estate investments-As a commercial mortgage lender, we customarily conduct environmental assessments prior to originating commercial mortgage loans secured by real estate and before taking title through foreclosure or deeds in lieu of foreclosure to real estate collateralizing delinquent commercial mortgage loans held by us. Compliance costs associated with environmental laws and regulations or any remediation of affected properties could have a material adverse effect on our results of operations or financial condition.
•
Certain concentrations in our commercial mortgage loan portfolio may subject us to losses-Concentration of borrowers and tenants in our commercial mortgage loan portfolio may expose us to potential losses resulting from a downturn in the economy, business performance of tenants, or adverse changes in a borrower’s financial condition. Although we diversify our commercial mortgage loan portfolio by location, type of property, borrower and tenants, such diversification may not eliminate the risk of such losses, which could have a material adverse effect on our business, financial position, results of operations or cash flows.
•
The concentration of our investments in California may subject us to losses resulting from an economic downturn-Our commercial mortgage loans are concentrated in the western region of the U.S., particularly in California. Currently, our California exposure is primarily in Los Angeles County, Orange County, San Diego County and the Bay Area Counties. We have a smaller concentration of commercial mortgage loans in the Inland Empire and the San Joaquin Valley where there has historically been greater economic decline. A decline in economic conditions in California could have a material adverse effect on our business, financial position, results of operations or cash flows.
•
The concentration of our investments in the western region of the U.S. may subject us to losses resulting from certain natural catastrophes in this area-Due to our commercial mortgage loan concentration in the western region of the U.S., particularly in California, we are exposed to potential losses resulting from certain natural catastrophes, such as earthquakes and fires, which may affect the region. Although we require borrowers to maintain fire insurance, consider the potential for earthquake loss based upon specific information to each property and diversify our commercial mortgage loan portfolio within the western region by both location and type of property in an effort to reduce earthquake exposure, such diversification may not eliminate the risk of such losses, which could have a material adverse effect on our business, financial position, results of operations or cash flows.
•
Catastrophe losses from a disease pandemic could have an adverse effect on us-Our life insurance operations are exposed to the risk of loss from an occurrence of catastrophic mortality caused by a disease pandemic, which could have a material adverse effect on our business, financial position, results of operations or cash flows.
•
Catastrophe losses from terrorism or other factors could have an adverse effect on us-An occurrence of a significant catastrophic event, including terrorism, natural or other disasters, or a change in the nature and availability of or continuation of existing reinsurance and catastrophe reinsurance, could have a material adverse effect on our business, financial position, results of operations, cash flows or capital levels.
•
As a holding company, we depend on the ability of our subsidiaries to transfer funds to us in sufficient amounts to pay dividends to shareholders, make payments on debt securities and meet our other obligations-We are a holding company for our insurance and asset management subsidiaries as well as for the subsidiaries that comprise our Other category and do not have any significant operations of our own. Dividends and permitted payments from our subsidiaries are our principal source of cash to pay dividends to shareholders, make payments on debt securities and meet our other obligations. As a result, our ability to pay dividends to shareholders and interest payments on debt securities will primarily depend upon the receipt of dividends and other distributions from our subsidiaries.
Many of our subsidiaries are non-insurance businesses and have no regulatory restrictions on dividends. Our insurance subsidiaries, however, are regulated by insurance laws and regulations that limit the maximum amount of dividends, distributions and other payments that they could declare and pay to us without prior approval of the states in which the subsidiaries are domiciled. Under Oregon law, Standard Insurance Company may pay dividends only from the earned surplus arising from its business. Oregon law gives the Director of the Oregon Department of Consumer and Business Services-Insurance Division (“Oregon Insurance Division”) broad discretion regarding the approval of dividends in excess
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of certain statutory limitations. Oregon law requires us to receive the prior approval of the Oregon Insurance Division to pay such a dividend. See Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Capital Management-Dividends from Subsidiaries.”
•
Our ability to refinance debt and raise capital in future years depends not only on contributions from our subsidiaries but also on market conditions and availability of credit in the market- We do not have any significant debt maturities in the near term. Our 10-year senior notes of $250 million will mature in August 2022, and our junior subordinated debentures of $252.9 million will mature in 2067 with a call option in 2017. We maintain a $250 million senior unsecured revolving credit facility (“Facility”) for general corporate purposes. Upon our request and with consent of the lenders under the Facility, the Facility can be increased to $350 million. The termination date of the Facility is June 22, 2018. We had no outstanding balance on the Facility at December 31, 2014. The Facility is composed of a syndication of seven banks. Commitments from the banks toward the available line of credit range from $15.0 million to $60.0 million per bank. Should a bank from this syndication default, the available line of credit would be reduced by that bank’s commitment toward the line.
•
Our portfolio of investments, including U.S. government and agency bonds and U.S. state and political subdivision bonds could be negatively impacted by U.S. credit and financial market conditions-A potential ratings downgrade of U.S. government securities could lead to future deterioration in the U.S. and global credit and financial markets. As a result, these events may materially adversely affect our business, financial condition and results of operations.
•
Our profitability may be adversely affected by a decline in equity and debt markets-U.S. and global equity markets heavily influence the value of our retirement plan assets under administration, which are a significant component from which our administrative fees are derived. A decline in equity and debt markets could result in decreases in the value of the assets under administration in our retirement plans, which could reduce our ability to earn administrative fees derived from the value of those assets.
•
A decline in equity and debt markets and low interest rates could affect the funding status of Company sponsored pension plans-Our estimates of liabilities and expenses for pension and other postretirement benefits incorporate significant assumptions including the rate used to discount the estimated future liability, the long-term rate of return on plan assets, inflation rates, mortality rates, and the employee workforce. Changes in the discount rate, inflation rates, mortality rates, or the rate of return on plan assets resulting from economic downturns could increase our required cash contributions or pension-related expenses in future periods. The funding status of the Company’s pension plans is evaluated annually during the fourth quarter.
•
Our ability to conduct business may be compromised if we are unable to maintain the availability of our systems and safeguard the security of our data in the event of a disaster or other unanticipated events-We use computer systems to store, retrieve, evaluate and utilize customer and company data and information. Our business is highly dependent on our ability to access these systems to perform necessary business functions. System failures, system outages, outsourcing risk or the failure or unwillingness of a service provider to perform could compromise our ability to perform these functions in a timely manner and could hurt our relationships with our business partners and customers. In the event of a disaster such as a natural catastrophe, fire, a blackout, a computer virus, a terrorist attack or war, these systems may be inaccessible to our employees, customers or business partners for an extended period of time. These systems could also be subject to physical and electronic break-ins and subject to similar disruptions from unauthorized tampering. This may impede or interrupt our business operations and could have a material adverse effect on our business, financial position, results of operations or cash flows.
•
Ongoing weakness and financial market uncertainty could continue to adversely affect us in the near term-Economic downturns and disruptions in the global financial market present risks and uncertainties. During an economic downturn, we face the following risks:
•
Declines in revenues or profitability as a result of lost wages or lower levels of insured employees by our customers due to reductions in workforce. Additionally, revenues and profitability could decline as a result of lower levels of assets under administration.
•
Increases in pricing pressure and competition resulting in a loss of customers or new business as customers seek to reduce benefit costs and competitors seek to protect market share.
•
A declining or a continued low interest rate environment and its effect on product pricing and the reserves we must carry.
•
Increases in commercial mortgage loan foreclosures.
•
Increases in holdings of Real Estate Owned properties due to a decline in demand for these properties and the decline in value of these properties during our holding period.
•
Continued pressure on budgets for public institutions could impact the employment and wage levels of our customer groups in this sector, which represents a significant customer group for our employee benefits business, which may have an adverse effect on our premium levels for our group businesses and revenues for our retirement plans business.
•
Increases in corporate tax rates to finance government-spending programs.
•
Reductions in the number of our potential lenders or to our committed credit availability due to combinations or failures of financial institutions.
12 STANCORP FINANCIAL GROUP, INC.
•
Loss of employer groups due to business acquisitions, bankruptcy or failure.
•
Declines in the financial health of reinsurers.
•
Reduction in the value of our general account investment portfolio.
•
Declines in revenues and profitability as a result of lower levels of assets under administration.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
Principal properties owned by Standard Insurance Company (“Standard”) and used by StanCorp Financial Group, Inc. or its subsidiaries consist of two office buildings in downtown Portland, Oregon: the Standard Insurance Center, with approximately 460,000 square feet; and the Standard Plaza, with approximately 220,000 square feet. All of our business segments use the facilities described above. We also own two buildings in Hillsboro, Oregon, each with 72,000 square feet of office space. The Hillsboro offices are used by StanCorp Mortgage Investors, LLC and our Employee Benefits claims operations. In addition, Standard leases approximately 160,000 square feet of office space located in downtown Portland, Oregon, for home office and claims operations. We lease 52 offices under commitments of varying terms to support our sales and regional processing offices throughout the United States. Management believes that the capacity and types of facilities are suitable and adequate for operations. See Part II, Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 1-Summary of Significant Accounting Policies-Property and Equipment, Net.”
Item 3.
Item 3. Legal Proceedings
In the normal course of business, we are involved in various legal actions and other state and federal proceedings. A number of actions or proceedings were pending at December 31, 2014. In some instances, lawsuits include claims for punitive damages and similar types of relief in unspecified or substantial amounts, in addition to amounts for alleged contractual liability or other compensatory damages. In the opinion of management, the ultimate liability, if any, arising from the actions or proceedings is not expected to have a material effect on our business, financial position, results of operations or cash flows.
Item 4.
Item 4. Mine Safety Disclosure
Not applicable.
Item 4A. Executive Officers of the Registrant
The following table sets forth the executive officers of StanCorp Financial Group, Inc. (“StanCorp”) and Standard Insurance Company (“Standard”):
Name
Age (as of
February 26,
2015)
Position
Floyd F. Chadee
Senior Vice President and Chief Financial Officer of StanCorp and Standard
Katherine Durham*
Vice President, Individual Disability Insurance and Marketing and Communications of Standard
James B. Harbolt*
Vice President, Asset Management of Standard
Scott A. Hibbs*
Vice President and Chief Investment Officer of Standard
John A. Hooper*
Vice President, Human Resources of Standard
Daniel J. McMillan*
Vice President, Employee Benefits of Standard
J. Gregory Ness
Chairman, President and Chief Executive Officer of StanCorp and Standard
David M. O’Brien*
Senior Vice President, Information Technology of Standard
* Denotes an officer of a subsidiary who is not an officer of StanCorp but who is considered an “executive officer” of StanCorp under the regulations of the Securities and Exchange Commission.
Set forth below is biographical information for the executive officers of StanCorp:
Floyd F. Chadee, Ph.D., FSA, has been Senior Vice President and Chief Financial Officer of StanCorp and Standard since April 2008. Prior to this position, Mr. Chadee served as Senior Vice President and Chief Financial Officer at Assurant Employee Benefits, a part of Assurant, Inc., and had been with Assurant Employee Benefits since 1998.
Katherine Durham has been Vice President, Individual Disability Insurance and Corporate Marketing and Communications of Standard since September 2013, which includes responsibility for corporate-wide marketing, corporate communications and the Individual Disability. From March 2010 to September 2013, Ms. Durham served as Vice President, Marketing and Communications
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of Standard. Prior to joining Standard, Ms. Durham served as Vice President of Marketing for Hewlett-Packard’s Americas Imaging and Printing Group. During nine years at HP, she moved into roles of increasing responsibility in a variety of functions including business planning, market insight, communication and operations.
James B. Harbolt has been Vice President, Asset Management of Standard since September 2013, which includes responsibility for retirement plans, individual annuities and StanCorp Investment Advisers, Inc. (“StanCorp Investment Advisers”). From October 2008 to September 2013, Mr. Harbolt served as Vice President, Insurance Services of Standard. Mr. Harbolt has been with the Company since June 1994 when he joined as Assistant Counsel. In 1996, Mr. Harbolt served as Second Vice President and Associate Counsel. From 1997 until 2000, Mr. Harbolt was the Assistant Vice President and Associate Counsel in Individual Insurance. He was named Vice President of Individual Disability in 2000, and in 2005, he became Vice President and Associate Counsel of Employee Benefits Law.
Scott A. Hibbs has been Vice President and Chief Investment Officer of Standard since September 2013, which includes responsibility for the Standard’s investment management division including the fixed income portfolio, StanCorp Mortgage Investors, LLC and StanCorp Real Estate, LLC. From January 2009 to September 2013, Mr. Hibbs served as Vice President, Asset Management of Standard. From September 2007 to January 2009, Mr. Hibbs served as Vice President, Insurance Services of Standard. From July 2005 to September 2007 Mr. Hibbs served as Vice President, Asset Management of Standard, which included responsibility for StanCorp Investment Advisers. From July 2004 to July 2005, Mr. Hibbs served as Vice President of Corporate Strategy and Business Development. Prior to July 2004, Mr. Hibbs served as Assistant Vice President of Investor Relations and Financial Planning. Mr. Hibbs has been with the Company since 2000.
John A. Hooper has been Vice President, Human Resources of Standard since March 2014, which includes responsibility for all aspects of human resources for Standard. Prior to joining Standard, Mr. Hooper served as Senior Vice President, Human Resources and Shared Services at Weyerhaeuser from July 2008 to March 2014. From March 2006 to July 2008, Mr. Hooper served as Vice President, Human Resources Operations at Weyerhaeuser. Prior to joining Weyerhaeuser, Mr. Hooper founded People Management Resources, Inc., a management consulting firm focused on leadership effectiveness, people strategy and human resources best practices.
Daniel J. McMillan has been Vice President, Employee Benefits of Standard since September 2013, which includes responsibility for all aspects of the Employee Benefits segment and The Standard Life Insurance Company of New York. From October 2008 to September 2013, Mr. McMillan served as Vice President, Insurance Services of Standard. Mr. McMillan has been with Standard since July 1989 and has held a number of positions in Insurance Services. In 2002, Mr. McMillan was named Business Program Executive at Standard, and in 2007, he was named Vice President of Shared Services.
J. Gregory Ness, LLIF, was elected Chairman of the Board of Directors of StanCorp and Standard in December 2011. He has been President and Chief Executive Officer of StanCorp and Standard since July 2009. From September 2008 until July 2009, Mr. Ness served as President and Chief Operating Officer of StanCorp and Standard. Prior to his appointment to President and Chief Operating Officer, Mr. Ness served as Senior Vice President, Insurance Services of Standard since the Company’s segment realignment in January 2006. From April 2004 to January 2006, Mr. Ness was Senior Vice President, group insurance division of Standard. From 1999 to April 2004, Mr. Ness was Senior Vice President, Investments of Standard.
David M. O’Brien has been Senior Vice President of Information Technology of Standard since June 2006. From May 2004 to June 2006, Mr. O’Brien was Vice President of Information Technology. Prior to joining Standard in 2004, Mr. O’Brien served as Chief Information Officer for FEI Company.
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Part II
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our common stock is listed on the New York Stock Exchange Euronext (“NYSE”) under the symbol “SFG.” As of February 13, 2015, there were 29,160 shareholders of record of common stock.
The following tables set forth the high and low sales prices as reported by the NYSE at the close of the trading day and cash dividends paid per share of common stock:
The declaration and payment of dividends in the future is subject to the discretion of our Board of Directors. We expect to pay annual dividends in December of each year depending on our financial condition, results of operations, cash requirements, future prospects, regulatory restrictions on the distributions from the insurance subsidiaries, the ability of the insurance subsidiaries to maintain adequate capital and other factors deemed relevant by our Board of Directors. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Capital Management.” Also see Part I, Item 1A, “Risk Factors.”
The following graph provides a comparison of the cumulative total shareholder return on our common stock with the cumulative total return of the Standard & Poor’s (“S&P”) 500 Index, the S&P Life and Health Insurance Index and the S&P Insurance Group Index. The comparison assumes $100 was invested on December 31, 2009, in our common stock and in each of the foregoing indexes, and assumes the reinvestment of dividends. The graph covers the period of time beginning December 31, 2009, through December 31, 2014.
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The following table sets forth share repurchase information:
On November 13, 2012, our Board of Directors authorized the repurchase of 3.0 million shares of StanCorp common stock through December 31, 2014 (“November 2012 Authorization”). On February 11, 2014, our Board of Directors authorized the repurchase of up to 3.0 million shares of StanCorp common stock through December 31, 2015 (“February 2014 Authorization”). The February 2014 Authorization took effect upon completion of the November 2012 Authorization during the second quarter of 2014. Share repurchases are made in the open market or in negotiated transactions in compliance with the safe harbor provisions of Rule 10b-18 under regulations of the Exchange Act. Execution of the share repurchase program is based upon management’s assessment of market conditions for its common stock, capital levels, our assessment of the overall economy and other potential growth opportunities or priorities for capital use.
The following table sets forth share repurchase activity:
Information required by Item 5 with respect to securities authorized for issuance under equity compensation plans is contained in Part III, Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”
16 STANCORP FINANCIAL GROUP, INC.
Item 6.
Item 6. Selected Financial Data
The following table sets forth selected financial data at or for the years ended December 31 and should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Item 8, “Financial Statements and Supplementary Data”:
* Includes operating expenses, commissions and bonuses, premium taxes, and the net increase in deferred acquisition costs, value of business acquired and other intangible assets.
**Statutory data represents Standard Insurance Company and The Standard Life Insurance Company of New York.
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Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following management assessment of the financial condition and results of operations should be read in conjunction with the consolidated financial statements and related notes thereto contained in Item 8, “Financial Statements and Supplementary Data.” Our consolidated financial statements and certain disclosures made in this Form 10-K have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and require us to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosures of contingent assets and contingent liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during each reporting period. The estimates most susceptible to material changes due to significant judgment are identified as critical accounting policies. The results of these estimates are critical because they affect our profitability and may affect key indicators used to measure our performance. See “Critical Accounting Policies and Estimates.”
Financial measures that exclude after-tax net capital gains and losses and accumulated other comprehensive income (“AOCI”) are non-GAAP measures. To provide investors with a broader understanding of earnings, we provide net income per diluted share excluding after-tax net capital gains and losses, along with the GAAP measure of net income per diluted share, because capital gains and losses are not likely to occur in a stable pattern.
Management believes that measuring net income return on average equity excluding after-tax net capital gains and losses from net income and AOCI from equity is important to investors because the low turnover of our portfolio of fixed maturity securities-available-for-sale (“fixed maturity securities”) may not be such that unrealized gains and losses reflected in AOCI are ultimately realized. Furthermore, management believes exclusion of AOCI provides investors with a better measure of return.
This management’s discussion and analysis of financial condition and results of operations contains forward-looking statements. See Part I, Item 1A, “Risk Factors-Forward-Looking Statements.”
EXECUTIVE SUMMARY
StanCorp Financial Group, Inc., through its subsidiaries marketed as The Standard-Standard Insurance Company (“Standard”), The Standard Life Insurance Company of New York, Standard Retirement Services, Inc. (“Standard Retirement Services”), StanCorp Mortgage Investors, LLC (“StanCorp Mortgage Investors”), StanCorp Investment Advisers, Inc., StanCorp Real Estate, LLC and StanCorp Equities, Inc. (“StanCorp Equities”)-is a leading provider of financial products and services. StanCorp’s subsidiaries offer group and individual disability insurance, group life and accidental death and dismemberment (“AD&D”) insurance, group dental and group vision insurance, absence management services, retirement plans products and services, individual annuities, origination and servicing of fixed-rate commercial mortgage loans and investment advice.
Financial Results Overview
The following table sets forth selected consolidated financial results:
Net income excluding after-tax net capital losses was $5.25 per diluted share for 2014, compared to $5.34 per diluted share for 2013. The decrease in net income per diluted share was primarily due to lower operating expenses for 2013, which included savings of $20.6 million or $0.30 per diluted share in 2013 due to an amendment of our postretirement medical plan, which did not recur in 2014.
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Net income excluding after-tax net capital losses was $5.34 per diluted share for 2013, compared to $3.24 per diluted share for 2012. The increase was primarily due to more favorable claims experience in Employee Benefits, lower operating expenses as a result of expense management actions in 2013, and higher earnings in Asset Management and Individual Disability for 2013. Operating
expenses were reduced by $20.6 million or $0.30 per diluted share for the first half of 2013 due to the amendment of our postretirement medical plan.
Primary Drivers of 2014 Results
Employee Benefits reported income before income taxes of $201.8 million for 2014, compared to $216.4 million for 2013. The decrease was primarily due to lower premiums and lower net investment income, partially offset by more favorable claims experience. Employee Benefits premiums decreased 4.4% to $1.84 billion for 2014 from $1.93 billion for 2013. The decrease in premiums for 2014 was primarily due to lower Employee Benefits sales in the first half of 2014 compared to prior periods. Employee Benefits annualized new sales were $215.6 million for 2014, compared to $222.1 million for 2013. The benefit ratio for Employee Benefits was 77.8% for 2014, compared to 78.9% for 2013. The average discount rate used for newly established long term disability insurance claim reserves was 4.00% for 2014, compared to 3.75% for 2013. A 25 basis point increase or decrease in the discount rate currently results in a corresponding increase or decrease in the quarterly pre-tax income of approximately $2 million or approximately $8 million for the full year.
Individual Disability reported income before income taxes of $52.9 million for 2014, compared to $56.0 million for 2013. Individual Disability premiums were $199.1 million for 2014, compared to $190.5 million for 2013. The Individual Disability benefit ratio was 65.3% for 2014, compared to 63.9% for 2013.
Asset Management reported income before income taxes of $77.9 million for 2014, compared to $79.3 million for 2013. Assets under administration, which include assets related to retirement plans, individual fixed annuities, private client wealth management and commercial mortgage loans managed for third-party investors, increased 7.4% to $26.53 billion at December 31, 2014 from $24.70 billion at December 31, 2013. The increase primarily reflected higher equity values and positive cash flows for retirement plan assets under administration. Commercial mortgage loan originations were $1.18 billion for 2014, compared to $1.30 billion for 2013. The decrease reflected increased competition in the commercial mortgage origination market.
We deployed $248.8 million of capital through our annual cash dividend to shareholders and the repurchase of shares and debt for 2014, while maintaining a strong balance sheet and growing book value per share, excluding AOCI, by 6.9% over the past 12 months.
These results show our commitment to our strategy of obtaining and retaining profitable business.
Outlook for 2015
As we look to 2015, we expect to face ongoing macro-economic factors: a persistent low interest rate environment, a price sensitive group insurance marketplace, elevated unemployment levels and challenges to wage and employment growth of our customers. Despite these challenges, we will continue to focus on our long-term objectives and address challenges that arise with financial discipline and from a position of financial strength. We manage for long-term profitability by focusing on business diversification, disciplined product pricing, sound underwriting, effective claims management and high-quality customer service.
We intend to preserve the value of our business by continuing to provide excellent service to our customers. We will optimize shareholder value through sustainable profitability by investing in new product and service capabilities and through the strategic use of capital. We believe these actions along with our strong performance in 2014 will continue to benefit the Company and the shareholders in 2015 and beyond.
For a discussion of our consolidated results of operations and business segment results, see “Consolidated Results of Operations.”
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
Our consolidated financial statements and certain disclosures made in this Form 10-K have been prepared in accordance with GAAP and require us to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosures of contingent assets and contingent liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The estimates most susceptible to material changes due to significant judgment (identified as the “critical accounting policies”) are those used in determining investment valuations, the reserves for future policy benefits and claims, deferred acquisition costs (“DAC”), value of business acquired (“VOBA”) and other intangible assets, pension and postretirement benefit plans and the provision for income taxes. The results of these estimates are critical because they affect our profitability and may affect key indicators used to measure our performance. These estimates have a material effect on our results of operations and financial condition.
2014 ANNUAL REPORT 19
Part II
Investment Valuations
Fixed Maturity Securities
Capital gains and losses for fixed maturity securities are recognized using the specific identification method. If the fair value of a fixed maturity security declines below its amortized cost, we assess whether the decline is other than temporary.
In our quarterly impairment analysis, we evaluate whether a decline in fair value of the fixed maturity security is other than temporary by considering the following factors:
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The nature of the fixed maturity security.
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The duration until maturity.
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The duration and extent the fair value has been below amortized cost.
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The financial quality of the issuer.
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Estimates regarding the issuer’s ability to make the scheduled payments associated with the fixed maturity security.
•
Our intent to sell or whether it is more likely than not we will be required to sell a fixed maturity security before recovery of the security’s cost basis through the evaluation of facts and circumstances including, but not limited to, decisions to rebalance our portfolio, current cash flow needs and sales of securities to capitalize on favorable pricing.
If we determine an other-than-temporary impairment (“OTTI”) exists, we separate the OTTI of fixed maturity securities into an OTTI related to credit loss and an OTTI related to noncredit loss. The OTTI related to credit loss represents the portion of losses equal to the difference between the present value of expected cash flows, discounted using the pre-impairment yields, and the amortized cost basis. All other changes in value represent the OTTI related to noncredit loss. The OTTI related to credit loss is recognized in earnings in the current period, while the OTTI related to noncredit loss is deemed recoverable and is recognized in other comprehensive income (loss). The cost basis of the fixed maturity security is permanently adjusted to reflect the credit loss. Once an impairment has been recorded, we continue to review the OTTI securities for further potential impairment.
We maintain an internally identified list of fixed maturity securities with characteristics that could indicate potential impairment (“watch list”). At December 31, 2014, our fixed maturity securities watch list totaled $12.7 million at fair value and $15.2 million at amortized cost after OTTI. We recorded $1.2 million of OTTI related to credit loss due to impairments for 2014, compared to $1.1 million for 2013. We recorded no OTTI related to noncredit loss for 2014 and 2013. See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 1-Summary of Significant Accounting Policies-Investment Valuations-Fixed Maturity Securities-Available-for-Sale” for further disclosures.
We will continue to evaluate our holdings; however, we currently expect the fair values of our investments to recover either prior to their maturity dates or upon maturity. Should the credit quality of our fixed maturity securities significantly decline, there could be a material adverse effect on our business, financial position, results of operations or cash flows.
In conjunction with determining the extent of credit losses associated with fixed maturity securities, we utilize certain information in order to determine the present value of expected cash flows discounted using pre-impairment yields. The information includes, but is not limited to, original scheduled contractual cash flows, current market spread information, risk-free rates, fundamentals of the industry and sector in which the issuer operates, and general market information.
Fixed maturity securities are classified as available-for-sale and are carried at fair value on the consolidated balance sheets. See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 9-Fair Value” for a detailed explanation of the valuation methods we use to calculate the fair value of our financial instruments. Valuation adjustments for fixed maturity securities not accounted for as OTTI are reported as net increases or decreases to other comprehensive income (loss), net of tax, on the consolidated statements of comprehensive income.
Commercial Mortgage Loans
The carrying value of commercial mortgage loans represents the outstanding principal balance less a loan loss allowance for probable uncollectible amounts. The commercial mortgage loan loss allowance is estimated based on evaluating known and inherent risks in the loan portfolio and consists of a general loan loss allowance and a specific loan loss allowance. The general loan loss allowance is based on our analysis of factors including changes in the size and composition of the loan portfolio, debt coverage ratios, loan to value ratios, actual loan loss experience and individual loan analysis. An impaired commercial mortgage loan is a loan where we do not expect to receive contractual principal and interest in accordance with the terms of the original loan agreement. A specific allowance for losses is recorded when a loan is considered to be impaired. We also hold specific allowances for losses on certain performing loans that we continue to monitor and evaluate. Impaired commercial mortgage loans without specific allowances for losses are those for which we have determined that it remains probable that we will collect all amounts due. In addition, for impaired commercial mortgage loans, we evaluate the loss to dispose of the underlying collateral, any significant out of pocket expenses the loan may incur, the loan-to-value ratio and other quantitative information we have concerning the loan. Negotiated reductions of principal are generally written off against the allowance, and recoveries, if any, are credited to the allowance. See “Liquidity and Capital Resources-Investing Cash Flows-Commercial Mortgage Loans.”
20 STANCORP FINANCIAL GROUP, INC.
Real Estate
Real estate is comprised of two components: real estate investments and real estate acquired in satisfaction of debt through foreclosure or the acceptance of deeds in lieu of foreclosure on commercial mortgage loans (“Real Estate Owned”).
Our real estate investments are recorded at the lower of cost or net realizable value. We generally depreciate real estate investments using the straight-line depreciation method with property lives varying from 30 to 40 years.
We record impairments when it is determined that the decline in fair value of an investment below its carrying value is other than temporary. The impairment is recorded to net capital losses, and the carrying value of the investment is adjusted to reflect the impairment.
Real Estate Owned is initially recorded at net realizable value, which includes an estimate for disposal costs. This amount may be adjusted in a subsequent period as additional information is received. Our Real Estate Owned is initially considered an investment held for sale and is expected to be sold within one year from acquisition. For any real estate expected to be sold, an impairment is recorded if we do not expect the investment to recover its carrying value prior to the expected date of sale. Once an impairment has been recorded, we continue to review the investment for further potential impairment.
Total real estate was $37.0 million at December 31, 2014, compared to $65.7 million at December 31, 2013. The $28.7 million decrease in total real estate during 2014 was primarily due to the sale of Real Estate Owned and the impairments on Real Estate Owned.
Other Invested Assets
Other invested assets include tax-advantaged investments, derivative instruments, policy loans and common stock. Valuation adjustments for these investments are recognized using the specific identification method.
Tax-advantaged Investments
Our tax-advantaged investments are structured as limited partnerships and are accounted for under the equity method of accounting. We have purchased tax-advantaged investments opportunistically due to the higher risk-adjusted returns. The primary sources of investment return are tax credits and the tax benefits derived from operating losses, both of which may exhibit variability over the life of the investment. Tax credits received from these investments are reported in our consolidated statements of income as either a reduction of state premium taxes, or a reduction of income taxes based on the nature of the credit. Our share of the operating losses of the limited partnerships decreases the carrying value of the investments and is reported as a component of net investment income. If the net present value of expected future cash flows of the tax-advantaged investments is less than the current book value of the investments, we evaluate whether a decline in value is other than temporary. If it is determined an OTTI exists, the investment is written down to the net present value of expected future cash flows and the OTTI is recognized as a capital loss.
Derivative Instruments
In 2014, we began the use of interest rate swaps to reduce the risks from changes in interest rates, to manage interest rate exposures arising from asset and liability mismatches, and to protect the value of investments held on the consolidated balance sheets. The interest rate swaps used by us are designed to qualify for hedge accounting.
Interest rate swaps are recognized as either other invested assets or other liabilities in our consolidated balance sheets and are reported at fair value. The accounting for an interest rate swap depends on whether it has been designated and qualifies as part of a hedging relationship and on the type of hedging relationship. To qualify for hedge accounting, we document the risk management objective and strategy for undertaking the hedging transaction and the designation of the hedge as either a fair value hedge or a cash flow hedge at the inception of the hedging transaction. The documentation includes a description of how the interest rate swap is expected to hedge the designated risk related to specific assets or liabilities on our balance sheets, the method that will be used to prospectively and retrospectively assess the hedge effectiveness, the method that will be used to measure ineffectiveness and how this ineffectiveness will be recorded.
An interest rate swap designated as part of a hedging relationship must be assessed as being highly effective in offsetting the designated risk of the hedged item. Hedge effectiveness is assessed at inception and periodically throughout the life of the designated hedging relationship, using qualitative and quantitative methods. Qualitative methods include comparison of critical terms of the interest rate swap to the hedged item. Quantitative methods include regression or other statistical analysis of changes in the fair value or cash flows associated with the hedge relationship.
Changes in the fair value of an interest rate swap designated as a fair value hedge, including amounts measured as ineffective, and changes in the fair value of the hedged item, are recognized in the consolidated statements of income as a component of net capital gains and losses. The gain or loss on the termination of a fair value hedge is recognized in the consolidated statements of income as a component of net capital gains and losses during the period in which the termination occurs. When interest rate swaps are used in hedge accounting relationships, periodic settlements are recorded in net investment income.
The gain or loss on the termination of an ineffective fair value hedge is reported in the consolidated statements of income as a component of net capital gains or losses. Additionally, when a hedged item is disposed, we will terminate the related derivative instrument and recognize the gain or loss on termination in the consolidated statements of income as a component of net capital gains or losses.
2014 ANNUAL REPORT 21
Part II
Index-based guarantees embedded in indexed annuities (“index-based interest guarantees”) and Standard & Poor’s (“S&P”) 500 Index call spread options (“S&P 500 Index options”) do not qualify for hedge accounting. We sell indexed annuities, which permit the holder to elect a fixed interest rate return or an indexed return, where interest credited to the contracts is based on the performance of the S&P 500 Index, subject to an upper limit or cap and minimum guarantees. Policyholders may elect to rebalance between interest crediting options at renewal dates annually. At each renewal date, we have the opportunity to re-price the indexed component by changing the cap, subject to minimum guarantees. We estimate the fair value of the index-based interest guarantees for the current period and for all future reset periods until contract maturity. Changes in the fair value of the index-based interest guarantees are recorded in interest credited.
We purchase S&P 500 Index options for our interest crediting strategy used in our indexed annuity product. The S&P 500 Index options are purchased from investment banks and are selected in a manner that supports the amount of interest that is expected to be credited in the current year to annuity policyholder accounts that are dependent on the performance of the S&P 500 Index. The purchase of S&P 500 Index options is a pivotal part of our risk management strategy for indexed annuity products. The S&P 500 Index options are exclusively used for risk management. Changes in the fair value of S&P 500 Index options are recorded in net investment income.
Cash settlement activity of derivative contracts is reported in the consolidated statements of cash flows as a component of proceeds from or acquisition of other invested assets. See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 11-Derivative Financial Instruments.”
Policy Loans
Policy loans are stated at their aggregate unpaid principal balances and are secured by policy cash values.
Common Stock
In 2013, Standard became a member of the Federal Home Loan Bank of Seattle (“FHLB of Seattle”) and purchased the required common stock for membership and activity. Our investment in common stock of FHLB of Seattle relates to Standard’s membership and activity in the FHLB of Seattle. The FHLB of Seattle common stock is carried at par value and accounted for under the cost method. We periodically evaluate FHLB of Seattle common stock for OTTI. Our determination of whether this investment is impaired is based on our assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. The Federal Home Loan Bank of Des Moines (“FHLB of Des Moines”) and the FHLB of Seattle have announced that they have entered into a definitive agreement to merge the two banks. The merger agreement has been unanimously approved by the boards of directors of both banks and by the Federal Housing Finance Agency (“FHFA”). The potential merger must be approved by the members of both banks through a voting process that is expected to take place in the first half of 2015. We do not expect the merger to have a material effect on our business, financial position, results of operations or cash flows.
Reserves for Future Policy Benefits and Claims
Reserves include policy reserve liabilities and claim reserve liabilities and represent amounts to pay future benefits and claims. Claim reserve liabilities are for claims that have been incurred or are estimated to have been incurred but not yet reported to us. Policy reserve liabilities reflect our best estimate of assumptions at the time of policy issuance including adjustments for adverse deviations in actual experience.
The following table sets forth total reserve balances by reserve type:
Developing the estimates for reserves, and thus the resulting impact on earnings, requires varying degrees of subjectivity and judgment, depending upon the nature of the reserve. For most of our reserves, the reserve calculation methodology is prescribed by various accounting and actuarial standards, although judgment is required in the determination of assumptions used in the calculation. We also hold reserves that lack a prescribed methodology but instead are determined by a formula that we have developed based on our own experience. Because this type of reserve requires a higher level of subjective judgment, we closely monitor its adequacy. These reserves are primarily incurred but not reported (“IBNR”) claim reserves associated with our disability products. Finally, a small amount of reserves is held based entirely upon subjective judgment. These reserves are generally set up as a result of unique circumstances that are not expected to continue far into the future and are released according to pre-established conditions and timelines.
22 STANCORP FINANCIAL GROUP, INC.
The following table sets forth total reserve balances by calculation methodology:
Policy Reserves
Policy reserves include reserves established for individual disability insurance, individual and group immediate annuity businesses and individual life insurance. Policy reserves are calculated using our best estimates of assumptions and considerations at the time the policy was issued, which includes an adjustment for the effect of adverse deviations in actual experience. These assumptions may need to be subsequently modified if policy reserves are projected to be inadequate. We maintain a policy reserve for as long as a policy is in-force, even after a separate claim reserve is established.
The following table sets forth policy reserves by block of business:
Individual disability insurance
Policy reserves for our individual disability insurance block of business are established at the time of policy issuance using the net level premium method as prescribed by GAAP and represent the current value of projected future benefits including expenses less projected future premium. Assumptions used to calculate individual disability insurance policy reserves may vary by the age, gender and occupation class of the insured, the year of policy issue and specific contract provisions and limitations.
Individual disability insurance policy reserves are sensitive to assumptions and considerations regarding:
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Claim incidence rates.
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Claim termination rates.
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Discount rates used to value expected future claim payments and premiums.
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Persistency rates.
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The amount of monthly benefit paid to the insured less reinsurance recoveries and other offsets.
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Expense rates including inflation.
Individual and group immediate annuity businesses
Policy reserves for our individual and group immediate annuity business are established when a policy is issued and represent the present value of future payments due under the annuity contracts. As the contracts are single premium contracts, there is no projected future premium. Assumptions used to calculate immediate annuity policy reserves may vary by the age and gender of the annuitant and year of policy issue.
Immediate annuity policy reserves are sensitive to assumptions and considerations regarding:
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Annuitant mortality rates.
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Discount rates used to value expected future annuity payments.
Individual life insurance
Effective January 1, 2001, substantially all of our individual life insurance policies and the associated reserves were ceded to Protective Life Insurance Company (“Protective Life”) under a reinsurance agreement. Effective February 1, 2015, Protective Life was acquired by The Dai-ichi Life Insurance Company, Limited (“Dai-ichi Life”) and is a wholly-owned subsidiary of Dai-ichi Life. If Protective Life were to become unable to meet its obligations, Standard would retain the reinsured liabilities. Therefore, the associated reserves remain on Standard’s consolidated balance sheets and an equal amount is recorded as recoverable from the reinsurer. We also retain a small number of individual policies arising out of individual conversions from our group life policies.
2014 ANNUAL REPORT 23
Part II
Claim Reserves
Claim reserves are established when a claim is incurred or is estimated to have been incurred but not yet reported to us and, as prescribed by GAAP, equal our best estimate of the present value of the liability of future unpaid claims and claim adjustment expenses. Reserves for IBNR claims are determined using our experience and historical incidence rates, claim-reporting patterns and the average cost of claims. The IBNR claim reserves are calculated using a company derived formula based primarily upon premiums, which is validated through an examination of reserve run-out experience. The claim reserves are related to group and individual disability insurance and group life insurance products offered within Employee Benefits and Individual Disability.
Claim reserves are subject to revision based on credible changes in claim experience and expectations of future factors that may influence claim experience. During each quarter, we monitor our emerging claims experience to ensure that the claim reserves remain appropriate. We make adjustments to our assumptions based on emerging trends that are credible and are expected to persist, and expectations of future factors that may influence our claims experience. Assumptions used to calculate claim reserves may vary by the age, gender and occupation class of the claimant, the year the claim was incurred, time elapsed since disablement, and specific contract provisions and limitations.
The following table sets forth total claim reserves by block of business:
Group and individual disability insurance
Claim reserves for our disability insurance products are sensitive to assumptions and considerations regarding:
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Claim incidence rates for IBNR claim reserves.
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Claim termination rates.
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Discount rates used to value expected future claim payments.
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The amount of monthly benefit paid to the insured less reinsurance recoveries and other offsets.
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Expense rates including inflation.
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Historical delay in reporting of claims incurred.
Certain of these factors could be materially affected by changes in social perceptions about work ethics, emerging medical perceptions and legal interpretations regarding physiological or psychological causes of disability, emerging or changing health issues and changes in industry regulation. If there are changes in one or more of these factors or if actual claims experience is materially inconsistent with our assumptions, we could be required to change our reserves.
Group life insurance
Claim reserves for our group life insurance products are established for death claims reported but not yet paid, IBNR for death and waiver claims and waiver of premium benefits. The death claim reserve is based on the actual amount to be paid. The IBNR claim reserves are calculated using historical information, and the waiver of premium benefit is calculated using a tabular reserve method that takes into account company experience and published industry tables.
Trends in Key Assumptions
Key assumptions affecting our reserve calculations include:
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The discount rate.
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The claim termination rate.
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The claim incidence rate for policy reserves and IBNR claim reserves.
The following table sets forth the average discount rate used for newly established long term disability insurance claim reserves and life waiver reserves:
24 STANCORP FINANCIAL GROUP, INC.
The reserve discount rate is reviewed quarterly and reflects our current and expected new investment yields. The discount rate is based on the average rate we received on newly invested assets attributable to the corresponding line of business during the previous 12 months, less a margin. We also consider our average investment yield and average discount rate on our entire block of claims when deciding whether to increase or decrease the discount rate. A 25 basis point increase or decrease in the discount rate currently results in a corresponding increase or decrease in quarterly pre-tax income of approximately $2 million. We do not adjust Employee Benefits premium rates based on short-term fluctuations in investment yields. Any offsetting adjustments of Employee Benefits premium rates due to sustained changes in investment yields can take from one to three years given that most contracts have rate guarantees in place.
Claim termination rates can vary widely from quarter to quarter. The claim termination assumptions used in determining our reserves represent our expectation for claim terminations over the life of our block of business and will vary from actual experience in any one quarter. While we have experienced some variation in our claim termination experience, we did not see any prolonged or systemic change in 2014 that would indicate a sustained underlying trend that would affect the claim termination rates used in the calculation of reserves.
As a result of studies of our long-term trends compared to reserving assumptions for our group long term disability insurance, we did not adjust our IBNR claim reserves in 2014 or 2013. We increased IBNR claim reserves by $3.7 million in 2012.
We evaluate the claim termination rate assumptions for the reserves on a small Minnesota Life Insurance Company (“Minnesota Life”) block of individual disability insurance claims annually. These assumptions were refined in 2014, 2013 and 2012, which resulted in an increase in reserves of $2.7 million, $2.1 million and $4.9 million, respectively. Our block of business is relatively small, and as a result, we view a blend of established industry tables and our own experience as a more appropriate method for establishing reserve levels compared solely to our own experience. We will continue to monitor the credibility of our developing experience and the use of available industry tables, and if necessary, will adjust reserves accordingly. We also refined our reserve calculation for certain other individual disability insurance reserves, which resulted in a net increase in our individual disability insurance reserves of $2.0 million and $5.1 million in 2014 and 2013, respectively and a net decrease of $1.1 million in 2012. The combination of these adjustments resulted in an overall net increase to individual disability reserves of $4.7 million, $7.2 million and $3.8 million in 2014, 2013 and 2012, respectively.
We monitor the adequacy of our reserves relative to our key assumptions. In our estimation, scenarios based on reasonably possible variations in claim termination assumptions could produce a percentage change in reserves for our Employee Benefits lines of business of approximately +/-0.2% or $8 million. However, given that claims experience can fluctuate widely from quarter to quarter, significant unanticipated changes in claim termination rates over time could produce a change in reserves for our Employee Benefits lines outside of this range.
DAC, VOBA and Other Intangible Assets
DAC, VOBA and other acquisition related intangible assets are generally originated through the issuance of new business or the purchase of existing business, either by purchasing blocks of insurance policies from other insurers or by the outright purchase of other companies. Our intangible assets are subject to impairment tests on an annual basis or more frequently if circumstances indicate that carrying values may not be recoverable.
The following table sets forth the balances of DAC, VOBA and other intangible assets:
We defer certain acquisition costs that vary with and are directly related to the origination of new business and placing that business in-force. Certain costs related to obtaining new business and acquiring business through reinsurance agreements have been deferred and are amortized to match related future premiums or gross profits as appropriate. We normally defer certain acquisition-related commissions and incentive payments, certain costs of policy issuance and underwriting, and certain printing costs. Assumptions used in developing DAC and amortization amounts each period include the amount of business in-force, expected future persistency, withdrawals, interest rates and profitability. These assumptions are modified to reflect actual experience when appropriate. Additional amortization of DAC is charged to current earnings to the extent it is determined that future premiums or gross profits are not adequate to cover the remaining amounts deferred. Changes in actual persistency are reflected in the calculated DAC balance. Costs that are not directly associated with the acquisition of new business are not deferred as DAC and are charged to expense as incurred. Generally, annual commissions are considered expenses and are not deferred.
2014 ANNUAL REPORT 25
Part II
DAC for group and individual disability insurance products and group life insurance products is amortized over the life of related policies in proportion to future premiums. We amortize DAC for group disability and life insurance products over the initial premium rate guarantee period, which averages 2.5 years. DAC for individual disability insurance products is amortized in proportion to future premiums over the life of the contract, averaging 20 to 25 years with approximately 50% and 75% expected to be amortized by years 10 and 15, respectively.
Our individual deferred annuities and group annuity products are classified as investment contracts. DAC related to these products is amortized over the life of related policies in proportion to expected gross profits. For our individual deferred annuities, DAC is generally amortized over 30 years with approximately 54% and 93% expected to be amortized by years 5 and 15, respectively. DAC for group annuity products is amortized over 10 years with approximately 76% expected to be amortized by year five.
VOBA primarily represents the discounted future profits of business assumed through reinsurance agreements. We have established VOBA for a block of individual disability insurance business assumed from Minnesota Life and a block of group disability insurance and group life insurance business assumed from Teachers Insurance and Annuity Association of America (“TIAA”). VOBA is generally amortized in proportion to future premiums for group and individual disability insurance products and group life insurance products. However, the VOBA related to the TIAA transaction associated with an in-force block of group long term disability insurance claims for which no ongoing premium is received is amortized in proportion to expected gross profits. If actual premiums or future profitability are inconsistent with our assumptions, we could be required to make adjustments to VOBA and related amortization. The VOBA associated with the TIAA transaction is amortized in proportion to expected gross profits with an amortization period of up to 20 years. For the VOBA associated with the Minnesota Life block of business assumed, the amortization period is up to 30 years and is amortized in proportion to future premiums. The accumulated amortization of VOBA was $71.0 million and $68.7 million at December 31, 2014 and 2013, respectively.
The following table sets forth the amount of DAC and VOBA balances amortized in proportion to expected gross profits and the percentage of the total balance of DAC and VOBA amortized in proportion to expected gross profits:
Key assumptions, which will affect the determination of expected gross profits for determining DAC and VOBA balances, include:
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Persistency.
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Interest rates, which affect both investment income and interest credited.
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Stock market performance.
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Capital gains and losses.
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Claim termination rates.
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Amount of business in-force.
These assumptions are modified to reflect actual experience when appropriate. Although a change in a single assumption may have an impact on the calculated amortization of DAC or VOBA for balances associated with investment contracts, it is the relationship of that change to the changes in other key assumptions that determines the ultimate impact on DAC or VOBA amortization. Because actual results and trends related to these assumptions vary from those assumed, we review, and if necessary, revise these assumptions annually to reflect our current best estimate of expected gross profits. As a result of this process, known as “unlocking”, the cumulative balances of DAC and VOBA are adjusted with an offsetting increase or decrease to income to reflect changes in the period of the revision. An unlocking event generally occurs as a result of actual experience or future expectations differing from previous estimates. We recorded a decrease to VOBA of $1.0 million in 2013 and $0.8 million in 2012 due to changes in expected gross profits related to a block of claims assumed. We did not record an adjustment to VOBA as a result of unlocking in 2014. As a result of unlocking, the amortization schedule for future periods is also adjusted.
The following table sets forth the impact of unlocking on DAC and VOBA balances:
Significant, unanticipated changes in key assumptions, which affect the determination of expected gross profits, may result in a large unlocking event that could have a material adverse effect on our financial position or results of operations. However, future changes in DAC and VOBA due to changes in underlying assumptions are not expected to be material.
26 STANCORP FINANCIAL GROUP, INC.
Our other intangible assets are subject to amortization and consist of certain customer lists from an Asset Management business acquired and an Individual Disability marketing agreement. Customer lists have a combined estimated weighted-average remaining life of approximately 6.5 years. The marketing agreement accompanied the Minnesota Life transaction and provides access to Minnesota Life agents, some of whom now market Standard’s individual disability insurance products. The Minnesota Life marketing agreement will be fully amortized by the end of 2023. The accumulated amortization of other intangible assets was $48.4 million and $42.6 million at December 31, 2014 and 2013, respectively.
Pension and Postretirement Benefit Plans
We have two non-contributory defined benefit pension plans: the employee pension plan and the agent pension plan. The employee pension plan is generally limited to eligible employees whose date of employment began before 2003 and a participant is entitled to normal retirement benefits at age 65. The agent pension plan is for former field employees and agents. The defined benefit pension plans provide benefits based on years of service and final average pay. The employee pension plan is sponsored by StanCorp and the agent pension plan is sponsored by Standard. Both plans are administered by Standard Retirement Services and are closed for new participants. In addition, eligible executive officers are covered by a non-qualified supplemental retirement plan.
We also have a postretirement benefit plan that includes medical, prescription drug benefits and group term life insurance. Eligible retirees are required to contribute specified amounts for medical and prescription drug benefits that are determined periodically and are based on retirees’ length of service and age at retirement. As of 2006, participation in the postretirement benefit plan was closed to new participants. This plan is sponsored and administered by Standard. An amendment announced in 2012 reduced future benefits to plan participants that did not retire by July 1, 2013.
We are required to recognize the funded status of our pension and postretirement benefit plans as an asset or liability on our consolidated balance sheets. For pension plans, this is measured as the difference between the plan assets at fair value and the projected benefit obligation as of the year-end balance sheet date. For our postretirement plan, this is measured as the difference between the plan assets at fair value and the accumulated benefit obligation as of the year-end balance sheet date. Unrecognized actuarial gains or losses, prior service costs or credits, and transition assets are amortized, net of tax, out of accumulated other comprehensive income or loss as components of net periodic benefit cost.
In accordance with the accounting principles related to our pension and other postretirement plans, we are required to make a significant number of assumptions to calculate the related liabilities and expenses each period. The major assumptions that affect net periodic benefit cost and the funded status of the plans include the weighted-average discount rate, the expected return on plan assets, changes in actuarial assumptions and the rate of compensation increase.
The weighted-average discount rate is an interest assumption used to convert the benefit payment stream to present value. The discount rate is selected based on the yield of a portfolio of high-quality corporate bonds with durations that are similar to the expected distributions from the employee benefit plan.
The expected return on plan assets assumption is the best long-term estimate of the average annual return that will be produced from the pension trust assets until current benefits are paid. Our expectations for the future investment returns of the asset categories are based on a combination of historical and projected market performance. The expected return for the total portfolio is calculated based on each plan’s strategic asset allocation.
The long-term rate of return for the employee pension plan portfolio is derived by calculating the average return for the portfolio monthly, from 1971 to the present, using the average mutual fund manager returns in each asset category, weighted by the target allocation to each category.
The actuarial present value of accumulated plan benefits is determined annually by applying actuarial assumptions to adjust the accumulated plan benefits to reflect the discount rate and the probability of payment between the valuation date and the expected date of payment. Changes in these assumptions, including the assumptions for mortality, are inherent in the estimations and assumptions process.
In 2014, we adopted an updated mortality table which was a significant driver of the increase in the projected benefit obligation at December 31, 2014 compared to December 31, 2013.
The rate of compensation increase is a long-term assumption that is based on an estimated inflation rate in addition to merit and promotion-related compensation increase components.
For the postretirement benefit plan, the expected long-term rate of return on assets was developed by considering the historical returns and the future expectations for returns, as well as the target asset allocation. In addition, the assumption for the health care cost trend rates also affect expenses and liabilities for the postretirement benefit plan. Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
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Our discount rate assumption is reviewed annually, and we use a December 31 measurement date for each of our plans. For more information concerning our pension and postretirement plans, see Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 4-Retirement Benefits.”
Income Taxes
We file a U.S. consolidated income tax return that includes all subsidiaries. Our U.S. income tax is calculated using regular corporate income tax rates on a tax base determined by laws and regulations administered by the Internal Revenue Service (“IRS”). We also file corporate income tax returns in various states. The provision for income taxes includes amounts currently payable and deferred amounts that result from temporary differences between financial reporting and tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply when the temporary differences are expected to reverse.
GAAP requires management to use a more likely than not standard to evaluate whether, based on available evidence, each deferred tax asset will be realized. A valuation allowance is recorded to reduce a deferred tax asset to the amount expected to be realized. We have recorded a deferred tax asset for loss carryforwards. Realization is dependent on generating sufficient taxable income prior to expiration of the loss carryforwards. Although realization is not assured, management believes it is more likely than not that the deferred tax asset for federal loss carryforwards will be realized. The amount of the deferred tax asset considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward period are reduced. Management has established a valuation allowance on some state and local loss carryforwards which it believes are not likely to be realized.
Income tax expense may differ from the amount computed by applying the federal corporate tax rate of 35% to pre-tax income because of the net results of permanent differences between book and taxable income, tax credits and the inclusion of state and local income taxes, net of the federal tax benefit. In addition, tax credits received due to the purchases of tax-advantaged investments also impact our federal tax rate. See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 7-Income Taxes.”
Management is required to determine whether tax return positions are more likely than not to be sustained upon audit by taxing authorities. Tax benefits of uncertain tax positions, as determined and measured by this interpretation, cannot be recognized in our financial statements.
We record interest paid on income tax liabilities as interest expense and income tax penalties incurred as an operating expense. Currently, the years 2011 through 2014 are open for audit by the IRS.
BASIS OF PRESENTATION
Revenues
Revenues consist of premiums, administrative fees, net investment income and net capital gains and losses. Historically, premium and net investment income growth in Insurance Services and administrative fee and net investment income growth in Asset Management have been the primary drivers of consolidated revenue growth.
Premiums
Premiums for Insurance Services are the primary driver of consolidated premiums and are affected by sales, persistency, organic growth in Employee Benefits and experienced rated refunds (“ERRs”). Organic growth in Employee Benefits is derived from existing policyholders’ employment and wage growth. ERRs represent cost sharing arrangements with certain group contract holders that provide refunds to the contract holders when claims experience is more favorable than contractual benchmarks, and provide for additional premiums to be paid when claims experience is less favorable than contractual benchmarks. ERRs can fluctuate widely from quarter to quarter depending on the underlying experience of specific contracts.
Premiums for Asset Management are generated from sales of life-contingent annuities, which are a single-premium product. Due to the competitive nature of single-premium products, premiums received by Asset Management can fluctuate widely from quarter to quarter due to low sales volume of life-contingent annuities and the varying size of single premiums. Increases or decreases in premiums for life-contingent annuities generally correlate with corresponding increases or decreases in benefits to policyholders.
Administrative Fees
Administrative fees for Asset Management include asset-based and plan-based fees related to our retirement plans and private client wealth management businesses, and fees related to the origination and servicing of commercial mortgage loans. The primary driver for administrative fees is the level of assets under administration for retirement plans, which is driven by equity and debt market performance and net customer deposits. Assets under administration that produce administrative fees include retirement plan group annuity and separate account products, retirement plan trust products, private client wealth management and commercial mortgage loans under administration for other investors.
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Administrative fees for Insurance Services are primarily derived from insurance products for which we provide only administrative services and absence management services.
Net Investment Income
Net investment income is primarily affected by changes in levels of invested assets, portfolio yields, fluctuations in the change in fair value of our S&P 500 Index options related to our equity-indexed annuity product, commercial mortgage loan prepayment fee revenues, bond call premiums on fixed maturity securities and operating losses related to our tax-advantaged investments.
Net Capital Gains and Losses
Net capital gains and losses are reported in the Other category and are not likely to occur in a stable pattern. Net capital gains and losses primarily occur as a result of sales of our assets for more or less than carrying value, OTTI of assets in our bond portfolio, provisions to our commercial mortgage loan loss allowance, impairments of real estate and impairments of other invested assets.
Benefits and Expenses
Benefits and expenses are amounts we pay to or on behalf of policyholders, interest credited to policyholders, commissions and bonuses, and other expenses.
Benefits to Policyholders
Benefits to policyholders for Insurance Services are primarily affected by the following factors:
•
Reserves that are established in part based on premium levels.
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Claims experience-the predominant factors affecting claims experience are claims incidence, measured by the number of claims, and claims severity, measured by the magnitude of the claim and the length of time a disability claim is paid.
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Reserve assumptions-the assumptions used to establish the related reserves reflect expected incidence and severity, and the discount rate. The discount rate is affected by new money investment rates attributable to the corresponding line of business and the overall portfolio yield. See “Critical Accounting Policies and Estimates-Reserves for Future Policy Benefits and Claims.”
Benefits to policyholders for Asset Management primarily represent current benefits and the change in reserves for future benefits on life-contingent annuities. Changes in the level of benefits to policyholders will generally correlate to changes in premium levels because these annuities are primarily single-premium life-contingent annuity products with a significant portion of all premium payments established as reserves.
Benefit Ratio
The benefit ratio for Employee Benefits is calculated as benefits to policyholders and interest credited as a percentage of premiums and is used to provide a measurement of claims normalized for growth in our in-force block. The benefit ratio for Employee Benefits can fluctuate widely from quarter to quarter and has historically been higher in the first half of the year. The benefit ratio for Individual Disability is calculated as benefits to policyholders as a percentage of premiums. Due to the relatively small size of the Individual Disability business, the benefit ratio for Individual Disability generally fluctuates more than Employee Benefits. See “Critical Accounting Policies and Estimates-Reserves for Future Policy Benefits and Claims” for more information.
Discount Rate
The discount rate used for newly established long term disability insurance claim reserves and life waiver reserves is reviewed quarterly and reflects our current and expected new investment yields. The discount rate is based on the average rate we received on newly invested assets attributable to the corresponding line of business during the previous 12 months, less a margin. We also consider our average investment yield and average discount rate on our entire block of claims when deciding whether to increase or decrease the discount rate. A 25 basis point increase or decrease in the discount rate currently results in a corresponding increase or decrease in the quarterly pre-tax income of approximately $2 million or approximately $8 million for the full year. See “Critical Accounting Policies and Estimates-Reserves for Future Policy Benefits and Claims-Claim Reserves.”
Interest Credited
Interest credited represents interest paid to policyholders on retirement plan general account assets, individual fixed-rate annuity deposits and index-based interest guarantees in Asset Management and interest paid on life insurance proceeds on deposit in Insurance Services. Interest credited is primarily affected by the following factors:
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Changes in general account assets under administration.
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Changes in new investment interest rates and overall portfolio yield, which influence our interest-crediting rate for our customers.
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Persistency.
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Changes in the fair value of the index-based interest guarantees. The changes may fluctuate from quarter to quarter due to changes in interest rates and equity market volatility.
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Commissions and Bonuses
Commissions and bonuses primarily represent sales-based compensation, which can vary depending on the product, the structure of the commission program and other factors such as customer retention, sales, in-force premium, growth in assets under administration and the profitability of business in each of our segments.
Net Change in DAC, VOBA and Other Intangible Assets
We normally defer certain acquisition-related commissions and incentive payments, certain costs of policy issuance and underwriting. These costs are then amortized into expenses over a period not to exceed the life of the related policies, which for Employee Benefits contracts is the initial premium rate guarantee period and averages 2.5 years. VOBA primarily represents the discounted future profits of business assumed through reinsurance agreements. A portion of VOBA is amortized each year to achieve matching against expected gross profits. Our other intangible assets, consisting of customer lists and marketing agreements, are also subject to amortization. See “Critical Accounting Policies and Estimates-DAC, VOBA and Other Intangible Assets.”
Income Taxes
Income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% to pre-tax income because of the net result of permanent differences between book and taxable income, tax credits and the inclusion of state and local income taxes, net of the federal tax benefit.
CONSOLIDATED RESULTS OF OPERATIONS
The following table sets forth our consolidated results of operations and key indicators:
30 STANCORP FINANCIAL GROUP, INC.
Year Ended December 31, 2014 Compared to Year Ended December 31, 2013
Net income for 2014 was $219.3 million, compared to $228.5 million for 2013. The decrease in net income was primarily due to lower operating expenses for 2013, which included savings of $20.6 million due to the amendment of our postretirement medical plan, which did not recur in 2014.
Revenues
The decrease in revenues for 2014 compared to 2013 was primarily due to a decrease in Employee Benefits premiums and net investment income. The decrease was partially offset by an increase in Individual Disability premiums and an increase in administrative fees from Asset Management. See “Business Segments-Insurance Services” and “Business Segments-Asset Management.”
Premiums
The decrease in premiums for 2014 compared to 2013 was primarily due to a decrease in Employee Benefits premiums as a result of lower Employee Benefits sales in the first half of 2014 compared to prior periods. See “Business Segments-Insurance Services.”
Administrative Fees
The increase in administrative fees for 2014 compared to 2013 was primarily due to the increase in administrative fees from Asset Management as a result of an increase in assets under administration related to higher equity values for retirement plan assets under administration. See “Business Segments-Asset Management.”
Net Investment Income
The decrease in net investment income for 2014 compared to 2013 was primarily due to lower average portfolio yields for both fixed maturity securities and commercial mortgage loans as shown in the table above, in addition to the change in fair value of our S&P 500 Index options related to our equity-indexed annuity product and higher operating losses on tax-advantage investments for 2014, compared to 2013. The change in fair value of our S&P 500 Index options increased net investment income by $8.6 million for 2014, compared to an increase of $14.4 million for 2013. Operating losses on tax-advantage investments increased to $19.4 million for 2014, compared to $13.9 million for 2013. See “Business Segments-Insurance Services” and “Business Segments-Asset Management.”
Net Capital Losses
The decrease in net capital losses for 2014 compared to 2013 was primarily due to a decrease in the provision for our commercial mortgage loan losses and lower capital losses on real estate. These net capital losses were partially offset by net capital gains related to the sale of certain fixed maturity securities. See “Business Segments-Other.”
Benefits to Policyholders
The decrease in benefits to policyholders for 2014 compared to 2013 was primarily due to more favorable claims experience in Employee Benefits. See “Business Segments-Insurance Services.”
Interest Credited
The decrease in interest credited for 2014 compared to 2013 was primarily due to a decrease in the average interest-crediting rate for our annuity products and the change in fair value of the index-based guarantees, which increased interest credited by $7.2 million for 2014, compared to an increase of $9.0 million for 2013. The decrease was partially offset by an increase in interest credited due to an increase in our retirement plan general account assets under administration. See “Business Segments-Asset Management.”
Operating Expenses
The increase in operating expenses for 2014 compared to 2013 was primarily due to expense management actions taken in the first half of 2013 and an increase in compensation related costs. Operating expenses were reduced by $20.6 million for the first half of 2013 due to the amendment of our postretirement medical plan, which did not recur in 2014. See “Business Segments-Other.”
Net Change in DAC, VOBA and Other Intangible Assets
The net increase in DAC, VOBA and other intangible assets for 2014 was relatively flat compared to 2013 and was primarily due to an increase in deferrals for individual annuities, which was primarily due to higher individual annuity sales. This increase was partially offset by an increase in the margin between net investment income and interest credited for our fixed deferred annuity products and an increase in DAC amortization for individual annuities related to unlocking. See “Business Segments-Asset Management.”
Income Taxes
The decrease in the effective income tax rate for 2014 compared to 2013 was primarily due to the utilization of tax credits from tax-advantaged investments. See Item 8, “Financial Statements and Supplementary Data-Notes to the Consolidated Financial Statements-Note 7-Income Taxes” for more information.
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Year Ended December 31, 2013 Compared to Year Ended December 31, 2012
Net income for 2013 was $228.5 million, compared to $138.5 million for 2012. The increase in net income was primarily due to more favorable claims experience in Employee Benefits, lower operating expenses as a result of expense management actions, and higher earnings in the Asset Management and Individual Disability segments for 2013. Operating expenses were reduced by $20.6 million for the first half of 2013 due to the amendment of our postretirement medical plan.
Revenues
The decrease in revenues for 2013 compared to 2012 was primarily due to a decrease in Employee Benefits premiums. The decrease was partially offset by an increase in Individual Disability premiums and an increase in administrative fees from Asset Management. See “Business Segments-Insurance Services” and “Business Segments-Asset Management.”
Premiums
The decrease in premiums for 2013 compared to 2012 was primarily due to a decrease in Employee Benefits premiums as a result of lower Employee Benefits sales and from the impact of ERRs. See “Business Segments-Insurance Services.”
Administrative Fees
The increase in administrative fees for 2013 compared to 2012 was primarily due to the increase in administrative fees from Asset Management as a result of an increase in assets under administration related to higher equity values for retirement plan assets under administration. See “Business Segments-Asset Management.”
Net Investment Income
The increase in net investment income for 2013 compared to 2012 was primarily due to higher contributions from the change in fair value of our S&P 500 Index options related to our indexed annuity product. In addition, commercial mortgage loan prepayment fee revenues contributed $16.6 million to net investment income in 2013, compared to $13.2 million in 2012. These increases were partially offset by lower average portfolio yields for both fixed maturity securities and commercial mortgage loans, and lower bond call premiums of $5.3 million in 2013, compared to $8.0 million in 2012. See “Business Segments-Insurance Services” and “Business Segments-Asset Management.”
Net Capital Gains and Losses
The increase in net capital losses for 2013 compared to 2012 was primarily due to an increase in the provision for our commercial mortgage loan losses and capital losses on real estate. These capital losses were partially offset by net capital gains related to the sale of certain fixed maturity securities. See “Business Segments-Other.”
Benefits to Policyholders
The decrease in benefits to policyholders for 2013 compared to 2012 was primarily due to more favorable claims experience in Employee Benefits. See “Business Segments-Insurance Services.”
Interest Credited
The increase in interest credited for 2013 compared to 2012 was primarily due to growth in our retirement plan general account assets under administration and individual fixed-rate annuity assets under administration, partially offset by a decrease in the average interest-crediting rate for our annuity products. See “Business Segments-Asset Management.”
Operating Expenses
The decrease in operating expenses for 2013 compared to 2012 was primarily due to expense management actions. Operating expenses were reduced by $20.6 million for the first half of 2013 due to the amendment of our postretirement medical plan. See “Business Segments-Other.”
Net Change in DAC, VOBA and Other Intangible Assets
The net increase in DAC, VOBA and other intangible assets was primarily due to higher Employee Benefits commissions and bonuses for 2013 compared to 2012.
Income Taxes
The increase in the effective income tax rate for 2013 compared to 2012 was primarily due to higher taxable income relative to permanent book-to-tax differences for 2013. The increase was partially offset by the utilization of tax credits from tax-advantaged investments. See Item 8, “Financial Statements and Supplementary Data-Notes to the Consolidated Financial Statements-Note 7-Income Taxes” for more information.
32 STANCORP FINANCIAL GROUP, INC.
BUSINESS SEGMENTS
We collectively view and operate our businesses as Insurance Services and Asset Management. Insurance Services contains two reportable product segments, Employee Benefits and Individual Disability. Insurance Services include our traditional risk acceptance businesses that reflect the application of our specialized expertise in the development, underwriting and administration of insurance products and services. Within Insurance Services, Employee Benefits offers group disability insurance, group life and AD&D insurance, group dental and group vision insurance, and absence management services. Asset Management is a separate reportable segment. Asset Management provides investment and asset management products and services and offers full-service 401(k) plans, 403(b) plans, 457 plans, defined benefit plans, money purchase pension plans, profit sharing plans and non-qualified deferred compensation products and services. Asset Management also offers investment advisory and management services, origination and servicing of fixed-rate commercial mortgage loans, individual fixed and indexed annuity products, group annuity contracts and retirement plan trust products. The Other category includes return on capital not allocated to the product segments, holding company expenses, operations of certain unallocated subsidiaries, interest on debt, unallocated expenses, net capital gains and losses primarily related to the impairment or the disposition of our invested assets and adjustments made in consolidation. We allocate resources and measure performance at the segment level.
The following table sets forth segment revenues measured as a percentage of total revenues, excluding revenues from the Other category:
Insurance Services
Insurance Services is comprised of our Employee Benefits and Individual Disability segments.
The following tables set forth our Insurance Services results of operations and key indicators:
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34 STANCORP FINANCIAL GROUP, INC.
Year Ended December 31, 2014 Compared to Year Ended December 31, 2013
Income before income taxes for Insurance Services was $254.7 million for 2014, compared to $272.4 million for 2013. The decrease in income before income taxes was primarily due to lower Employee Benefits premiums and lower net investment income, partially offset by more favorable claims experience in Employee Benefits.
Premiums
The decrease in premiums for Employee Benefits for 2014 compared to 2013 was primarily due to lower sales during the first half of 2014 compared to prior periods. The decrease in new sales reflected our pricing discipline in a competitive group insurance market. See “Basis of Presentation-Premiums.”
The increase in premiums for Individual Disability for 2014 compared to 2013 was primarily due to a high persistency level and new policy sales for 2014.
Net Investment Income
The decrease in net investment income for Insurance Services for 2014 compared to 2013 was primarily due to operating losses on tax-advantaged investments, which increased to $16.9 million for 2014, compared to $11.9 million for 2013. In addition, portfolio yields for both fixed maturity securities and commercial mortgage loans were lower for 2014 compared to 2013. See “Critical Accounting Policies and Estimates-Other Invested Assets-Tax-advantaged Investments” for more information.
Benefits to Policyholders (including interest credited)
The decrease in benefits to policyholders (including interest credited) for Insurance Services for 2014 compared to 2013 was primarily due to more favorable claims experience in the group life and group disability businesses of Employee Benefits. Benefits to policyholders related to incurred claims for 2014 decreased 6.5% compared to the incurred claims for 2013, which primarily resulted from a 1.6% reduction in long term disability insurance claims incidence for 2014 compared to 2013.
The benefit ratio for Employee Benefits was 77.8% for 2014, compared to 78.9% for 2013. Contributing to the decrease in the Employee Benefits benefit ratio was a 25 basis point higher average discount rate used for newly established long term disability insurance claim reserves and life waiver reserves for 2014 compared to 2013. A 25 basis point increase or decrease in the discount rate currently results in a corresponding increase or decrease in quarterly pre-tax income of approximately $2 million or approximately $8 million for the full year. The increase in the discount rate was primarily due to the mix and timing of new investments we acquired and the yields on these new investments attributable to the corresponding line of business. See “Critical Accounting Policies and Estimates-Reserves for Future Policy Benefit and Claims” for more information.
The favorable claims experience for 2014 did not result in a significant change in our underlying assumptions or methods used to determine the claim reserves, primarily due to the long-term nature of our group long term disability insurance business and the materiality of other factors, including the potential impact of economic uncertainty. We monitor trends in reserve assumptions and when these trends become credible and are expected to persist, we incorporate these factors into our reserves to ensure the best estimates are established.
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The benefit ratio for Individual Disability increased to 65.3% for 2014, compared to 63.9% for 2013. Due to the relatively small size of the Individual Disability business, the benefit ratio generally fluctuates more than Employee Benefits. See “Critical Accounting Policies and Estimates-Reserves for Future Policy Benefits and Claims-Claim Reserves” for more information.
Operating Expenses
The increase in operating expenses for Insurance Services for 2014 compared to 2013 was primarily due to an increase in compensation related costs.
Commissions and bonuses
The decrease in commissions and bonuses for Insurance Services for 2014 compared to 2013 was primarily due to lower Employee Benefits premiums and sales.
Premium taxes
The decrease in premium taxes for Insurance Services for 2014 compared to 2013 was primarily due to the utilization of state premium tax credits for 2014.
Year Ended December 31, 2013 Compared to Year Ended December 31, 2012
Income before income taxes for Insurance Services was $272.4 million for 2013, compared to $179.8 million for 2012. The increase in income before income taxes was primarily due to more favorable claims experience in Employee Benefits, partially offset by lower Employee Benefits premiums and lower net investment income.
Premiums
The decrease in premiums for Employee Benefits for 2013 compared to 2012 was primarily due to lower Employee Benefits sales for 2013 and from the impact of ERRs. ERRs decreased premiums by $13.1 million for 2013 and increased premiums by $4.0 million for 2012. See “Basis of Presentation-Premiums” for more information regarding ERRs.
The increase in premiums for Individual Disability for 2013 compared to 2012 was primarily due to a high persistency level and sales for 2013.
Net Investment Income
The decrease in net investment income for Insurance Services for 2013 compared to 2012 was primarily due to lower portfolio yields on fixed maturity securities and commercial mortgage loans. In addition, bond call premiums decreased to $2.0 million for 2013, compared to $5.3 million for 2012 and operating losses on tax-advantaged investments increased to $11.9 million for 2013, compared to $9.5 million for 2012. The decrease in net investment income was partially offset by an increase in commercial mortgage loan prepayment fee revenues to $10.0 million for 2013, compared to $7.8 million for 2012.
Benefits to Policyholders (including interest credited)
The decrease in benefits to policyholders (including interest credited) for Insurance Services for 2013 compared to 2012 was primarily due to comparatively favorable claims experience in the Employee Benefits segment. The benefit ratio for Employee Benefits was 78.9% for 2013 compared to 83.9% for 2012. The decrease in the annual benefit ratio was primarily due to pricing actions implemented on our long term disability insurance business and an improvement in long term disability insurance claims incidence.
Our pricing actions reflected our long-term expectations of claims experience, demographic changes, return objectives and interest rates. The targeted pricing actions implemented in 2011 on our group long term disability insurance business were, on average, in the high single digit range. These pricing increases were applied to both new sales and renewal business and were not focused on any specific sector. As a result of our pricing actions we were able to increase premiums for those customers where premium levels were not adequate to cover underlying experience for the group, or in some cases, poorly performing groups chose to move their coverage to another carrier offering lower rates.
Benefits to policyholders related to incurred claims for the Employee Benefits segment for 2013 decreased 3.8% compared to the incurred claims for 2012, which primarily resulted from a 3.5% reduction in long term disability insurance claims incidence for 2013 compared to 2012. The decrease in benefits to policyholders was offset by a 43 basis point lower average discount rate for 2013 compared to 2012 used for newly established long term disability insurance claims reserves. The decrease in the average discount rate was primarily the result of a continued low interest rate environment. Claims experience can fluctuate widely from period to period and tends to be more stable when measured over a longer period of time. See “Critical Accounting Policies and Estimates-Basis of Presentation” for more information.
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The favorable claims experience for 2013 did not result in a significant change in our underlying assumptions or methods used to determine the claim reserves, primarily due to the long-term nature of our group long term disability insurance business and the materiality of other factors, including the potential impact of economic uncertainty. We monitor trends in reserve assumptions and when these trends become credible and are expected to persist, we incorporate these factors into our reserves to ensure the best estimates are established.
The benefit ratio for Individual Disability decreased to 63.9% for 2013, compared to 65.8% for 2012. Due to the relatively small size of the Individual Disability business, the benefit ratio generally fluctuates more than Employee Benefits. See “Critical Accounting Policies and Estimates-Investment Valuations-Claim Reserves” for more information.
Operating Expenses
The decrease in operating expenses for Insurance Services for 2013 compared to 2012 was primarily due to expense management actions, which reduced headcount and other non-compensation related expenses to align operating expenses with lower anticipated premium levels.
Asset Management
The following tables set forth our Asset Management results of operations and key indicators:
* n.m. = not a material change
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Year Ended December 31, 2014 Compared to Year Ended December 31, 2013
Income before income taxes for Asset Management was $77.9 million for 2014, compared to $79.3 million for 2013. The decrease in income before income taxes was primarily due to the change in fair values of the hedging assets and liabilities related to our equity-indexed annuity product, which decreased income before income taxes by $0.5 million for 2014, compared to an increase of $2.6 million for 2013. The decrease was partially offset by an increase in administrative fees for 2014 compared to 2013, which was primarily due to an increase in assets under administration.
Administrative Fees
The increase in administrative fees for Asset Management for 2014 compared to 2013 was primarily due to an increase in assets under administration. Assets under administration increased 7.4% to $26.53 billion at December 31, 2014, compared to $24.70 billion at December 31, 2013, primarily due to higher equity values and positive cash flows for retirement plan assets under administration.
Net Investment Income
The decrease in net investment income for Asset Management for 2014 compared to 2013 was primarily due to lower portfolio yields for both fixed maturity securities and commercial mortgage loans and the change in fair value of the S&P 500 Index options related to our equity indexed annuity product. The change in fair value of the S&P 500 Index options increased net investment income by $8.6 million for 2014, compared to an increase of $14.4 million for 2013.
Benefits to Policyholders
The increase in benefits to policyholders for Asset Management for 2014 compared to 2013 was primarily due to an increase in premiums for single-premium life-contingent annuity products. See “Basis of Presentation-Premiums.”
Interest Credited
The decrease in interest credited for Asset Management for 2014 compared to 2013 was primarily due to a decrease in the average interest-crediting rate for our annuity products and the change in fair value of the index-based guarantees, which increased interest credited by $7.2 million for 2014, compared to an increase of $9.0 million for 2013. The decrease was partially offset by an increase in our retirement plan general account assets under administration.
Operating Expenses
The increase in operating expenses for Asset Management for 2014 compared to 2013 was primarily to support business growth, consistent with growth in assets under administration.
Commissions and Bonuses
The increase in commissions and bonuses for Asset Management for 2014 compared to 2013 was primarily due to an increase in individual annuity sales for 2014 compared to 2013.
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Net Change in DAC, VOBA and Other Intangible Assets
The net decrease in DAC, VOBA and other intangible assets for Asset Management for 2014 compared to 2013 was primarily due to an increase in the margin between net investment income and interest credited for our fixed deferred annuity products and an increase in DAC amortization for individual annuities related to unlocking. This increase was partially offset by an increase in deferrals for individual annuities, which was primarily due to higher individual annuity sales. See “Critical Accounting Policies and Estimates-DAC, VOBA and Other Intangible Assets” for more information.
Year Ended December 31, 2013 Compared to Year Ended December 31, 2012
Income before income taxes for Asset Management was $79.3 million for 2013, compared to $64.0 million for 2012. The increase in income before income taxes was primarily due to higher administrative fees as a result of the increase in assets under administration and lower benefits to policyholders as a result of favorable mortality experience in the individual annuity business. In addition, bond call premiums and commercial mortgage loan prepayment fees and their related effect on DAC amortization added $8.6 million of income before income taxes for 2013, compared to $6.6 million for 2012. Income before income taxes also increased $2.6 million for 2013 and $0.2 million for 2012 as a result of the change in fair values of the hedging assets and liabilities related to our equity-indexed annuity product.
Administrative Fees
The increase in administrative fees for Asset Management for 2013 compared to 2012 was primarily due to an increase in assets under administration. Assets under administration increased 13.8% to $24.70 billion at December 31, 2013, compared to $21.69 billion at December 31, 2012, primarily due to higher equity values for retirement plan assets under administration.
Net Investment Income
The increase in net investment income for Asset Management for 2013 compared to 2012 was primarily due to a higher contribution from the change in fair value of our S&P 500 Index options related to our equity-indexed annuity product. The change in fair value of our S&P 500 Index options in 2013 was $14.4 million compared to $7.8 million in 2012. In addition, bond call premiums and commercial mortgage loan prepayment fees added $9.9 million to net investment income for 2013, compared to $8.0 million for 2012. These increases were partially offset by lower portfolio yields for both fixed maturity securities and commercial mortgage loans.
Benefits to Policyholders
The decrease in benefits to policyholders for Asset Management for 2013 compared to 2012 was primarily due to favorable mortality experience in the individual annuity business.
Interest Credited
The increase in interest credited for Asset Management for 2013 compared to 2012 was primarily due to growth in our retirement plan general account assets under administration and individual fixed-rate annuity assets under administration, partially offset by a decrease in the average interest-crediting rate for our annuity products.
Operating Expenses
The decrease in operating expenses for Asset Management for 2013 compared to 2012 was primarily due to expense management actions, which reduced headcount and other non-compensation related expenses.
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Other
We report our holding company and corporate activities in the Other category. This category includes return on capital not allocated to the product segments, holding company expenses, operations of certain unallocated subsidiaries, interest on debt, unallocated expenses, net capital gains and losses primarily related to the impairment or the disposition of our invested assets and adjustments made in consolidation.
The following table sets forth results and key indicators for the Other category:
Year Ended December 31, 2014 Compared to Year Ended December 31, 2013
The Other category reported a loss before income taxes of $45.7 million for 2014, compared to a loss before income taxes of $38.7 million for 2013. Net capital losses were $14.0 million for 2014, compared to $15.7 million for 2013. The loss before income taxes excluding net capital losses was $31.7 million for 2014, compared to $23.0 million for 2013. The increase in the loss before income taxes for 2014 was primarily due to the amendment of our postretirement medical plan that resulted in a $20.6 million decrease in operating expenses for the first half of 2013, which did not recur in 2014.
Net Investment Income
The increase in net investment income for the Other category for 2014 compared to 2013 was primarily due to a larger amount of invested assets allocated to the Other category.
Net Capital Losses
The decrease in net capital losses for the Other category for 2014 compared to 2013 was primarily due to a decrease in the provision for our commercial mortgage loan losses and lower capital losses associated with the sale of real estate. These lower net capital losses were partially offset by a decrease in net capital gains related to the sale of certain fixed maturity securities.
Operating Expenses
The increase in operating expenses for the Other category for 2014 compared to 2013 was primarily due to the result of expense management actions taken in the first half of 2013. Operating expenses were reduced by $20.6 million for the first half of 2013 due to the amendment of our postretirement medical plan, which did not recur in 2014.
40 STANCORP FINANCIAL GROUP, INC.
Interest Expense
The decrease in interest expense for the Other category for 2014 compared to 2013 was primarily due to the $47.1 million repurchase of junior subordinated debentures (“Subordinated Debt”) in the first quarter of 2014. We had $252.9 million of Subordinated Debt outstanding at December 31, 2014, compared to $300.0 million outstanding at December 31, 2013. See “Liquidity and Capital Resources-Financing Cash Flows.”
Year Ended December 31, 2013 Compared to Year Ended December 31, 2012
The Other category reported a loss before income taxes of $38.7 million for 2013, compared to a loss before income taxes of $60.4 million for 2012. Net capital losses were $15.7 million for 2013, compared to $8.7 million for 2012. The loss before income taxes excluding net capital losses was $23.0 million for 2013, compared to $51.7 million for 2012. The loss before income taxes for 2013 included lower operating expenses, higher net investment income and lower interest expense.
Net Investment Income
The increase in net investment income for the Other category for 2013 compared to 2012 was primarily due to interest income from fixed maturity securities of $11.0 million for 2013, compared to $9.0 million for 2012, which was primarily due to a larger amount of invested assets allocated to the Other category. In addition, operating losses related to our tax-advantaged investments decreased to $2.0 million for 2013, compared to $3.8 million for 2012.
Net Capital Losses
The increase in net capital losses for the Other category for 2013 compared to 2012 was primarily due to the provision for our commercial mortgage loan losses and capital losses on real estate. These capital losses were partially offset by net capital gains related to the sale of certain fixed maturity securities.
Operating Expenses
The decrease in operating expenses for the Other category for 2013 compared to 2012 was primarily due to the result of expense management actions. Operating expenses were reduced by $20.6 million for the first half of 2013 due to the amendment of our postretirement medical plan.
Interest Expense
On August 10, 2012, we issued $250 million of 5.00%, 10-year senior notes (“2022 Senior Notes”). On September 28, 2012, we used the net proceeds from the issuance to repay our $250 million of 6.875%, 10-year senior notes (“2012 Senior Notes”) due October 1, 2012. The decrease in interest expense for the Other category for 2013 compared to 2012 was primarily due to the overlap of the outstanding 2022 Senior Notes in 2012 and the higher interest rate on the repaid 2012 Senior Notes resulting in higher interest expense for 2012 of approximately $5 million.
LIQUIDITY AND CAPITAL RESOURCES
Asset-Liability Matching and Interest Rate Risk Management
Asset-liability management is a part of our risk management structure. The risks we assume related to asset-liability mismatches vary with economic conditions. The primary sources of economic risk are interest rate related and include changes in interest rate term risk, credit risk and liquidity risk. It is generally management’s objective to align the characteristics of assets and liabilities to meet our financial obligations under a wide variety of economic conditions. From time to time, management may choose to liquidate certain investments and reinvest in different investments to increase the likelihood of meeting our financial obligations is increased. See “-Investing Cash Flows.”
Interest rate risk management, along with asset-liability analysis informs us of an appropriate allocation of invested assets to mitigate our interest rate risk exposure. We also use interest rate swaps, whereby we agree with another party to exchange, at specified intervals, the difference between fixed-rate and floating rate interest amounts as calculated by reference to an agreed notional amount, in fair value hedging relationships to reduce interest rate exposure arising from asset and liability duration mismatches. In accordance with presently accepted actuarial standards, we have made adequate provisions for the anticipated cash flows required to meet contractual obligations and related expenses through the use of statutory reserves and related items in light of the assets held at December 31, 2014.
Our interest rate risk analysis reflects the influence of call and prepayment rights present in our fixed maturity securities and commercial mortgage loans. The majority of these investments have contractual provisions that require the borrower to compensate us in part or in full for reinvestment losses if the security or loan is retired before maturity. Callable bonds, excluding bonds with make-whole provisions and bonds with provisions that allow the borrower to prepay near maturity, represented 3.5%, or $275.1 million, of our fixed maturity securities portfolio at December 31, 2014. We also originate commercial mortgage loans containing a make-whole prepayment provision requiring the borrower to pay a prepayment fee. As interest rates decrease, potential prepayment fees increase.
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These larger prepayment fees deter borrowers from refinancing during a low interest rate environment. Approximately 96% of the commercial mortgage loan portfolio contains this prepayment provision. In addition, approximately 1% of the commercial mortgage loan portfolio contains fixed percentage prepayment fees that mitigate prepayments but may not fully protect our expected cash flows in the event of prepayment.
Our financial instruments are exposed to financial market volatility and potential disruptions in the market that may result in certain financial instruments becoming less valuable. Financial market volatility includes interest rate risk. We have analyzed the estimated loss in fair value of certain market sensitive financial assets held at December 31, 2014 and 2013, using a hypothetical 10% increase in interest rates and related qualitative information on how we manage interest rate risk. The interest rate sensitivity analysis was based upon our fixed maturity securities net of fair value hedges and commercial mortgage loans held at December 31, 2014 and 2013. Interest rate sensitivity of our financial assets was measured assuming a parallel shift in interest rates. All security yields were increased by 10% of the year-end 10-year U.S. Government Treasury bond yield, or 0.22% and 0.30% for the 2014 and 2013 analyses, respectively. The change in fair value of each security was estimated as the change in the option adjusted value of each security. Option adjusted values were computed using our payment models and provisions for the effects of possible future changes in interest rates. The analyses did not explicitly provide for the possibility of non-parallel shifts in the yield curve, which would involve discount rates for different maturities being increased by different amounts. The actual change in fair value of our financial assets can be significantly different from that estimated by the model. The hypothetical reduction in the fair value of our financial assets that resulted from the model was estimated to be $124 million and $164 million at December 31, 2014 and 2013, respectively.
Additionally, a cash management process is in place that anticipates short-term cash needs. Depending upon capital market conditions, anticipated cash needs may be covered by liquid asset holdings or a draw upon our line of credit. In almost all cases, borrowed funds can be retired from normal operating cash flows in conjunction with adjustments to long-term investing practice within half a year. For more information about our line of credit, see “-Financing Cash Flows,” and Part I, Item 1A, “Risk Factors.”
Operating Cash Flows
Net cash provided by operating activities is net income adjusted for non-cash items and accruals, and was $238.2 million, $279.6 million and $375.7 million for 2014, 2013 and 2012, respectively. These changes were mainly due to fluctuations in future policy benefits and claims due to changes in reserve requirements in Employee Benefits and other assets and other liabilities, mainly attributable to timing differences. We typically generate positive cash flows from operating activities, as premiums collected from our insurance products and income received from our investments exceed policy acquisition costs, benefits paid, redemptions and operating expenses. These positive cash flows are then invested to support the obligations of our insurance products and required capital supporting these products. Our cash flows provided by operating activities are affected by the timing of premiums, administrative fees and investment income received and expenses paid.
Investing Cash Flows
We maintain a diversified investment portfolio primarily consisting of fixed maturity securities and fixed-rate commercial mortgage loans. Investing cash inflows primarily consist of the proceeds from investments sold, matured or repaid. Investing cash outflows primarily consist of payments for investments acquired or originated.
Net cash used in investing activities was $616.8 million, $504.3 million and $763.0 million for 2014, 2013 and 2012, respectively. The increase in net cash used in investing activities for 2014 compared to 2013 was primarily due to lower proceeds from the sale, maturity or repayment of fixed maturity securities and higher acquisitions of fixed maturity securities and other invested assets. These increases were partially offset by an increase in proceeds from the sale or repayment of commercial mortgage loans. Our target investment portfolio allocation is approximately 60% fixed maturity securities and 40% commercial mortgage loans with a maximum allocation of 45% in commercial mortgage loans. At December 31, 2014, total cash and investments consisted of 56.8% fixed maturity securities, 38.8% commercial mortgage loans, 2.3% other invested assets, 1.8% cash and cash equivalents and 0.3% real estate.
Fixed Maturity Securities
We maintain prudent diversification across industries, issuers and maturities. Our corporate bond industry diversification targets are based on the Bank of America Merrill Lynch U.S. Corporate Master Index, which we believe reasonably reflects the mix of issuers broadly available in the market. Our fixed maturity securities rated below investment grade are primarily managed by a third party.
Our fixed maturity securities portfolio generates unrealized gains or losses primarily resulting from market interest rates that are lower or higher relative to our book yield at the reporting date. In addition, changes in the spread between the risk-free rate and market rates for any given issuer can fluctuate based on the demand for the instrument, the near-term prospects of the issuer and the overall economic climate.
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The following tables set forth the composition of our fixed maturity securities portfolio by industry category with the associated unrealized gains and losses:
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The following table sets forth key indicators of our fixed maturity securities portfolio:
We recorded OTTI of $1.2 million and $1.1 million for 2014 and 2013, respectively. See “Critical Accounting Policies and Estimates-Investment Valuations-Fixed Maturity Securities.” We did not have any direct exposure to sub-prime or Alt-A mortgages in our fixed maturity securities portfolio at December 31, 2014.
Commercial Mortgage Loans
StanCorp Mortgage Investors originates and services fixed-rate commercial mortgage loans for the investment portfolios of our insurance subsidiaries and generates additional fee income from the origination and servicing of commercial mortgage loans participated to institutional investors. The level of commercial mortgage loan originations in any period is influenced by market conditions as we respond to changes in interest rates, available spreads and borrower demand.
The following table sets forth commercial mortgage loan originations:
The decrease in commercial mortgage loan originations for 2014 compared to 2013 was primarily due to an increase in competition in the commercial real estate market. The increase in 2013 compared to 2012 was primarily due to an increase in commercial real estate market activity.
The following table sets forth commercial mortgage loan servicing data:
The estimated average loan to value ratio for the overall portfolio was less than 70% at December 31, 2014. The average loan balance of our commercial mortgage loan portfolio was approximately $0.8 million at December 31, 2014. We have the contractual ability to pursue personal recourse on approximately 74% of our loans and partial personal recourse on a majority of the remaining loans. The weighted-average capitalization rate for the portfolio at December 31, 2014 was approximately 9%. Capitalization rates, which vary by property type and geographic region, are used as part of our annual internal analysis of our commercial mortgage loan portfolio. The rate is used in converting the property’s income to an estimated property value.
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At December 31, 2014, we did not have any direct exposure to sub-prime or Alt-A mortgages in our commercial mortgage loan portfolio. When we undertake mortgage risk, we do so directly through loans that we originate ourselves rather than in packaged products such as commercial mortgage-backed securities. Given that we service the vast majority of loans in our portfolios, we are prepared to deal with them promptly and proactively. Should the delinquency rate or loss performance of our commercial mortgage loan portfolio increase significantly, the increase could have a material adverse effect on our business, financial position, results of operations or cash flows.
Our largest concentration of commercial mortgage loan property type was retail properties, which primarily consisted of convenience related properties in strip malls, convenience stores and restaurants. Our exposure to retail properties is diversified among various borrowers, properties and geographic regions. In addition, retail commercial lending represents an area of experience and expertise, where careful underwriting and consistent surveillance mitigate risks surrounding our commercial mortgage lending in this area. See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 10-Investments-Commercial Mortgage Loans.”
At December 31, 2014, our ten largest borrowers represented less than 7% of our total commercial mortgage loan portfolio balance. Our largest borrower concentrations within our commercial mortgage loan portfolio consisted of one borrower that comprised less than 2% of our total commercial mortgage loan portfolio balance. The second largest borrower comprised less than 1% of our total commercial mortgage loan portfolio balance.
Due to the concentration of commercial mortgage loans in California, we could be exposed to potential losses as a result of an economic downturn in California as well as certain catastrophes. See Part I, Item 1A, “Risk Factors.”
Under the laws of certain states, environmental contamination of a property may result in a lien on the property to secure recovery of the costs of cleanup. In some states, such a lien has priority over the lien of an existing mortgage against such property. As a commercial mortgage lender, we customarily conduct environmental assessments prior to making commercial mortgage loans secured by real estate and before taking title through foreclosure on real estate collateralizing delinquent commercial mortgage loans held by us. Based on our environmental assessments, we believe that any compliance costs associated with environmental laws and regulations or any remediation of affected properties would not have a material effect on our business, financial position, results of operations or cash flows. However, we cannot provide assurance that material compliance costs will not be incurred by us.
In the normal course of business, we commit to fund commercial mortgage loans generally up to 90 days in advance. At December 31, 2014, we had outstanding commitments to fund commercial mortgage loans totaling $134.8 million, with fixed interest rates ranging from 4.00% to 6.00%. These commitments generally have fixed expiration dates. A small percentage of commitments expire due to the borrower’s failure to deliver the requirements of the commitment by the expiration date. In these cases, we will retain the commitment fee and good faith deposit. Alternatively, if we terminate a commitment due to the disapproval of a commitment requirement, the commitment fee and good faith deposit may be refunded to the borrower, less an administrative fee.
The following table sets forth key commercial mortgage loan statistics:
The performance of our commercial mortgage loan portfolio may fluctuate in the future. However, based on our business approach of diligently underwriting high-quality loans, we believe our delinquency rate will remain low. The increase in restructured commercial mortgage loans of $8.0 million during 2014 was primarily due to a net increase in the number of restructured commercial mortgage loans, which was partially offset by commercial mortgage loans that were paid off or became delinquent during the period.
The following table sets forth details of our commercial mortgage loans foreclosed or accepted as deeds in lieu of foreclosure:
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Commercial mortgage loan foreclosures may result in the sale of the property to a third party at the time of foreclosure, resulting in fewer properties transferred to Real Estate Owned than the number of loans foreclosed during the period. Commercial mortgage loans may have multiple properties as collateral, resulting in more properties transferred to Real Estate Owned than the number of loans foreclosed during the period. Real Estate Owned is initially recorded at estimated net realizable value, which includes an estimate for disposal costs. These amounts may be adjusted in a subsequent period as additional market information regarding fair value is received, however, these adjustments would not result in a carrying value greater than the initial recorded amount. The book value of real estate acquired during 2014 decreased compared to 2013 primarily due to fewer properties being foreclosed in 2014. See “Critical Accounting Policies and Estimates-Investment Valuations-Commercial Mortgage Loans” for our commercial mortgage loan loss allowance policy.
The following table sets forth changes in the commercial mortgage loan loss allowance:
The decrease in the commercial mortgage loan loss allowance for 2014 compared to 2013 was primarily due to fewer loans with a general loan loss allowance and specific loan loss allowance. The decrease in net charge-offs was primarily due to lower losses related to foreclosures, accepted deeds in lieu of foreclosure on commercial mortgage loans and other related charges associated with commercial mortgage loans leaving the portfolio for 2014. The higher provision and net charge-offs for the commercial mortgage loan loss allowance for 2013 compared to 2012 were primarily due to higher losses associated with foreclosures, accepted deeds in lieu of foreclosure on commercial mortgage loans and other related charges associated with commercial mortgage loans leaving the portfolio for 2013. The decrease in the commercial mortgage loan loss allowances for 2013 compared to 2012 was primarily due to the decrease in the general loan loss allowance, which was driven by improvement in the composition factors of the commercial mortgage loan portfolio that impacts the general loan loss allowance.
The following table sets forth impaired commercial mortgage loans identified in management’s specific review of probable loan losses and the related allowance:
A commercial mortgage loan is impaired when we do not expect to receive contractual principal and interest in accordance with the terms of the original loan agreement. A specific allowance for losses is recorded when a loan is considered to be impaired and it is probable that all amounts due will not be collected based on the terms of the original note. We also hold specific loan loss allowances on certain performing commercial mortgage loans that we continue to monitor and evaluate. Impaired commercial mortgage loans without specific allowances for losses are those for which we have determined that it remains probable that all amounts due will be collected although the timing or nature may be outside the original contractual terms. The decrease to the net carrying value of impaired commercial mortgage loans at December 31, 2014 compared to 2013 was primarily due to a decrease in impaired commercial mortgage loans with a specific allowance in our industrial and retail segments for 2014 associated with a small number of borrowers.
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See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 1-Summary of Significant Accounting Policies-Investment Valuations-Commercial Mortgage Loans” for policies regarding interest income for delinquent commercial mortgage loans.
Financing Cash Flows
Financing cash flows primarily consist of policyholder fund deposits and withdrawals, borrowings and repayments on the line of credit, borrowings and repayments on long-term debt, issuances and repurchases of common stock and dividends paid on common stock. Net cash provided by financing activities was $250.4 million, $443.3 million and $409.6 million for 2014, 2013 and 2012, respectively. The decrease in funds provided by financing cash flows for 2014 compared to 2013 was primarily due to a $64.7 million increase in share repurchases, a $47.1 million repurchase of debt, and a $34.3 million decrease in policyholder fund deposits, net of withdrawals. See “Capital Management-Share Repurchases” for further discussion on share repurchases.
We maintain a four-year, $250 million senior unsecured revolving credit facility (“Facility”). Upon our request and with consent of the lenders under the Facility, the Facility can be increased to $350 million. In June 2014, the termination date of the Facility was extended by one year to June 22, 2018. We expect to use any borrowings under the Facility for working capital, general corporate purposes and for issuance of letters of credit.
Under the facility, we are subject to customary covenants that take into consideration the impact of material transactions, changes to the business, compliance with legal requirements and financial performance. Under the two financial covenants, we are required to maintain a total debt to total capitalization ratio that does not exceed 35% and a consolidated net worth that is equal to at least $1.48 billion. The financial covenants exclude the unrealized gains and losses related to fixed maturity securities that are held in accumulated other comprehensive income (loss). At December 31, 2014, we had a total debt to total capitalization ratio of 20.6% and consolidated net worth of $1.95 billion as defined by the financial covenants. The Facility is subject to pricing levels based upon our publicly announced debt ratings and includes an interest rate option at the election of the borrower of a base rate plus the applicable margin or the London Interbank Offered Rate (“LIBOR”) plus the applicable margin, plus facility and utilization fees. At December 31, 2014, we were in compliance with all covenants under the Facility and had no outstanding balance on the Facility. We believe we will continue to meet the financial covenants throughout the life of the Facility.
We have $250 million of 5.00%, 10-year senior notes (“Senior Notes”), which mature on August 15, 2022. Interest is paid semi-annually on February 15 and August 15.
We have $252.9 million of Subordinated Debt, which matures on June 1, 2067, and is non-callable prior to June 1, 2017. In the first quarter of 2014, we repurchased $47.1 million in principal amount of Subordinated Debt. Interest is payable semi-annually on June 1 and December 1 until June 1, 2017, and quarterly thereafter at a floating rate equal to three-month LIBOR plus 2.51%. We have the option to defer interest payments for up to five years. The declaration and payment of dividends to shareholders would be restricted if we elected to defer interest payments on our Subordinated Debt. If elected, the restriction would be in place during the interest deferral period. We are not currently deferring interest on the Subordinated Debt.
In 2013, Standard became a member of the FHLB of Seattle. Standard issues collateralized funding agreements to the FHLB of Seattle and invests the cash received from advances to support various spread-based businesses and enhance our asset-liability management. Membership also provides an additional funding source and access to financial services that can be used as an alternative source of liquidity. At December 31, 2014, Standard had $139.0 million outstanding under funding agreements with the FHLB of Seattle. At December 31, 2014, Standard pledged $174.4 million of commercial mortgage loans as collateral to the FHLB of Seattle for our outstanding advances. There were no assets pledged as collateral to the FHLB of Seattle at December 31, 2013. The FHLB of Des Moines and the FHLB of Seattle have announced that they have entered into a definitive agreement to merge the two banks. The merger agreement has been unanimously approved by the boards of directors of both banks and by the FHFA. The potential merger must be approved by the members of both banks through a voting process that is expected to take place in the first half of 2015. We do not expect the merger to have a material effect on our business, financial position, results of operations or cash flows.
CAPITAL MANAGEMENT
State insurance departments require insurance enterprises to maintain minimum levels of capital and surplus. Our target for our statutory insurance subsidiaries is generally to maintain statutory capital and surplus at 300% of the Company Action Level of Risk-Based Capital (“RBC”) required by regulators, which is 600% of the Authorized Control Level RBC required by our states of domicile. The statutory insurance subsidiaries capital and surplus as a percentage of the Company Action Level RBC was approximately 445% at December 31, 2014. At December 31, 2014, capital and surplus, adjusted to exclude asset valuation reserves, for our regulated statutory insurance subsidiaries totaled $1.33 billion.
Capital and surplus growth from our statutory insurance subsidiaries is generally a result of generated income, less a charge for business growth, measured by insurance premium growth, which includes individual annuity sales. The level of capital and surplus in excess of targeted RBC we generate varies inversely in relation to the level of our premium growth. As premium growth increases, capital and surplus is used to fund additional reserve requirements, meet increased regulatory capital requirements based on premium
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and cover certain acquisition costs associated with policy issuance, leaving less available capital beyond our target level. Higher levels of premium growth can result in increased utilization of capital and surplus beyond that which is generated by the business, and at very high levels of premium growth, we could generate the need for capital infusions. At lower levels of premium growth, additional capital and surplus produced by the business exceeds the capital and surplus utilized to meet these requirements, which can result in additional capital and surplus above our targeted RBC level. In assessing our capital and surplus position, we also consider cash and capital at the holding company and non-insurance subsidiaries.
In the third quarter of 2014, Standard transferred its group life reinsurance from an external party to StanCap Insurance Company, Inc. (“StanCap Insurance Company”), who also reinsures Standard’s AD&D insurance business. The result of this transaction increased the RBC ratio at our statutory insurance subsidiaries by approximately 25%.
Investments
The insurance laws of the states of domicile and other states in which the insurance subsidiaries conduct business regulate the investment portfolios of the insurance subsidiaries. Relevant laws and regulations generally limit the admissibility of investments to bonds and other fixed maturity securities, commercial mortgage loans, common and preferred stock and real estate. Decisions to acquire and dispose of investments are made in accordance with guidelines adopted and modified from time to time by the Boards of Directors of our insurance subsidiaries. Each investment transaction requires the approval of one or more members of senior investment staff, with increasingly higher approval authorities required for transactions that are more significant. Transactions are reported quarterly to the Audit Committee of the Board of Directors for Standard and to the Board of Directors for The Standard Life Insurance Company of New York.
Dividends from Subsidiaries
Our ability to pay dividends to shareholders, repurchase shares and meet obligations substantially depends upon the receipt of distributions from Standard. Standard’s ability to pay dividends to StanCorp is affected by factors deemed relevant by Standard’s Board of Directors and by Oregon law, which limits Standard’s dividend payments and other distributions to the earned surplus arising from its business. If the proposed dividend or other distribution exceeds certain statutory limitations, Standard must receive prior approval of the Director of the Oregon Department of Consumer and Business Services-Insurance Division (“Oregon Insurance Division”). The current statutory dividend limitations are the greater of (a) 10% of Standard’s combined capital and surplus as of December 31 of the preceding year, or (b) the net gain from operations after dividends to policyholders and federal income taxes and before realized capital gains or losses for the 12-month period ended on the preceding December 31. In each case, the limitation must be determined under statutory accounting practices. Oregon law gives the Oregon Insurance Division broad discretion to approve or decline requests for dividends and other distributions in excess of these limits. With the exception of StanCorp Equities, a limited broker-dealer and member of the Financial Industry Regulatory Authority, there are no regulatory restrictions on dividends from our non-insurance subsidiaries.
As of December 31, 2014, Standard’s net gain from operations after dividends to policyholders and federal income taxes and before capital gains or losses for the 12-month period then ended was $208.5 million and capital and surplus was $1.15 billion. Based upon Standard’s results for 2014, the amount of ordinary dividends and other distributions available in 2015, without prior approval from the Oregon Insurance Division is $208.5 million. As of December 31, 2013, Standard’s net gain from operations after dividends to policyholders and federal income taxes and before capital gains or losses for the 12-month period then ended was $195.1 million and capital and surplus was $1.29 billion. Based upon Standard’s results for 2013, the amount of ordinary dividends and other distributions available in 2014, without prior approval from the Oregon Insurance Division was $195.1 million.
In August 2012, Standard paid an extraordinary cash distribution of $250.0 million to StanCorp from its paid-in and contributed surplus. Concurrently with the distribution, Standard issued a $250.0 million subordinated surplus note (“Surplus Note”), payable to StanCorp. The Surplus Note matures in 2042 and bears an interest rate of 5.25%, with interest payments due March 31, June 30, September 30 and December 31 of each year. Standard has the right to prepay the principal balance of the Surplus Note, in whole or in part, at any time or from time to time, without penalty. In accordance with the requirements of the National Association of Insurance Commissioners (“NAIC”), the Surplus Note provides that no interest or principal payments may be made by Standard without the prior approval of the Oregon Insurance Division, interest will not be represented as an addition to the instrument, interest will not accrue additional interest and any payments with respect to the Surplus Note will be subordinate to Standard’s other obligations to policyholders, lenders and creditors. As a result of the extraordinary distribution in August 2012, dividends through August 14, 2013 were considered extraordinary.
During 2014 and 2013, Standard made distributions to StanCorp totaling $390.0 million and $130.0 million, respectively. The 2014 distribution included a $240.0 million extraordinary distribution to StanCorp that was used to capitalize StanCap Insurance Company. Effective September 30, 2014, StanCap Insurance Company entered into a reinsurance agreement with Standard to reinsure Standard’s group life and AD&D business. This reinsurance agreement between StanCap Insurance Company and Standard replaced the yearly renewable term group life reinsurance agreement with Canada Life Assurance Company, which was terminated effective September 30, 2014. As a result of the extraordinary distribution in September 2014, future dividends will require approval from the Oregon Insurance Division through September 2015 and will be considered extraordinary.
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Dividends paid from Standard to StanCorp will be based on levels of available capital and needs at the holding company, which are driven by the financial results of Standard and the Company as a whole. Standard paid extraordinary cash distributions to StanCorp of $310.0 million and ordinary cash dividends to StanCorp of $80.0 million for 2014. Standard paid ordinary cash dividends to StanCorp of $70.0 million and extraordinary cash distributions to StanCorp of $60.0 million for 2013. Standard paid extraordinary cash distributions to StanCorp of $310.0 million and ordinary cash dividends to StanCorp of $10.0 million for 2012.
Dividends received from our non-insurance subsidiaries were $33.0 million and $17.0 million for 2014 and 2013, respectively.
Dividends to Shareholders
On November 11, 2014, our Board of Directors declared an annual cash dividend of $1.30 per common share. The dividend was paid on December 8, 2014 to shareholders of record on November 24, 2014. In 2013 and 2012, we paid an annual cash dividend of $1.10 and $0.93 per common share, respectively. The Board of Directors has increased the annual dividend per common share to shareholders each year for the past 15 consecutive years. The declaration and payment of dividends to shareholders in the future is subject to the discretion of our Board of Directors. It is anticipated that an annual dividend to shareholders will be paid in December of each year depending on our financial condition, results of operations, cash requirements, future prospects, regulatory restrictions on distributions from the insurance subsidiaries, the ability of the insurance subsidiaries to maintain adequate capital and other factors deemed relevant by the Board of Directors. In addition, the declaration and payment of dividends to shareholders would be restricted if we elect to defer interest payments on our Subordinated Debt issued May 7, 2007. If elected, the restriction would be in place during the interest deferral period, which cannot exceed five years. We have not deferred interest on the Subordinated Debt, and have paid dividends each year since our initial public offering in 1999.
Share Repurchases
On November 13, 2012, our Board of Directors authorized the repurchase of 3.0 million shares of StanCorp common stock through December 31, 2014 (“November 2012 Authorization”). On February 11, 2014, our Board of Directors authorized the repurchase of 3.0 million additional shares of StanCorp common stock through December 31, 2015 (“February 2014 Authorization”). The February 2014 Authorization took effect upon the completion of the November 2012 Authorization during the second quarter of 2014. As of December 31, 2014, there were 2.0 million shares remaining under the February 2014 Authorization. Share repurchases under the repurchase program are made in the open market or in negotiated transactions in compliance with the safe harbor provisions of Rule 10b-18 under regulations of the Securities Exchange Act of 1934 (“Exchange Act”). Execution of the share repurchase program is based upon management’s assessment of market conditions for its common stock, capital levels, our assessment of the overall economy and other potential growth opportunities or priorities for capital use.
The following table sets forth share repurchases activity:
FINANCIAL STRENGTH AND CREDIT RATINGS
See Part I, Item 1, “Business-Financial Strength and Credit Ratings.”
CONTINGENCIES AND LITIGATION
See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 19-Commitments and Contingencies.”
OFF-BALANCE SHEET ARRANGEMENTS
See discussion of loan commitments, “Liquidity and Capital Resources-Investing Cash Flows-Commercial Mortgage Loans.”
CONTRACTUAL OBLIGATIONS
Our financing obligations generally include debts, lease payment obligations and commitments to fund commercial mortgage loans. The remaining obligations reflect the long-term portion of other liabilities and our obligations under our insurance and annuity product contracts.
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The following table summarizes our contractual obligations by period in which payments are due:
(1) The estimated payments expected to be due by period for insurance obligations reflect future estimated cash payments, for pending and future potential claims, to be made to policyholders and others for future policy benefits, policyholders’ account balances, policyholders’ dividends and reinsurance payables. These future estimated net cash payments are based on mortality, morbidity, lapse and other assumptions comparable with our experience, consider future premium receipts on current policies in-force, and assume market growth and interest crediting consistent with assumptions used in amortizing DAC and VOBA. These net cash payments are undiscounted with respect to interest and, as a result, the sum of the net cash payments shown for all years in the table of $7.49 billion exceeds the corresponding liability amount of $5.83 billion included in the Consolidated Financial Statements as of December 31, 2014. We have made significant assumptions to determine the future estimated net cash payments related to the underlying policies and contracts. Due to the significance of the assumptions used, actual net cash payments will differ, possibly materially, from these estimates.
(2) While historical withdrawal patterns indicate withdrawal primarily occurs in periods in excess of one year, policyholder fund obligations in the amount of $4.99 billion have been included in the less than one year column of the table as they may be withdrawn upon request. These net cash payments are undiscounted with respect to interest but reflect an offsetting effect due to reinsurance receivables and, as a result, the sum of the net cash payments shown for all years in the table of $6.14 billion differs from the corresponding liability amount of $6.54 billion included in the Consolidated Financial Statements as of December 31, 2014. Due to the significance of the assumptions used, actual net cash payments will differ, possibly materially, from these estimates.
(3) Separate account liabilities are legally insulated from general account obligations, and it is generally expected these liabilities will be fully funded by separate account assets and their related cash flows. While historical withdrawal patterns indicate withdrawal primarily occurs in periods in excess of one year, separate account liabilities in the amount of $7.18 billion have been included in the less than one year column of the table as they may be withdrawn upon request.
Our debt obligations consisted primarily of the $250 million of 5.00% Senior Notes and the $252.9 million of 6.90% Subordinated Debt. See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 18-Long-Term Debt”.
In the normal course of business, we commit to fund commercial mortgage loans generally up to 90 days in advance. At December 31, 2014, we had outstanding commitments to fund commercial mortgage loans totaling $134.8 million, with fixed interest rates ranging from 4.00% to 6.00%. These commitments generally have fixed expiration dates. A small percentage of commitments expire due to the borrower’s failure to deliver the requirements of the commitment by the expiration date. In these cases, we will retain the commitment fee and good faith deposit. Alternatively, if we terminate a commitment due to the disapproval of a commitment requirement, the commitment fee and deposit may be refunded to the borrower, less an administrative fee.
The insurance obligations in the table are actuarial estimates of the cash required to meet our obligations for future policy benefits and claims. These estimates do not represent an exact calculation of our future benefit liabilities, but are instead based on assumptions, which involve a number of factors, including mortality, morbidity, recovery, the consumer price index, reinsurance arrangements and other sources of income for people on claim. Assumptions may vary by age and gender and, for individual policies occupation class of the claimant, time elapsed since disablement, and contract provisions and limitations. Certain of these factors could be materially affected by changes in social perceptions about work ethics, emerging medical perceptions and legal interpretations regarding physiological or psychological causes of disability, emerging or changing health issues and changes in industry regulation. Changes in one or more of these factors or incorrect assumptions could cause actual results to be materially different from the information presented in the table.
Policyholder fund obligations include payments based on currently scheduled withdrawals and annuity benefit payments stemming from liabilities shown on the consolidated balance sheets as policyholder funds.
At December 31, 2014, we had $139.0 million outstanding under funding agreements with the FHLB of Seattle, with fixed interest rates ranging from 0.38% to 3.79% that mature in 1 to 15 years. The funding agreements with the FHLB of Seattle are recorded as other policyholder funds on the consolidated balance sheets. The FHLB of Des Moines and the FHLB of Seattle have
50 STANCORP FINANCIAL GROUP, INC.
announced that they have entered into a definitive agreement to merge the two banks. The merger agreement has been unanimously approved by the boards of directors of both banks and by the FHFA. The potential merger must be approved by the members of both banks through a voting process that is expected to take place in the first half of 2015. We do not expect the merger to have a material effect on our business, financial position, results of operations or cash flows.
Other long-term obligations reflected in the consolidated balance sheets at December 31, 2014, included $210.6 million in expected benefit payments for supplemental, home office, and field office retirement plans, $13.6 million in expected benefit payments for the postretirement benefit plan, $62.6 million in commitments to fund tax-advantaged investment partnerships, a $12.2 million tax reimbursement liability related to the block of life insurance business sold to Protective Life in 2001, and a $12.6 million liability for our deferred compensation plan.
INSOLVENCY ASSESSMENTS
Insolvency regulations exist in many of the jurisdictions in which our subsidiaries do business. Such regulations may require insurance companies operating within the jurisdiction to participate in guaranty associations. The associations levy assessments against their members for the purpose of paying benefits due to policyholders of impaired or insolvent insurance companies. Association assessments levied against us were $0.7 million, $1.9 million and $0.2 million for 2014, 2013 and 2012, respectively. At December 31, 2014, we maintained a reserve of $0.4 million for future assessments with respect to currently impaired, insolvent or failed insurers.
STATUTORY FINANCIAL ACCOUNTING
Standard and The Standard Life Insurance Company of New York prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by their states of domicile. Prescribed statutory accounting principles include state laws, regulations, and general administrative rules, as well as the Statements of Statutory Accounting Practices set forth in publications of the NAIC.
Statutory accounting practices differ in some respects from GAAP. The principal statutory practices that differ from GAAP are:
•
Bonds and commercial mortgage loans are reported principally at amortized cost and adjusted carrying value, respectively.
•
Asset valuation and the interest maintenance reserves are provided as prescribed by the NAIC.
•
Certain assets designated as non-admitted, principally deferred tax assets, furniture, equipment, and unsecured receivables, are not recognized as assets, resulting in a charge to statutory surplus.
•
Annuity considerations with life contingencies, or purchase rate guarantees, are recognized as revenue when received.
•
Reserves for life and disability policies and contracts are reported net of ceded reinsurance and calculated based on statutory requirements, including required discount rates.
•
Commissions, including initial commissions and expense allowance paid for reinsurance assumed, and other policy acquisition expenses are expensed as incurred.
•
Initial commissions and expense allowance received for a block of reinsurance ceded net of taxes are reported as deferred gains in surplus and recognized as income in subsequent periods.
•
Federal income tax expense includes current income taxes defined as current year estimates of federal income taxes and tax contingencies for current and prior years and amounts incurred or received during the year relating to prior periods, to the extent not previously provided.
•
Deferred tax assets, net of deferred tax liabilities, are included in the regulatory financial statements but are limited to those deferred tax assets that will be realized within three years.
•
Annuity reserves follow the commissioner’s annuity reserve valuation methodology rather than GAAP guidance for investment contracts.
•
Surplus notes are classified as a component of surplus for statutory reporting and are classified as a liability for GAAP reporting.
The following table sets forth the difference between the statutory net gains from insurance operations before federal income taxes and net capital gains and losses (“Statutory Results”) and GAAP income before income taxes excluding net capital gains and losses (“Adjusted GAAP Results”):
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The decrease in Statutory Results for 2014 compared to 2013 was primarily due to lower net investment income and the adoption of new statutory accounting guidance for share based compensation, partially offset by more favorable claims experience in Employee Benefits. The increase in Statutory Results for 2013 compared to 2012 was primarily due to more favorable claims experience in Employee Benefits.
The fluctuations in the difference between the Statutory Results and Adjusted GAAP Results for 2014 compared to 2013 and 2013 compared to 2012 were primarily due to differences in the prescribed accounting treatments between GAAP and Statutory accounting practices for net investment income, reserves for our individual annuity products, net income or loss from the holding company and noninsurance subsidiaries and lower operating expenses as a result of expense management actions. The expense management actions taken in 2013 included an amendment to our postretirement medical plan, which reduced operating expenses by $20.6 million for 2013. The reduced operating expenses were included in the Adjusted GAAP Results but were not included in the Statutory Results.
The following table sets forth statutory capital and the associated asset valuation reserve:
The change in asset valuation reserve is primarily due to the reduction in reserve factors prescribed by the NAIC in 2014 for commercial mortgage loans.
ACCOUNTING PRONOUNCEMENTS
See Item 8, “Financial Statements and Supplementary Data-Notes to Consolidated Financial Statements-Note 1-Summary of Significant Accounting Policies-Accounting Pronouncements.”
FORWARD-LOOKING STATEMENTS
From time to time StanCorp or its representatives make written or oral statements, including some of the statements contained or incorporated by reference in this Annual Report on Form 10-K and in other reports, filings with the Securities and Exchange Commission, press releases, conferences or otherwise, that are other than purely historical information. These statements, including estimates, projections, expected operating results, statements related to business plans, strategies, objectives and the assumptions upon which those statements are based, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and Section 21E of the Exchange Act. Forward-looking statements also include, without limitation, any statement that includes words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,” “seeks,” “will be,” “will continue,” “will likely result” and similar expressions that are predictive in nature or that depend on or refer to future events or conditions. Our forward-looking statements are not guarantees of future performance and involve uncertainties that are difficult to predict. They involve risks and uncertainties which may cause actual results to differ materially from the forward-looking statements and include, but are not limited to, the following:
•
Growth of sales, premiums, annuity deposits, cash flows, assets under administration including performance of equity investments in the separate account, gross profits and profitability.
•
Availability of capital required to support business growth and the effective use of capital, including the ability to achieve financing through debt or equity.
•
Changes in liquidity needs and the liquidity of assets in our investment portfolios, including the ability to pledge collateral as required.
•
Performance of business acquired through reinsurance or acquisition.
•
Changes in financial strength and credit ratings.
•
Changes in the regulatory environment at the state or federal level.
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Changes in accounting standards, practices or policies.
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Findings in litigation or other legal proceedings.
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Intent and ability to hold investments consistent with our investment strategy.
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Receipt of dividends from, or contributions to, our subsidiaries.
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Adequacy of the diversification of risk by product offerings and customer industry, geography and size, including concentration of risk, especially inherent in group life products.
•
Adequacy of asset-liability management.
•
Events of terrorism, natural disasters or other catastrophic events, including losses from a disease pandemic.
52 STANCORP FINANCIAL GROUP, INC.
•
Benefit ratios, including changes in claims incidence, severity and recovery.
•
Levels of customer persistency.
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Adequacy of reserves established for future policy benefits.
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The effect of changes in interest rates on reserves, policyholder funds, investment income, bond call premiums and commercial mortgage loan prepayment fees.
•
Levels of employment and wage growth and the impact of rising benefit costs on employer budgets for employee benefits.
•
Competition from other insurers and financial services companies, including the ability to competitively price our products.
•
Ability of reinsurers to meet their obligations.
•
Availability, adequacy and pricing of reinsurance and catastrophe reinsurance coverage and potential charges incurred.
•
Achievement of anticipated levels of operating expenses.
•
Adequacy of diversification of risk within our fixed maturity securities portfolio by industries, issuers and maturities.
•
Adequacy of diversification of risk within our commercial mortgage loan portfolio by borrower, property type and geographic region.
•
Credit quality of the holdings in our investment portfolios.
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The condition of the economy and expectations for interest rate changes.
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The effect of changing levels of bond call premiums, commercial mortgage loan prepayment fees and commercial mortgage loan participation levels on cash flows.
•
Experience in delinquency rates or loss experience in our commercial mortgage loan portfolio.
•
Adequacy of commercial mortgage loan loss allowance.
•
Concentration of commercial mortgage loan assets collateralized in certain states such as California.
•
Environmental liability exposure resulting from commercial mortgage loan and real estate investments.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Liquidity and Capital Resources-Asset-Liability and Interest Rate Risk Management.”
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Item 8.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
54 STANCORP FINANCIAL GROUP, INC.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
StanCorp Financial Group, Inc.
Portland, Oregon
We have audited the accompanying consolidated balance sheets of StanCorp Financial Group, Inc. and subsidiaries (the “Company”) as of December 31, 2014 and 2013, and the related consolidated statements of income, comprehensive income, changes in shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2014. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements 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, such consolidated financial statements present fairly, in all material respects, the financial position of StanCorp Financial Group, Inc. and subsidiaries as of December 31, 2014 and 2013, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2014, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2014, based on the criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 26, 2015 expressed an unqualified opinion on the Company’s internal control over financial reporting.
/s/ DELOITTE & TOUCHE LLP
Portland, Oregon
February 26, 2015
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STANCORP FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME
See Notes to Consolidated Financial Statements.
56 STANCORP FINANCIAL GROUP, INC.
STANCORP FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(1) Net of tax expense of $24.6 million, tax benefit of $111.1 million and tax expense of $38.3 million for 2014, 2013 and 2012, respectively.
(2) Net of tax benefits of $1.1 million, $3.1 million and $2.2 million for 2014, 2013 and 2012, respectively.
(3) Net of tax benefit of $37.9 million and tax expenses of $22.2 million and $0.2 million for 2014, 2013 and 2012, respectively.
(4) Net of tax expense of $0.9 million, tax benefit of $3.2 million and tax expense of $3.4 million for 2014, 2013 and 2012, respectively.
See Notes to Consolidated Financial Statements.
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STANCORP FINANCIAL GROUP, INC.
CONSOLIDATED BALANCE SHEETS
See Notes to Consolidated Financial Statements.
58 STANCORP FINANCIAL GROUP, INC.
STANCORP FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
See Notes to Consolidated Financial Statements.
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STANCORP FINANCIAL GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See Notes to Consolidated Financial Statements.
60 STANCORP FINANCIAL GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
As used in Item 8, the terms “StanCorp,” “Company,” “we,” “us” and “our” refer to StanCorp Financial Group, Inc. and its subsidiaries, unless the context otherwise requires.
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization, principles of consolidation, and basis of presentation
StanCorp, headquartered in Portland, Oregon, is a holding company and conducts business through wholly-owned operating subsidiaries throughout the United States. Through its subsidiaries, StanCorp has the authority to underwrite insurance products in all 50 states. The Company collectively views and operates its businesses as Insurance Services and Asset Management. Insurance Services contains two reportable product segments, Employee Benefits and Individual Disability. Asset Management is a separate reportable segment. See “Note 5-Segments.”
StanCorp has the following wholly-owned operating subsidiaries: Standard Insurance Company (“Standard”), The Standard Life Insurance Company of New York, Standard Retirement Services, Inc. (“Standard Retirement Services”), StanCorp Equities, Inc. (“StanCorp Equities”), StanCorp Mortgage Investors, LLC (“StanCorp Mortgage Investors”), StanCorp Investment Advisers, Inc. (“StanCorp Investment Advisers”), StanCorp Real Estate, LLC (“StanCorp Real Estate”), Standard Management, Inc. (“Standard Management”) and StanCap Insurance Company, Inc. (“StanCap Insurance Company”).
Standard, the Company’s largest subsidiary, underwrites group and individual disability insurance and annuity products, group life and accidental death and dismemberment (“AD&D”) insurance, and provides group dental and group vision insurance, absence management services and retirement plan products. Founded in 1906, Standard is domiciled in Oregon, licensed in all states except New York, and licensed in the District of Columbia and the U.S. territories of Guam, Puerto Rico and the Virgin Islands.
The Standard Life Insurance Company of New York was organized in 2000 and is licensed to provide group and individual disability insurance, group life and AD&D insurance, group dental insurance and vision insurance in New York.
The Standard is a service mark of StanCorp and its subsidiaries and is used as a brand mark and marketing name by Standard and The Standard Life Insurance Company of New York.
Standard Retirement Services administers and services StanCorp’s retirement plans group annuity contracts and trust products. Retirement plan products are offered in all 50 states through Standard or Standard Retirement Services.
StanCorp Equities is a limited business broker-dealer and member of the Financial Industry Regulatory Authority. As a wholesaler, StanCorp Equities activities are limited to soliciting and supporting third-party broker-dealers and investment advisers that offer or advise their retirement plan clients on using an unregistered group annuity contract or a mutual fund trust platform.
StanCorp Mortgage Investors originates and services fixed-rate commercial mortgage loans for the investment portfolios of the Company’s insurance subsidiaries. StanCorp Mortgage Investors also generates additional fee income from the origination and servicing of commercial mortgage loans participated to institutional investors.
StanCorp Investment Advisers is a Securities and Exchange Commission registered investment adviser providing performance analysis, fund selection support, model portfolios and other investment advisory and investment management services.
StanCorp Real Estate is a property management company that owns and manages the Hillsboro, Oregon home office properties and other properties held for investment and held for sale. StanCorp Real Estate also manages the Portland, Oregon home office properties.
Standard Management manages certain real estate properties held for sale from time to time in conjunction with our real estate business.
StanCap Insurance Company is a pure captive insurance company domiciled in Oregon. Effective September 30, 2014, StanCap Insurance Company entered into a reinsurance agreement with Standard to reinsure Standard’s group life and AD&D insurance business.
Standard holds interests in tax-advantaged investments. These interests are accounted for under the equity method of accounting. The carrying value of these interests was $296.3 million and $192.4 million at December 31, 2014 and 2013, respectively.
The consolidated financial statements include StanCorp and its subsidiaries. Intercompany balances and transactions have been eliminated on a consolidated basis.
Use of estimates
The Company’s consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) which require management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosures of contingent assets and contingent liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The estimates most susceptible to material changes due to significant judgment are those used in determining investment valuations, the reserves for future policy benefits and claims, DAC, VOBA and other intangible assets, pension and postretirement benefit plans and the provision for income taxes. The results of these estimates are critical because they affect the Company’s profitability and may affect key indicators used to measure the Company’s performance. These estimates have a material effect on the Company’s results of operations and financial condition.
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Investment Valuations
Fixed Maturity Securities-Available-for-sale (“Fixed Maturity Securities”)
Capital gains and losses for fixed maturity securities are recognized using the specific identification method. If the fair value of a fixed maturity security declines below its amortized cost, the Company assesses whether the decline is other than temporary.
In the Company’s quarterly impairment analysis, management evaluates whether a decline in fair value of the fixed maturity security is other than temporary by considering the following factors:
•
The nature of the fixed maturity security.
•
The duration until maturity.
•
The duration and extent the fair value has been below amortized cost.
•
The financial quality of the issuer.
•
Estimates regarding the issuer’s ability to make the scheduled payments associated with the fixed maturity security.
•
The Company’s intent to sell or whether it is more likely than not it will be required to sell a fixed maturity security before recovery of the security’s cost basis through the evaluation of facts and circumstances including, but not limited to, decisions to rebalance the Company’s portfolio, current cash flow needs and sales of securities to capitalize on favorable pricing.
If it is determined an other-than-temporary impairment (“OTTI”) exists, the Company separates the OTTI of fixed maturity securities into an OTTI related to credit loss and an OTTI related to noncredit loss. The OTTI related to credit loss represents the portion of losses equal to the difference between the present value of expected cash flows, discounted using the pre-impairment yields, and the amortized cost basis. All other changes in value represent the OTTI related to noncredit loss. The OTTI related to credit loss is recognized in earnings in the current period, while the OTTI related to noncredit loss is deemed recoverable and is recognized in other comprehensive income (loss). The cost basis of the fixed maturity security is permanently adjusted to reflect the credit loss. Once an impairment has been recorded, the Company continues to review the OTTI securities for further potential impairment.
The Company will continue to evaluate its holdings; however, the Company currently expects the fair values of its investments to recover either prior to their maturity dates or upon maturity. Should the credit quality of the Company’s fixed maturity securities significantly decline, there could be a material adverse effect on the Company’s business, financial position, results of operations or cash flows.
In conjunction with determining the extent of credit losses associated with fixed maturity securities, the Company utilizes certain information in order to determine the present value of expected cash flows discounted using pre-impairment yields. The information includes, but is not limited to, original scheduled contractual cash flows, current market spread information, risk-free rates, fundamentals of the industry and sector in which the issuer operates, and general market information.
Fixed maturity securities are classified as available-for-sale and are carried at fair value on the consolidated balance sheets. See “Note 9-Fair Value” for a detailed explanation of the valuation methods the Company uses to calculate the fair value of its financial instruments. Valuation adjustments for fixed maturity securities not accounted for as OTTI are reported as net increases or decreases to other comprehensive income (loss), net of tax, on the consolidated statements of comprehensive income.
Commercial Mortgage Loans
Commercial mortgage loans are stated at amortized cost less a loan loss allowance for probable uncollectible amounts. The commercial mortgage loan loss allowance is estimated based on evaluating known and inherent risks in the loan portfolio and consists of a general and a specific loan loss allowance.
Impairment Evaluation
The Company continuously monitors its commercial mortgage loan portfolio for potential impairment by evaluating the portfolio and individual loans. Key factors that are monitored are as follows:
•
Loan loss experience.
•
Delinquency history.
•
Debt coverage ratio.
•
Loan to value ratio.
•
Refinancing and restructuring history.
•
Request for payment forbearance history.
If the analysis above indicates a loan might be impaired, it is further analyzed through the consideration of the following additional factors:
•
Delinquency status.
•
Foreclosure status.
•
Restructuring status.
•
Borrower history.
If it is determined a loan is impaired, a specific allowance is recorded.
62 STANCORP FINANCIAL GROUP, INC.
General Loan Loss Allowance
The general loan loss allowance is based on the Company’s analysis of factors including changes in the size and composition of the loan portfolio, debt coverage ratios, loan to value ratios, actual loan loss experience and individual loan analysis.
Specific Loan Loss Allowance
An impaired commercial mortgage loan is a loan where the Company does not expect to receive contractual principal and interest in accordance with the terms of the original loan agreement. A specific allowance for losses is recorded when a loan is considered to be impaired and it is probable that all amounts due will not be collected based on the terms of the original agreement. The Company also holds specific loan loss allowances on certain performing commercial mortgage loans that it continues to monitor and evaluate. Impaired commercial mortgage loans without specific allowances for losses are those for which the Company has determined that it remains probable that all amounts due will be collected although the timing or nature may be outside the original agreement terms. In addition, for impaired commercial mortgage loans, the Company evaluates the cost to dispose of the underlying collateral, any significant out of pocket expenses the loan may incur and other quantitative information management has concerning the loan. Portions of loans that are deemed uncollectible are charged-off against the allowance, and recoveries, if any, are credited to the allowance. See “Note 10-Investments-Commercial Mortgage Loans.”
Interest Income
The Company records interest income in net investment income and continues to recognize interest income on delinquent commercial mortgage loans until the loans are more than 90 days delinquent. Interest income and accrued interest receivable are reversed when a loan is more than 90 days delinquent. For loans that are less than 90 days delinquent, management may reverse interest income and accrued interest receivable if there is a question on the collectability of the interest. Interest income on loans in the 90-day delinquent category is recognized in the period the cash is collected. The Company resumes the recognition of interest income when the loan becomes less than 90 days delinquent and management determines it is probable that the loan will remain performing.
Real Estate
Real estate is comprised of two components: real estate investments and real estate acquired in satisfaction of debt through foreclosure or acceptance of deeds in lieu of foreclosure on commercial mortgage loans (“Real Estate Owned”).
Real estate investments are recorded at the lower of cost or net realizable value. The Company depreciates real estate investments using the straight-line depreciation method with useful lives varying from 30 to 40 years. The Company records impairments when it is determined that the decline in fair value of an investment below its carrying value is other than temporary. The impairment is recorded to net capital losses, and the carrying value of the investment is adjusted to reflect the impairment. There were no impairments recorded on real estate investments for 2014, 2013 or 2012.
Real Estate Owned is initially recorded at net realizable value, which includes an estimate for disposal costs. This amount may be adjusted in a subsequent period as additional information is received. Real Estate Owned is initially considered an investment held for sale and is expected to be sold within one year from acquisition. For any real estate expected to be sold, an impairment is recorded if the Company does not expect the investment to recover its carrying value prior to the expected date of sale. Once an impairment has been recorded, the Company continues to review the investment for further potential impairment. Impairments recorded on Real Estate Owned were $5.2 million, $8.7 million and $3.0 million for 2014, 2013 and 2012 respectively.
Total real estate was $37.0 million at December 31, 2014, compared to $65.7 million at December 31, 2013. Accumulated depreciation for real estate totaled $12.0 million and $13.4 million at December 31, 2014 and 2013, respectively.
Other Invested Assets
Other invested assets include tax-advantaged investments, derivative financial instruments, policy loans and common stock. Valuation adjustments for these investments are recognized using the specific identification method.
Tax-advantaged Investments
The Company’s tax-advantaged investments are structured as limited partnerships and are accounted for under the equity method of accounting. The Company has purchased tax-advantaged investments opportunistically due to the higher risk-adjusted returns. The primary sources of investment return are tax credits and the tax benefits derived from operating losses, both of which may exhibit variability over the life of the investment. Tax credits received from these investments are reported in the Company’s consolidated statements of income as either a reduction of state premium taxes, or a reduction of income taxes, based on the nature of the credits. The Company’s share of the operating losses of the limited partnerships decreases the carrying value of the investments and is reported as a component of net investment income. If the net present value of expected future cash flows of a tax-advantaged investment is less than the current book value of the investment, the Company evaluates whether a decline in value is other than temporary. If it is determined an OTTI exists, the investment is written down to the net present value of expected future cash flows and the OTTI is recognized as a capital loss in the period in which it was determined to be impaired.
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Derivative Instruments
In 2014, the Company began the use of interest rate swaps to reduce the risks from changes in interest rates, to manage interest rate exposures arising from asset and liability mismatches, and to protect the value of investments held on the consolidated balance sheets. The interest rate swaps used by the Company are designed to qualify for hedge accounting. Interest rate swaps are recognized as either other invested assets or other liabilities in the Company’s consolidated balance sheets and are reported at fair value. The accounting for an interest rate swap depends on whether it has been designated and qualifies as part of a hedging relationship and on the type of hedging relationship. To qualify for hedge accounting, the Company documents the risk management objective and strategy for undertaking the hedging transaction and the designation of the hedge as either a fair value hedge or a cash flow hedge at the inception of the hedging transaction. The documentation includes a description of how the interest rate swap is expected to hedge the designated risk related to specific assets or liabilities on its balance sheets, the method that will be used to prospectively and retrospectively assess the hedge effectiveness, the method that will be used to measure ineffectiveness and how this ineffectiveness will be accounted for.
An interest rate swap designated as part of a hedging relationship must be assessed as being highly effective in offsetting the designated risk of the hedged item. Hedge effectiveness is assessed at inception and periodically throughout the life of the designated hedging relationship, using qualitative and quantitative methods. Qualitative methods include comparison of critical terms of the interest rate swap to the hedged item. Quantitative methods include regression or other statistical analysis of changes in the fair value or cash flows associated with the hedge relationship.
Changes in the fair value of an interest rate swap designated as a fair value hedge, including amounts measured as ineffective, and changes in the fair value of the hedged item, are recognized in the consolidated statements of income as a component of net capital gains and losses each period. The gain or loss on the termination of a fair value hedge is recognized in the consolidated statements of income as a component of net capital gains and losses during the period in which the termination occurs. When interest rate swaps are used in hedge accounting relationships, periodic settlements are recorded in net investment income.
The gain or loss on the termination of an ineffective fair value hedge is reported in the consolidated statements of income as a component of net capital gains or losses. Additionally, when a hedged item is disposed, the Company will terminate the related derivative instrument and recognize the gain or loss on termination in the Company’s consolidated statements of income as a component of net capital gains or losses.
Index-based guarantees embedded in indexed annuities (“index-based interest guarantees”) and Standard & Poor’s (“S&P”) 500 Index call spread options (“S&P 500 Index options”) do not qualify for hedge accounting. The Company sells indexed annuities, which permit the holder to elect a fixed interest rate return or an indexed return, where interest credited to the contracts is based on the performance of the S&P 500 Index, subject to an upper limit or cap and minimum guarantees. Policyholders may elect to rebalance between interest crediting options at renewal dates annually. At each renewal date, the Company has the opportunity to re-price the indexed component by changing the cap, subject to minimum guarantees. The Company estimates the fair value of the index-based interest guarantees for the current period and for all future reset periods until contract maturity. Changes in the fair value of the index-based interest guarantees are recorded in interest credited.
The Company purchases S&P 500 Index options for its interest crediting strategy used in its indexed annuity product. The S&P 500 Index options are purchased from investment banks and are selected in a manner that supports the amount of interest that is expected to be credited in the current year to annuity policyholder accounts that are dependent on the performance of the S&P 500 Index. The purchase of S&P 500 Index options is a pivotal part of the Company’s risk management strategy for indexed annuity products. The S&P 500 Index options are exclusively used for risk management. Changes in the fair value of S&P 500 Index options are recorded in net investment income.
Cash settlement activity of derivative contracts is reported in the consolidated statements of cash flows as a component of proceeds from or acquisition of other invested assets. See “Note 11-Derivative Financial Instruments.”
Policy Loans
Policy loans are stated at their aggregate unpaid principal balances and are secured by policy cash values.
Common Stock
In 2013, Standard became a member of the Federal Home Loan Bank of Seattle (“FHLB of Seattle”) and purchased the required common stock for membership and activity. The FHLB of Seattle common stock is carried at par value and accounted for under the cost method. The Company periodically evaluates the FHLB of Seattle common stock for OTTI. The Company’s determination of whether this investment is impaired is based on its assessment of the ultimate recoverability of cost rather than by recognizing temporary declines in value. There were no impairments recorded on the common stock of FHLB of Seattle in 2014 or 2013. The Federal Home Loan Bank of Des Moines (“FHLB of Des Moines”) and the FHLB of Seattle have announced that they have entered into a definitive agreement to merge the two banks. The merger agreement has been unanimously approved by the boards of directors of both banks and by the Federal Housing Finance Agency (“FHFA”). The potential merger must be approved by the members of both banks through a voting process that is expected to take place in the first half of 2015. The Company does not expect the merger to have a material effect on its business, financial position, results of operations, or cash flows.
64 STANCORP FINANCIAL GROUP, INC.
Cash and Cash Equivalents
Cash and cash equivalents include cash and investments purchased with original maturities of three months or less at the time of acquisition. The carrying amount of cash equivalents approximates the fair value of those instruments.
DAC, VOBA and Other Intangible Assets
DAC, VOBA and other acquisition related intangible assets are generally originated through the issuance of new business or the purchase of existing business, either by purchasing blocks of insurance policies from other insurers or by the outright purchase of other companies. The Company’s intangible assets are subject to impairment tests on an annual basis or more frequently if circumstances indicate that carrying values may not be recoverable.
The Company defers certain acquisition costs that vary with and are directly related to the origination of new business and placing that business in-force. Certain costs related to obtaining new business and acquiring business through reinsurance agreements have been deferred and are amortized to accomplish matching against related future premiums or gross profits as appropriate. The Company normally defers certain acquisition-related commissions and incentive payments, certain costs of policy issuance and underwriting, and certain printing costs. Assumptions used in developing DAC and amortization amounts each period include the amount of business in-force, expected future persistency, withdrawals, interest rates and profitability. These assumptions are modified to reflect actual experience when appropriate. Additional amortization of DAC is charged to current earnings to the extent it is determined that future premiums or gross profits are not adequate to cover the remaining amounts deferred. Changes in actual persistency are reflected in the calculated DAC balance. Costs that are not directly associated with the acquisition of new business are not deferred as DAC and are charged to expense as incurred. Generally, annual commissions are considered expenses and are not deferred.
DAC for group and individual disability insurance products and group life insurance products is amortized over the life of related policies in proportion to future premiums. The Company amortizes DAC for group disability and life insurance products over the initial premium rate guarantee period, which averages 2.5 years. DAC for individual disability insurance products is amortized in proportion to future premiums over the life of the contract, averaging 20 to 25 years with approximately 50% and 75% expected to be amortized by years 10 and 15, respectively.
The Company’s individual deferred annuities and group annuity products are classified as investment contracts. DAC related to these products is amortized over the life of related policies in proportion to expected gross profits. For the Company’s individual deferred annuities, DAC is generally amortized over 30 years with approximately 54% and 93% expected to be amortized by years 5 and 15, respectively. DAC for group annuity products is amortized over 10 years with approximately 76% expected to be amortized by year five.
VOBA primarily represents the discounted future profits of business assumed through reinsurance agreements. The Company has established VOBA for a block of individual disability insurance business assumed from Minnesota Life Insurance Company (“Minnesota Life”) and a block of group disability and group life insurance business assumed from Teachers Insurance and Annuity Association of America (“TIAA”). VOBA is generally amortized in proportion to future premiums for group and individual disability insurance products and group life insurance products. However, the VOBA related to the TIAA transaction associated with an in-force block of group long term disability insurance claims for which no ongoing premium is received is amortized in proportion to expected gross profits. If actual premiums or future profitability are inconsistent with the Company’s assumptions, the Company could be required to make adjustments to VOBA and related amortization. The VOBA associated with the TIAA transaction is amortized in proportion to expected gross profits with an amortization period of up to 20 years. For the VOBA associated with the Minnesota Life block of business assumed, the amortization period is up to 30 years and is amortized in proportion to future premiums.
Key assumptions, which will affect the determination of expected gross profits for determining DAC and VOBA balances, include:
•
Persistency.
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Interest rates, which affect both investment income and interest credited.
•
Stock market performance.
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Capital gains and losses.
•
Claim termination rates.
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Amount of business in-force.
These assumptions are modified to reflect actual experience when appropriate. Although a change in a single assumption may have an impact on the calculated amortization of DAC or VOBA for balances associated with investment contracts, it is the relationship of that change to the changes in other key assumptions that determines the ultimate impact on DAC or VOBA amortization. Because actual results and trends related to these assumptions vary from those assumed, the Company revises these assumptions annually to reflect its current best estimate of expected gross profits. As a result of this process, known as “unlocking,” the cumulative balances of DAC and VOBA are adjusted with an offsetting increase or decrease to income to reflect changes in the period of the revision. An unlocking event generally occurs as a result of actual experience or future expectations differing from previous estimates. As a result of unlocking, the amortization schedule for future periods is also adjusted.
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Significant, unanticipated changes in key assumptions, which affect the determination of expected gross profits, may result in a large unlocking event that could have a material adverse effect on the Company’s financial position or results of operations.
The Company’s other intangible assets are subject to amortization and consist of certain customer lists from Asset Management business acquired and an individual disability marketing agreement. Customer lists have a combined estimated weighted-average remaining life of approximately 6.5 years. The marketing agreement accompanied the Minnesota Life transaction and provides access to Minnesota Life agents, some of whom now market Standard’s individual disability insurance products. The Minnesota Life marketing agreement will be fully amortized by the end of 2023.
Property and Equipment, Net
The following table sets forth the major classifications of the Company’s property and equipment and accumulated depreciation:
Property and equipment are stated at cost less accumulated depreciation. The Company depreciates property and equipment using the straight-line method over the estimated useful lives with a half-year convention. The estimated useful lives are generally 40 years for properties, range from three to ten years for equipment and range from three to five years for capitalized software. Leasehold improvements are depreciated over the lesser of the estimated useful life of the asset or the life of the lease. Depreciation expense for 2014, 2013 and 2012 was $17.8 million, $19.9 million and $24.1 million, respectively. The Company reviews property and equipment for impairment when circumstances or events indicate the carrying amount of the asset may not be recoverable and recognizes a charge to earnings if an asset is impaired.
Non-affiliated tenants leased 34.2%, 33.8% and 33.3% of the corporate headquarters in Portland, Oregon at December 31, 2014, 2013 and 2012, respectively. Income from the leases is included in net investment income.
Separate Account
Separate account assets and liabilities represent segregated funds held for the exclusive benefit of contract holders. The activities of the account primarily relate to contract holder-directed 401(k) agreements. Standard charges the separate account with asset management and plan administration fees associated with the contracts. Separate account assets are carried at fair value and separate account liabilities are carried at the amount of the related assets.
Reserves for Future Policy Benefits and Claims
Benefits and expenses are matched with recognized premiums to result in recognition of profits over the life of the contracts. The match is accomplished by recording a provision for future policy benefits and unpaid claims and claim adjustment expenses. For most of the Company’s product lines, management establishes and carries as a liability actuarially determined reserves that are calculated to meet the Company’s obligations for future policy benefits and claims. These reserves do not represent an exact calculation of the Company’s future benefit liabilities but are instead estimates based on assumptions and considerations concerning a number of factors, which include:
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The amount of premiums that the Company will receive in the future.
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The rate of return on assets the Company purchases with premiums received.
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Expected number and severity of claims.
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Expenses.
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Persistency, which is the measurement of the percentage of premiums remaining in-force from year to year.
In particular, the Company’s group and individual long term disability insurance reserves are sensitive to assumptions and considerations regarding the following factors:
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Claim incidence rates for incurred but not reported claim reserves.
•
Claim termination rates.
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Discount rates used to value expected future claim payments.
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•
Persistency rates.
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The amount of monthly benefit paid to the insured less reinsurance recoveries and other offsets.
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Expense rates including inflation.
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Historical delay in reporting of claims incurred.
Assumptions may vary by:
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Age, gender and, for individual policies, occupation class of the claimant.
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Year of issue for policy reserves or incurred date for claim reserves.
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Time elapsed since disablement.
•
Contract provisions and limitations.
Other Policyholder Funds
Other policyholder funds are liabilities for investment-type contracts and are based on the policy account balances including accumulated interest. Other policyholder funds also include amounts related to advanced premiums of $188.3 million and $186.1 million at December 31, 2014 and 2013, respectively, and premiums on deposit and experience rated liabilities totaling $187.0 million and $193.5 million at December 31, 2014 and 2013, respectively.
Recognition of Premiums
Premiums from group life and group and individual disability contracts are recognized as revenue when due. Investment-type contract fee revenues consist of charges for policy administration and surrender charges assessed during the period. Charges related to services to be performed are deferred until earned. The amounts received in excess of premiums and fees are unearned and included in other policyholder funds on the consolidated balance sheets. Experience rated refunds (“ERRs”) are computed in accordance with the terms of the contracts with certain group policyholders and are accounted for as an adjustment to premiums.
Income Taxes
The Company files a U.S. consolidated income tax return that includes all subsidiaries. The Company’s U.S. income tax is calculated using regular corporate income tax rates on a tax base determined by laws and regulations administered by the Internal Revenue Service (“IRS”). The Company also files corporate income tax returns in various states. The provision for income taxes includes amounts currently payable and deferred amounts that result from temporary differences between financial reporting and tax bases of assets and liabilities. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply when the temporary differences are expected to reverse.
GAAP requires management to use a more likely than not standard to evaluate whether, based on available evidence, each deferred tax asset will be realized. A valuation allowance is recorded to reduce a deferred tax asset to the amount expected to be realized.
Management is required to determine whether tax return positions are more likely than not to be sustained upon audit by taxing authorities. Tax benefits of uncertain tax positions, as determined and measured by this interpretation, cannot be recognized in the Company’s financial statements.
The Company records interest paid on income tax liabilities as interest expense and income tax penalties incurred as an operating expense.
Other Comprehensive Income
Other comprehensive income includes changes in unrealized capital gains and losses on fixed maturity securities, net of the related tax effects, and changes in unrealized prior service costs and credits and net gains and losses associated with the Company’s employee benefit plans, net of the related tax effects.
Accounting Pronouncements
Accounting Standards Update (“ASU”) No. 2014-01, Accounting for Investments in Qualified Affordable Housing Projects
In January 2014, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2014-01, Accounting for Investments in Qualified Affordable Housing Projects. This ASU permits entities to account for qualified affordable housing projects under the proportional amortization method (“PAM”) of accounting. Under PAM, the cost of the investments is amortized in each period in proportion to the tax credits and benefits of tax losses received in that period to total benefits to be received over the life of the investments and allows the amortization of the investments and the tax benefits to be recognized in income taxes on the consolidated statements of income.
ASU No. 2014-01 is effective for annual reporting periods and interim reporting periods within those annual reporting periods beginning after December 15, 2014. Early adoption is permitted. The Company is adopting this ASU effective January 1, 2015, which it expects will decrease the beginning balance of 2015 retained earnings between $15 million and $20 million. Based on the investments held at December 31, 2014, the Company estimates the adoption of the ASU will result in a decrease in net income
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of approximately $13 million for 2015. The adoption of this ASU will change the timing of the benefit realized in net income but will not change the cumulative total benefit to net income over the life of the investments.
ASU No. 2014-09, Revenue from Contracts with Customers
In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers. The main objective of ASU No. 2014-09 is to provide a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. This ASU does not apply to insurance contracts, financial instruments, and various other topics within the FASB Accounting Standards Codification. The core principle of the revenue model is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services.
ASU No. 2014-09 is effective for annual reporting periods and interim reporting periods within those annual reporting periods beginning after December 15, 2016. Early adoption is not permitted. The Company’s revenue is primarily from insurance contracts and financial instruments; therefore, the Company does not expect this ASU to have a material effect on its results of operations.
ASU No. 2015-01, Income Statement-Extraordinary and Unusual Items
In January 2015, the FASB issued ASU No. 2015-01, Income Statement-Extraordinary and Unusual Items. The main objective of ASU No. 2015-01 is to eliminate from GAAP the concept of extraordinary items, however, the requirement to disclose unusual and infrequent items still exists. Under this guidance, an entity will no longer segregate extraordinary items from the results of ordinary operations; separately present an extraordinary item on its income statement, net of tax, after income from continuing operations; and disclose income taxes and earnings-per-share data applicable to an extraordinary item. The ASU affects the reporting and disclosure requirements for an event that is unusual in nature or that occurs infrequently.
ASU No. 2015-01 is effective for annual reporting periods and interim reporting periods within those annual reporting periods beginning after December 15, 2015. Early adoption is permitted if guidance is applied as of the beginning of the annual reporting period of adoption. The Company does not expect this ASU to have a material effect on its results of operations or disclosures.
2. NET INCOME PER COMMON SHARE
Net income per basic common share was calculated by dividing net income by the weighted-average common shares outstanding. Net income per diluted common share was calculated using the treasury stock method and reflects the dilutive effects of stock awards and potential exercises of dilutive outstanding stock options. Diluted weighted-average common shares outstanding does not include stock options with an option exercise price greater than the average market price because they are antidilutive and inclusion would increase net income per diluted common share.
The following table sets forth the calculation of net income per basic and diluted weighted-average common shares outstanding:
3. SHARE-BASED COMPENSATION
The Company has two active share-based compensation plans: the 2002 Stock Incentive Plan (“2002 Plan”) and the 1999 Employee Share Purchase Plan (“ESPP”). The 2002 Plan authorizes the Board of Directors to grant incentive or non-statutory stock options and stock awards to eligible employees and certain specified parties. The Company’s ESPP allows eligible employees to purchase StanCorp common stock at a discount. Of the 7,000,000 shares of common stock authorized for the 2002 Plan, 2,694,980 shares or options for shares remain available for grant at December 31, 2014. Of the 3,500,000 shares authorized for the ESPP, 1,378,369 shares remain available for issuance at December 31, 2014.
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The following table sets forth the total compensation cost and related income tax benefit under the Company’s share-based compensation plans:
2002 Plan
The Company has provided two types of share-based compensation pursuant to the 2002 Plan: option grants and stock award grants.
Option Grants
Options are granted to officers and certain non-officer employees. Executive officers typically receive annual grants in amounts determined by the Organization & Compensation Committee of the Board of Directors. Non-executive officers typically receive annual grants as determined by management. Officers may also receive options when hired or promoted to an officer position. In addition, the Chief Executive Officer has authority to award a limited number of options at his discretion to non-executive officers and other employees. Options are granted with an exercise price per share equal to the closing market price of StanCorp common stock on the grant date. Options typically vest in four equal installments on the first four anniversaries of the vesting reference date. Option awards to certain officers vest if the officer’s employment is terminated by the Company without cause or the officer terminates for good reason within 24 months after a change of control of the Company as defined in the Company’s change of control agreement. Options generally expire 10 years from the grant date.
The following table sets forth a summary of option activity and options outstanding and exercisable:
(1) The intrinsic value of outstanding options can fluctuate significantly due to changes in the year end closing stock price from year to year.
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The fair value of each option award was estimated using the Black-Scholes option pricing model as of the grant date using the assumptions noted in the following table. The Black-Scholes option pricing model uses the expected term as an input with the calculated option value varying directly with the length of time until exercise. The Company bases its estimate of the expected term on an analysis of the historical exercise experience of similar options granted to similar employee or director groups. The expected term given below represents the weighted-average expected term of options granted. Expected stock price volatility is based on the volatility of StanCorp’s common stock price per share over the prior period equal in duration to the expected term. The dividend rate is the rate expected to be paid over the expected term, generally estimated to be equal to the rate for the year prior to the grant. The risk-free rate is the interest rate on a U.S. Treasury bond of a maturity closest to the expected term of the option granted.
The following table sets forth the weighted-average assumptions used to determine the fair value of option grants:
The weighted-average grant date fair value of options granted was $23.29, $16.15 and $13.73 for 2014, 2013 and 2012, respectively.
The total intrinsic value of the options exercised was $5.9 million, $14.4 million and $3.2 million for 2014, 2013 and 2012, respectively. The amount that the Company received from the exercise of stock options was $10.9 million, $50.2 million and $7.6 million for 2014, 2013 and 2012, respectively. The related tax benefit derived from the tax deduction received by the Company for the difference between the market price of StanCorp common stock and the exercise price when the options were exercised was $3.6 million for both 2014 and 2013 and $1.1 million for 2012.
The compensation cost of stock options is recognized over the vesting period, which is also the period over which the grantee must provide services to the Company. At December 31, 2014, the total cost related to unvested option awards that had not yet been recognized in the financial statements was $5.5 million. This cost will be recognized over a weighted-average period of 2.4 years.
Stock Award Grants
The Company currently grants three types of stock awards: restricted stock unit awards (“RSUs”), performance-based stock awards (“Performance Shares”) and non-employee director stock awards (“Director Stock Grants”). Under the 2002 Plan, the Company had 1,059,828 shares available for issuance as stock award grants at December 31, 2014.
The following table sets forth a summary of the activity of RSU and Performance Shares outstanding:
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RSUs
The Company grants annual RSUs to officers and senior officers of the Company. RSUs typically cliff vest three years from the grant date. The actual number of shares issued is based on continued employment with a portion of shares withheld to cover required tax withholding.
The Company granted 48,294 and 59,823 RSUs for 2014 and 2013, respectively. The fair value of the RSUs is determined based on the closing market price of StanCorp common stock on the grant date.
The compensation cost of RSUs is recognized over the vesting period, which is the period over which the grantee must provide services to the Company. At December 31, 2014, the total compensation cost related to unvested RSUs that had not yet been recognized in the financial statements was $2.8 million. This cost will be recognized over a weighted-average remaining period of 1.7 years.
Performance Shares
The Company grants Performance Shares to designated senior officers as long-term incentive compensation. The payout for these awards is based on the Company’s financial performance over a three-year period. Performance Share grants represent the maximum number of shares of StanCorp common stock issuable to the designated senior officers if specified criteria are met. The actual number of shares issued at the end of the performance period is based on continued employment and satisfaction of the Company’s financial performance conditions, with a portion of the shares withheld to cover required tax withholding.
The Company granted 77,634 and 129,172 Performance Shares for 2014 and 2013, respectively.
The Company issued 8,846 and 9,899 shares of StanCorp common stock for 2014 and 2012, respectively. Due to timing of when performance shares vested, the Company did not issue shares for 2013.
The fair value of the Performance Shares is based on the closing market price of StanCorp common stock on the grant date.
The compensation cost of Performance Shares is based on an estimate of the number of shares that will be earned and cost is recognized over the vesting period. The cost the Company will ultimately recognize as a result of these stock awards is dependent on the Company’s financial performance. Assuming that the maximum performance is achieved for each performance goal, $7.7 million in additional compensation cost would be recognized through 2016. Assuming that the target performance is achieved, this cost would be recognized over a weighted-average period of 1.4 years. The target payout is 50% of the maximum performance shares. Assuming that the target performance is achieved for each performance goal, $2.1 million in additional compensation cost would be recognized through 2016.
Director Stock Grants
Each non-employee director receives annual stock grants with fair value equal to $100,000 based on the closing market price of StanCorp common stock on the day of the annual shareholder meeting. The stock grants generally vest after one year. Prior to May 7, 2012, the non-employee directors received compensation of $50,000 in stock options and $50,000 in stock grants.
The Company issued 17,294, 20,099 and 9,489 shares of StanCorp common stock for 2014, 2013 and 2012, respectively, related to the vesting of the annual Director stock grant for 2013, 2012 and 2011. The weighted-average fair value per share for the shares issued was $45.74, $44.12 and $36.40 for the same periods, respectively.
Employee Share Purchase Plan
The Company’s ESPP allows eligible employees to purchase StanCorp common stock at a 5% discount of the lesser of the closing market price of StanCorp common stock on either the commencement date or the final date of each six-month offering period. Under the terms of the plan, each eligible employee may elect to have the lesser of up to 5% of the employee’s gross total cash compensation or $5,000 per offering period withheld to purchase StanCorp common stock. No employee may purchase StanCorp common stock having a fair market value in excess of $25,000 in any calendar year.
The compensation cost for the ESPP is measured as the sum of the value of the discount and the value of the embedded six-month option. The value of the discount is equal to the available discount multiplied by of the fair market value of the common stock at the offering date. The value of the embedded option is calculated using the Black-Scholes option pricing model and the assumptions noted in the following table. Expected stock price volatility was based on the volatility of the price of StanCorp common stock during the six months preceding the offering period. The risk-free rate was based on the six-month U.S. Treasury yield curve in effect at the time of the grant.
The following table sets forth the assumptions used to determine the fair value of the ESPP embedded option:
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The following table sets forth the fair value per share, compensation cost and related income tax benefit under the Company’s ESPP:
4. RETIREMENT BENEFITS
Pension Benefits
The Company has two non-contributory defined benefit pension plans: the employee pension plan and the agent pension plan. The employee pension plan is generally limited to eligible employees of the Company whose date of employment began before 2003 and a participant is entitled to a normal retirement benefit at age 65. The agent pension plan is for former field employees and agents. The defined benefit pension plans provide benefits based on years of service and final average pay. The employee pension plan is sponsored by StanCorp and the agent pension plan is sponsored by Standard. Both plans are administered by Standard Retirement Services and are closed to new participants.
The Company recognizes the funded status of the pension plans as an asset or liability on the balance sheet. The funded status is measured as the difference between the fair value of the plan assets and the projected benefit obligation as of the year-end balance sheet date.
The following table sets forth a reconciliation of the changes in the pension plans’ projected benefit obligations, fair value of plan assets and the funded status:
The following table sets forth the projected and accumulated benefit obligations and the fair value of the plan assets for the pension plans:
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The Company recognizes as a component of accumulated other comprehensive (income) loss, net of tax, the actuarial gains or losses, prior service costs or credits, and transition assets that have not yet been recognized as components of net periodic benefit cost.
The following table sets forth the amounts recognized in accumulated other comprehensive (income) loss:
The estimated net loss and prior service cost for the pension plans that will be amortized from accumulated other comprehensive (income) loss into net periodic benefit cost in 2015 are $6.9 million and $0.4 million net of tax, respectively.
The following table sets forth the components of net periodic benefit (credit) cost, other changes in plan assets and benefit obligations recognized in other comprehensive (income) loss, and assumptions used in the measurement of the net periodic benefit cost and the benefit obligations:
The long run rate of return for the employee pension plan portfolio is derived by calculating the average return for the portfolio monthly, from 1971 to the present, using the average mutual fund manager returns in each asset category, weighted by the target allocation to each category.
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The Company made contributions to the employee pension plan of $15.0 million and $10.0 million in 2014 and 2012, respectively. The Company did not make any contributions to the employee pension plan in 2013. The Company is not obligated to make any contributions to its pension plans for 2015. In addition, no plan assets are expected to be returned to the Company in 2015.
The following table sets forth the expected benefit payments for the Company’s pension plans:
The investment goal of the employee pension plan is to produce long-run portfolio returns that are consistent with reasonable contribution rates and a well-funded plan. To manage the overall risk of the portfolio, the portfolio is reviewed quarterly and rebalanced as necessary to keep the allocation of debt and equity securities within target allocation tolerance levels. The equity securities include pooled separate account funds comprised of large cap growth, large cap blend, large cap value, mid cap blend and foreign mutual funds and are diversified across investment strategies. The employee pension plan held no StanCorp equity securities as plan assets at December 31, 2014 and 2013. The plan invests in a stable asset fund comprised of debt securities included in the general account represented by a Deposit Administration Contract with Standard. Standard maintains the contributions in an unallocated fund, whose assets are invested with other assets in the general account of Standard. The account is credited with earnings on the underlying investments and charged for plan withdrawals and administrative expenses charged by Standard Retirement Services. The stable asset fund contract may subject the plan to concentrations of risk as its contract value is dependent on the ability of Standard to honor its contractual commitments. There are no reserves against the contract value for credit risk of Standard or otherwise.
The investment goal of the agent pension plan is to invest in stable value assets in order to maintain its funded status.
The following table sets forth the Company’s target and actual weighted-average asset allocations for the pension plans:
Pension plan assets are recorded at fair value and are disclosed below using a three-level hierarchy. See “Note 9-Fair Value” for additional fair value information. The fair values of pooled separate accounts are valued daily based upon quoted market prices in an active market and are classified as Level 1 assets. Pooled separate accounts are recorded at fair value on a recurring basis. The fair value of the stable asset fund is included in the financial statements at the Deposit Administration Contract value and is classified as a Level 2 asset. The contract value approximates fair value, as the contract crediting rate resets annually, and the contracts are fully benefit-responsive. Contract value represents contributions made under the contracts, plus earnings, less withdrawals and administrative expenses. The Stable asset fund is primarily invested in investment grade securities and commercial mortgage loans.
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The following tables set forth the estimated fair values of pension plan assets and liabilities measured and recorded at fair value on a recurring basis:
There were no transfers into or from Level 1, 2 or 3 for 2014 and 2013.
As a result of inputs used during the current period to estimate the fair value of the stable asset fund, Plan management has categorized the stable asset fund as having Level 2 inputs at December 31, 2014. The valuation methods may produce fair value calculations that may not be indicative of net realizable values or reflective of future fair values. See “Note 9-Fair Value” for further disclosure on valuation methods. Furthermore, although the Plan believes its valuation methods are appropriate and consistent with other market participants, the use of different methodologies or assumptions to determine the fair value of certain financial instruments could result in a different fair value measurement at the reporting date.
Deferred Compensation Plans
Eligible employees are covered by a qualified deferred compensation plan sponsored by Standard under which a portion of the employee contribution is matched. Employees not eligible for the employee pension plan are eligible for an additional non-elective employer contribution. Contributions to the plan for 2014, 2013 and 2012 were $10.7 million, $9.9 million and $9.9 million, respectively.
Eligible executive officers, directors, agents and group producers may participate in one of several non-qualified deferred compensation plans under which a portion of the deferred compensation for participating executive officers, agents and group producers is matched. The liability for the plans was $12.6 million and $11.6 million at December 31, 2014 and 2013, respectively.
Postretirement Benefits Other Than Pensions
Standard sponsors and administers a postretirement benefit plan that includes medical, prescription drug benefits and group term life insurance. Eligible retirees are required to contribute specified amounts for medical and prescription drug benefits that are
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determined periodically and are based on retirees’ length of service and age at retirement. As of 2006, participation in the postretirement benefit plan was closed to new participants. An amendment announced in 2012 reduced future benefits for plan participants that did not retire by July 1, 2013.
The Company recognizes the funded status of the postretirement benefit plan as an asset or liability on the consolidated balance sheets. The funded status is measured as the difference between the fair value of the plan assets and the accumulated postretirement benefit obligation.
The following table sets forth a reconciliation of the changes in the postretirement benefit plan’s accumulated postretirement benefit obligation, fair value of plan assets and the funded status:
The gains and losses, and prior service costs or credits excluded from the projected postretirement benefit obligation are recognized as a component of accumulated other comprehensive loss (income), net of tax.
The following table sets forth the amounts recognized in accumulated other comprehensive loss (income):
In 2015, no estimated prior service credit or net loss (gain) for the postretirement benefit plan will be amortized from accumulated other comprehensive loss (income) into net periodic benefit cost. The projected discounted cash flow obligation for the postretirement benefit plan was $24.7 million and $17.6 million at December 31, 2014 and 2013, respectively.
The following table sets forth the assumed health care cost trend rates for next year:
* Year that the rate reaches the ultimate trend is 2027.
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Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:
The following table sets forth the components of net periodic benefit cost (credit), other changes in plan assets and benefit obligations recognized in other comprehensive (income) loss, and assumptions used in the measurement of the postretirement net periodic benefit (credit) cost and the postretirement benefit obligations:
For the postretirement benefit plan, the expected long-term rate of return on assets was developed by considering the historical returns and the future expectations for returns, as well as the target asset allocation. Assumptions for rate of compensation increase were not applicable in determining benefit obligations or net periodic costs for 2014, 2013 or 2012 due to the curtailment of the group term life insurance benefit as of December 31, 2011.
The Company contributed $0.5 million, $0.4 million and $0.3 million to fund the postretirement benefit plan in 2014, 2013 and 2012, respectively. The Company expects to make contributions of $0.8 million to its postretirement benefit plan in 2015. No plan assets are expected to be returned to the Company in 2015.
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The following table sets forth the expected benefit payments for the Company’s postretirement benefit plan:
The investment goal of the postretirement plan is to produce a steady return on plan assets to maintain its funded status. To achieve this goal, the Company’s postretirement benefit plan assets are comprised primarily of municipal bonds and cash and cash equivalents.
The following table sets forth the Company’s target and actual weighted-average asset allocations for the postretirement medical plan:
Postretirement benefit plan assets are recorded at fair value and are disclosed below using a three-level hierarchy. See “Note 9-Fair Value” for additional fair value information. As there was not an active market for the Company’s municipal and corporate bond holdings at December 31, 2014, the municipal and corporate bonds were valued using Level 2 measurements.
The following tables set forth the estimated fair values of assets measured and recorded at fair value on a recurring basis:
Non-Qualified Supplemental Retirement Plan
Eligible executive officers are covered by a non-qualified supplemental retirement plan (“non-qualified plan”). Under the non-qualified plan, a participant is entitled to a normal retirement benefit once the participant reaches age 65. A participant can also
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receive a normal, unreduced retirement benefit once the sum of his or her age plus years of service is at least 90. The Company recognizes the unfunded status of the non-qualified plan in other liabilities on the consolidated balance sheets. The unfunded status was $42.8 million and $31.1 million at December 31, 2014 and 2013, respectively. Expenses were $3.9 million, $3.1 million and $1.9 million for 2014, 2013 and 2012, respectively. The net loss and prior service cost, net of tax, excluded from the net periodic benefit cost and reported as a component of accumulated other comprehensive income were $11.7 million, $5.7 million and $4.7 million at December 31, 2014, 2013 and 2012, respectively.
5. SEGMENTS
The Company collectively views and operates its businesses as Insurance Services and Asset Management. Insurance Services contains two reportable product segments, Employee Benefits and Individual Disability. Insurance Services offers group and individual disability insurance, group life and AD&D insurance, group dental and group vision insurance, and absence management services. Asset Management is a separate reportable segment. Asset Management provides investment and asset management products and services. Asset Management offers full-service 401(k) plans, 403(b) plans, 457 plans, defined benefit plans, money purchase pension plans, profit sharing plans and non-qualified deferred compensation products and services. Asset Management also offers investment advisory and management services, origination and servicing of fixed-rate commercial mortgage loans, individual fixed and indexed annuity products, group annuity contracts and retirement plan trust products. The Other category includes return on capital not allocated to the product segments, holding company expenses, operations of certain unallocated subsidiaries, interest on debt, unallocated expenses, net capital gains and losses primarily related to the impairment or the disposition of the Company’s invested assets and adjustments made in consolidation. Resources are allocated and performance is evaluated at the segment level. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. See “Note 1-Summary of Significant Accounting Policies.”
Intersegment revenues are comprised of administrative fees charged by Asset Management to manage the fixed maturity securities and commercial mortgage loan portfolios for the Company’s insurance subsidiaries. Intersegment fees are determined based on the level of assets in the insurance subsidiaries’ fixed maturity securities and commercial mortgage loan portfolios.
The following table sets forth intersegment revenues:
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The following table sets forth premiums, administrative fees and net investment income by major product line or category within each of the Company’s segments:
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The following tables set forth select segment information:
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6. PARENT HOLDING COMPANY CONDENSED FINANCIAL INFORMATION
Set forth below are the unconsolidated condensed financial statements of StanCorp. The significant accounting policies used in preparing StanCorp’s financial statements are substantially the same as those used in the preparation of the consolidated financial statements of the Company except that StanCorp’s subsidiaries are carried under the equity method.
The following table sets forth StanCorp’s condensed statements of income and comprehensive income:
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The following table sets forth StanCorp’s condensed balance sheets:
The following table sets forth StanCorp’s condensed statements of cash flows:
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7. INCOME TAXES
The following table sets forth the provision for income taxes:
The following table sets forth the reconciliation between taxes calculated as if the federal corporate tax rate of 35% was applied to income before income taxes and the recorded income tax provision:
The following table sets forth the tax effect of temporary differences that gave rise to significant portions of the net deferred tax liability:
The Company is carrying forward net operating losses (“NOLs”) of $54 million that originated in StanCorp and certain subsidiaries. The losses will be used in future years to offset taxable income from those entities to the degree allowed by the Internal Revenue Code. If unutilized, these losses would expire between the years 2024 to 2034. In addition, the Company is carrying forward a $46 million federal NOLs from a business acquisition. This carryforward is subject to limitations under IRS Section 382, which potentially reduces the annual amount that may be utilized. This NOLs carryforward will expire between 2020 and 2025.
Realization of the Company’s NOLs carryforwards is dependent upon generating sufficient taxable income of the appropriate character before expiration of the losses. Although realization is not assured, management believes it is more likely than not that all of
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the deferred tax asset relating to the federal loss carryforwards will be realized. The amount of the deferred tax asset considered realizable could be reduced in the future if estimates of expected taxable income during the carryforward period are reduced.
The Company is carrying forward a deferred tax asset of $13.2 million related to losses attributable to various states and municipalities. In some instances, state and local loss carryforwards are subject to a shorter expiration period than the 20-year federal period. Further, some losses originated in a subsidiary which has reduced its operations in the state where the loss was incurred. The Company believes that the benefit from certain state and local NOLs carryforwards will not be realized. As such, the Company has provided a valuation allowance of $8.4 million at December 31, 2014 on the deferred tax assets relating to these assets. The Company also has an additional $1.1 million in valuation allowances for other assets that are not state and local NOLs. If the Company’s assumptions change, the Company may be able to realize these NOLs. The state and local loss carryforwards expire at various dates through 2034.
As of December 31, 2014, the Company is subject to examination by the IRS for the years 2011 through 2014.
The Company did not have any material unrecognized tax benefits at December 31, 2014 and 2013. The Company records interest paid on income tax liabilities as interest expense and income tax penalties incurred as an operating expense. See “Note 1-Summary of Significant Accounting Policies-Income Taxes.”
8. GOODWILL
Goodwill is related to Asset Management and totaled $36.0 million at both December 31, 2014 and 2013. Goodwill is not amortized and is tested at least annually for impairment. If indicators of impairment appear throughout the year, or in the event of material changes in circumstances, the test will be more frequent. The Company performs a step-one test and compares the carrying value of the tested assets with the fair value of the assets. Fair value is measured using a combination of the income approach and the market approach. The income approach consists of utilizing the discounted cash flow method that incorporates the Company’s estimates of future revenues and costs, discounted using a market participant weighted-average cost of capital. The estimates the Company uses in the income approach are consistent with the plans and estimates that the Company uses to manage its operations. The market approach utilizes multiples of profit measures in order to estimate the fair value of the assets. As the income approach more closely aligns with how the Company internally evaluates and manages its business, the Company weights the income approach more heavily than the market approach in determining the fair value of the assets. However, the Company performs testing to ensure that both models are providing reasonably consistent results. Additionally, the Company performs sensitivity analysis on the key input factors in these models to determine whether any input factor or combination of factors moving moderately in either direction would change the results of these tests. Through the performance of these tests, the Company determined the fair value of goodwill substantially exceeded the carrying value, and concluded that it was not impaired as of December 31, 2014.
9. FAIR VALUE
Assets and liabilities recorded at fair value are disclosed using a three-level hierarchy. The classification of assets and liabilities within the hierarchy is based on whether the inputs to the valuation methodology used for measurement are observable or unobservable. Observable inputs reflect market-derived or market-based information obtained from independent sources while unobservable inputs reflect the Company’s estimates about market data.
The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels: Level 1 inputs are based upon quoted prices in active markets for identical assets or liabilities that the Company can access at the measurement date. Level 2 inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market. Level 3 inputs are generated from model-based techniques that use significant assumptions not observable in the market. These unobservable assumptions reflect the Company’s estimates of assumptions that market participants would use in pricing the asset or liability.
There are three types of valuation techniques used to measure assets and liabilities recorded at fair value:
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The market approach uses prices or other relevant information generated by market transactions involving identical or comparable assets or liabilities.
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The income approach uses the present value of cash flows or earnings.
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The cost approach, which uses replacement costs more readily adaptable for valuing physical assets.
The Company uses both the market and income approach in its fair value measurements. These measurements are discussed in more detail below.
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The following tables set forth the carrying value and the estimated fair value of each financial instrument:
Financial Instruments Not Recorded at Fair Value
The Company did not elect to measure and record commercial mortgage loans, policy loans, other policyholders funds that are investment-type contracts, short-term debt, or long-term debt at fair value on the consolidated balance sheets.
For disclosure purposes, the fair values of commercial mortgage loans were estimated using an option-adjusted discounted cash flow valuation. The valuation includes both observable market inputs and estimated model parameters.
Significant observable inputs to the valuation include:
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Indicative year-end pricing for a package of loans similar to those originated by the Company near year-end.
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U.S. Government treasury yields.
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Indicative yields from industrial bond issues.
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The contractual terms of nearly every mortgage subject to valuation.
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Significant estimated parameters include:
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A liquidity premium that is estimated from historical loan sales and is applied over and above base yields.
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Adjustments in interest rate spread based on an aggregate portfolio loan-to-value ratio, estimated from historical differential yields with respect to loan-to-value ratios.
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Projected prepayment activity.
For policy loans, the carrying value represents historical cost but approximates fair value. While potentially financial instruments, policy loans are an integral component of the insurance contract and have no maturity date.
The fair value of other policyholder funds that are investment-type contracts was calculated using the income approach in conjunction with the cost of capital method. The parameters used for discounting in the calculation were estimated using the perspective of the principal market for the contracts under consideration. The principal market consists of other insurance carriers with similar contracts on their books.
The fair value for long-term debt was predominantly based on quoted market prices as of December 31, 2014 and December 31, 2013, and trades occurring close to December 31, 2014 and December 31, 2013.
Financial Instruments Measured and Recorded at Fair Value
Fixed maturity securities, S&P 500 Index options, interest rate swaps and index-based interest guarantees are recorded at fair value on a recurring basis. In the Company’s consolidated statements of comprehensive income, unrealized gains and losses are reported in other comprehensive income (loss) for fixed maturity securities. In the Company’s consolidated statements of income, the change in fair value for S&P 500 Index options is reported in net investment income. For interest rate swaps that are designated as a fair value hedge, the change in the fair values of the interest rate swap and the hedged item are reported in net capital gains and losses. The fair value of interest rate swaps is determined through Level 2 inputs using quoted prices from an independent pricing service. The change in fair value for index-based interest guarantees is reported in interest credited.
Separate account assets represent segregated funds held for the exclusive benefit of contract holders. The activities of the account primarily relate to participant-directed 401(k) contracts. Separate account assets are recorded at fair value on a recurring basis, with changes in fair value recorded to separate account liabilities. Separate account assets consist of mutual funds. The mutual funds’ fair value is determined through Level 1 and Level 2 inputs. The majority of the separate account assets are valued using quoted prices in an active market with the remainder of the assets valued using quoted prices from an independent pricing service. The Company reviews the values obtained from the pricing service for reasonableness through analytical procedures and performance reviews.
Fixed maturity securities are comprised of the following classes:
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Corporate bonds.
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U.S. government and agency bonds.
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U.S. state and political subdivision bonds.
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Foreign government bonds.
The fixed maturity securities are diversified across industries, issuers and maturities. The Company calculates fair values for all classes of fixed maturity securities using valuation techniques described below. They are placed into three levels depending on the valuation technique used to determine the fair value of the securities.
The Company uses an independent pricing service to assist management in determining the fair value of these assets. The pricing service incorporates a variety of information observable in the market in its valuation techniques, including:
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Reported trading prices.
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Benchmark yields.
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Broker-dealer quotes.
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Benchmark securities.
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Bids and offers.
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Credit ratings.
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Relative credit information.
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Other reference data.
The pricing service also takes into account perceived market movements and sector news, as well as a bond’s terms and conditions, including any features specific to that issue that may influence risk, and thus marketability. Depending on the security, the priority of the use of observable market inputs may change as some observable market inputs may not be relevant or additional inputs may be necessary. The Company generally obtains one value from its primary external pricing service. On a case-by-case basis, the Company may obtain further quotes or prices from additional parties as needed.
The pricing service provides quoted market prices when available. Quoted prices are not always available due to bond market inactivity. The pricing service obtains a broker quote when sufficient information, such as security structure or other market information, is not available to produce a valuation. Valuations and quotes obtained from third-party commercial pricing services are non-binding and do not represent quotes on which one may execute the disposition of the assets.
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The significant unobservable inputs used in the fair value measurement of the reporting entity’s bonds are valuations and quotes received from the secondary pricing service, analytical reviews and broker quotes. Significant increases or decreases in any of those inputs in isolation would result in a significantly lower or higher fair value measurement. Generally, a change in the assumption used for the pricing evaluation is accompanied by a directionally similar change in the assumption used for the methodologies.
The Company performs control procedures over the external valuations at least quarterly through a combination of procedures that include an evaluation of methodologies used by the pricing service, analytical reviews and performance analysis of the prices against statistics, trends and secondary pricing sources, back testing of sales activity and maintenance of a list of fixed maturity securities with characteristics that could indicate potential impairment. As necessary, the Company compares prices received from the pricing service to prices independently estimated by the Company utilizing discounted cash flow models or through performing independent valuations of inputs and assumptions similar to those used by the pricing service in order to ensure prices represent a reasonable estimate of fair value. Although the Company does identify differences from time to time as a result of these validation procedures, the Company did not make any significant adjustments as of December 31, 2014 or December 31, 2013.
S&P 500 Index options and certain fixed maturity securities were valued using Level 3 inputs. The Level 3 fixed maturity securities were valued using matrix pricing, independent broker quotes and other standard market valuation methodologies. The fair value was determined using inputs that were not observable or could not be derived principally from, or corroborated by, observable market data. These inputs included assumptions regarding liquidity, estimated future cash flows and discount rates. Unobservable inputs to these valuations are based on management’s judgment or estimation obtained from the best sources available. The Company’s valuations maximize the use of observable inputs, which include an analysis of securities in similar sectors with comparable maturity dates and bond ratings. Broker quotes are validated by management for reasonableness in conjunction with information obtained from matrix pricing and other sources.
The Company calculates the fair value for its S&P 500 Index options using the Black-Scholes option pricing model and parameters derived from market sources. The Company’s valuations maximize the use of observable inputs, which include direct price quotes from the Chicago Board Options Exchange (“CBOE”) and values for on-the-run treasury securities and London Interbank Offered Rate (“LIBOR”) as reported by Bloomberg. Unobservable inputs are estimated from the best sources available to the Company and include estimates of future gross dividends to be paid on the stocks underlying the S&P 500 Index, estimates of bid ask spreads, and estimates of implied volatilities on options. Valuation parameters are calibrated to replicate the actual end-of-day market quotes for options trading on the CBOE. The Company performs additional validation procedures such as the daily observation of market activity and conditions and the tracking and analyzing of actual quotes provided by banking counterparties each time the Company purchases options from them. Additionally, in order to help validate the values derived through the procedures noted above, the Company obtains indicators of value from representative investment banks.
The Company uses the discounted cash flow valuation model to determine the fair value of the interest rate swaps. The inputs used in the model are observable in the market. The interest rate swaps qualify as Level 2 under the fair value hierarchy since their valuation is based on a model for which all significant assumptions are observable in the market.
The Company uses the income approach valuation technique to determine the fair value of index-based interest guarantees. The liability is the present value of future cash flows attributable to the projected index growth in excess of cash flows driven by fixed interest rate guarantees for the indexed annuity product. Level 3 assumptions for policyholder behavior and future index crediting rate declarations significantly influence the calculation. Index-based interest guarantees are included in the other policyholder funds line on the Company’s consolidated balance sheets.
While valuations for the S&P 500 Index options are sensitive to a number of variables, valuations for S&P 500 Index options purchased are most sensitive to changes in the estimates of bid ask spreads, or the S&P 500 Index value, and the implied volatilities of this index. Significant fluctuations in any of those inputs in isolation would result in a significantly lower or higher fair value measurement. Generally, an increase or decrease used in the assumption for the implied volatilities and in the S&P 500 Index value would result in a directionally similar change in the fair value of the asset.
Valuations for the index-based interest guarantees are sensitive to a number of variables, but are most sensitive to the S&P 500 Index value, the implied volatilities of this index, and the interest rate environment. Generally, a significant increase or decrease used in the assumption for the implied volatilities and in the S&P 500 Index value would result in a directionally similar change, while an increase or decrease in interest rate environment would result in a directionally opposite change in the fair value of the liability.
Valuations for commercial mortgage loans measured at fair value on a nonrecurring basis using significant unobservable Level 3 inputs are sensitive to a number of variables, but are most sensitive to net operating income and the applied capitalization rate. Generally, an increase or decrease resulting from a change in the stabilized net operating income from the collateralized property would result in a directionally similar change in the fair value of the asset. An increase or decrease in the assumption for the capitalization rate would result in a directionally opposite change in the fair value of the asset.
Valuations for Real Estate Owned are measured at fair value on a nonrecurring basis using significant unobservable Level 3 inputs and are sensitive to a number of variables. Real Estate Owned is most sensitive to the reductions taken on appraisals obtained, which may result in a fair value and carrying value below the appraised value. Generally, an increase in the reductions taken on appraisals obtained would result in a reduction in the fair value of the asset.
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The following table sets forth quantitative information regarding significant unobservable inputs used in Level 3 valuations of assets and liabilities measured and recorded at fair value:
(a) Represents various assumptions derived from market data, which include estimates of bid ask spreads and the implied volatilities for the S&P 500 Index.
(b) Represents various actuarial assumptions which include combined lapse, mortality and withdrawal decrement rates which generally have a range of inputs from 5%-36% for both December 31, 2014 and December 31, 2013.
(c) Capitalization rates are used as an internal analysis in converting the underlying property income to an estimated property value.
The following tables set forth the reconciliation for all assets and liabilities measured at fair value on a recurring basis using significant unobservable Level 3 inputs:
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For all periods disclosed above, fixed maturity securities transferred into Level 3 from Level 2 are the result of the Company being unable to obtain observable assumptions for these investments in the market. Fixed maturity securities transferred from Level 3 into Level 2 are the result of the Company being able to obtain observable assumptions for these investments in the market. There were no transfers between Level 1 and Level 2 for 2014 and 2013.
The following table sets forth the changes in unrealized gains (losses) included in net income relating to Level 3 assets and liabilities that the Company continued to hold:
Changes in the fair value of fixed maturity securities that are not designated as part of a hedging relationship are recorded to other comprehensive income. Changes in the fair value of the S&P 500 Index options are recorded to net investment income. Changes in the fair value of the index-based interest guarantees are recorded to interest credited and are sensitive to a number of variables and assumptions. As a result of the Company’s annual update of the key assumptions used to value index-based interest guarantees, a process known as “unlocking”, interest credited decreased $4.0 million and $4.1 million for 2014 and 2013, respectively.
Certain assets and liabilities are measured at fair value on a nonrecurring basis such as impaired commercial mortgage loans with specific allowances for losses and Real Estate Owned. The impaired commercial mortgage loans and Real Estate Owned are valued using Level 3 measurements. These Level 3 inputs are reviewed for reasonableness by management and evaluated on a quarterly basis. The commercial mortgage loan measurements include valuation of the market value of the asset using general underwriting procedures and appraisals. Real Estate Owned is initially recorded at net realizable value, which includes an estimate for disposal costs. These amounts may be adjusted in a subsequent period as additional information is received.
The following table sets forth the assets measured at fair value on a nonrecurring basis as of December 31, 2014 that the Company continued to hold:
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Commercial mortgage loans measured on a nonrecurring basis with a carrying amount of $74.2 million were written down to their fair value of $56.0 million, less selling costs, at December 31, 2014. The specific commercial mortgage loan loss allowance related to these commercial mortgage loans was $23.8 million at December 31, 2014. The Real Estate Owned measured on a nonrecurring basis as of December 31, 2014, and still held at December 31, 2014 had net capital losses totaling $1.2 million for 2014. Real Estate Owned measured on a nonrecurring basis represents newly acquired properties or properties whose value has been adjusted based on pending sale or other market information.
The following table sets forth the assets measured at fair value on a nonrecurring basis as of December 31, 2013 that the Company continued to hold:
Commercial mortgage loans measured on a nonrecurring basis with a carrying amount of $87.7 million were written down to their fair value of $68.7 million, less selling costs, at December 31, 2013. The specific commercial mortgage loan loss allowance related to these commercial mortgage loans was $25.9 million at December 31, 2013. The Real Estate Owned measured on a nonrecurring basis as of December 31, 2013, and still held at December 31, 2013 had capital losses totaling $7.2 million for 2013. See “Note 10-Investments-Commercial Mortgage Loans” for further disclosures regarding the commercial mortgage loan loss allowance.
10. INVESTMENTS
Fixed Maturity Securities
The following tables set forth the amortized costs, gross unrealized gains and losses and fair values of the Company’s fixed maturity securities:
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The following table sets forth the amortized costs and fair values of the Company’s fixed maturity securities by contractual maturity:
Actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations. Callable bonds, excluding bonds with make-whole provisions and bonds with provisions that allow the borrower to prepay near maturity, represented 3.5%, or $275.1 million, of the Company’s fixed maturity securities portfolio at December 31, 2014. At December 31, 2014, the Company did not have any direct exposure to sub-prime or Alt-A mortgages in its fixed maturity securities portfolio.
Gross Unrealized Losses
The following tables set forth the gross unrealized losses and fair value of investments, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position:
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The unrealized losses on the fixed maturity securities set forth above were partly due to increases in market interest rates subsequent to their purchase by the Company and have also been affected by overall economic factors. The Company expects the fair value of these fixed maturity securities to recover as the fixed maturity securities approach their maturity dates or sooner if market yields for such fixed maturity securities decline. The Company does not believe that any of the fixed maturity securities are impaired due to credit quality or due to any company or industry specific event. Based on management’s evaluation of the securities and the Company’s intent to hold the securities, and as it is unlikely that the Company will be required to sell the securities, none of the unrealized losses summarized in this table are considered other-than-temporary. See “Note 1-Summary of Significant Accounting Policies-Investment Valuations-Fixed Maturity Securities” for a discussion regarding OTTI for fixed maturity securities.
Commercial Mortgage Loans
The Company underwrites mortgage loans on commercial property throughout the United States. In addition to real estate collateral, the Company requires either partial or full recourse on most loans. At December 31, 2014, the Company did not have any direct exposure to sub-prime or Alt-A mortgages in its commercial mortgage loan portfolio.
The following table sets forth the commercial mortgage loan portfolio by property type, by geographic region within the U.S. and by U.S. state:
* Geographic regions obtained from the American Council of Life Insurers Mortgage Loan Portfolio Profile.
Due to the concentration of commercial mortgage loans in California, the Company could be exposed to potential losses as a result of an economic downturn in California as well as certain catastrophes, such as earthquakes and fires, which may affect the region.
The carrying value of commercial mortgage loans represents the outstanding principal balance less a loan loss allowance for probable uncollectible amounts. The commercial mortgage loan loss allowance is estimated based on evaluating known and inherent risks in the loan portfolio and consists of a general and a specific loan loss allowance.
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Impairment Evaluation
The Company continuously monitors its commercial mortgage loan portfolio for potential impairment by evaluating the portfolio and individual loans. See “Note 1-Summary of Significant Accounting Policies-Investment Valuations-Commercial Mortgage Loans” for the Company’s commercial mortgage loan impairment evaluation.
General Loan Loss Allowance
The general loan loss allowance is based on the Company’s analysis of factors including changes in the size and composition of the loan portfolio, debt coverage ratios, loan to value ratios, actual loan loss experience and individual loan analysis.
Specific Loan Loss Allowance
An impaired commercial mortgage loan is a loan where the Company does not expect to receive contractual principal and interest in accordance with the terms of the original loan agreement. A specific allowance for losses is recorded when a loan is considered to be impaired and it is probable that all amounts due will not be collected based on the terms of the original note. The Company also holds specific loan loss allowances on certain performing commercial mortgage loans that it continues to monitor and evaluate. Impaired commercial mortgage loans without specific allowances for losses are those for which the Company has determined that it remains probable that all amounts due will be collected although the timing or nature may be outside the original contractual terms. In addition, for impaired commercial mortgage loans, the Company evaluates the cost to dispose of the underlying collateral, any significant out of pocket expenses the loan may incur and other quantitative information management has concerning the loan. Negotiated reductions of principal are generally written off against the allowance, and recoveries, if any, are credited to the allowance.
The following table sets forth changes in the commercial mortgage loan loss allowance:
Changes in the commercial mortgage loan loss allowance can result from the number of commercial mortgage loans with a specific loan loss allowance and general loan loss allowance and the composition factors of the commercial mortgage loan portfolio. Changes in the provision and charge-offs can result from losses related to foreclosures, accepted deeds in lieu of foreclosure on commercial mortgage loans and other related charges associated with commercial mortgage loans in the commercial mortgage loan portfolio.
The following table sets forth the recorded investment in commercial mortgage loans:
The Company assesses the credit quality of its commercial mortgage loan portfolio quarterly by reviewing the performance of its portfolio, which includes evaluating its performing and nonperforming commercial mortgage loans. Nonperforming commercial mortgage loans include all commercial mortgage loans that are 60 days or more past due and commercial mortgage loans that are not 60 days past due but are not substantially performing to other original contractual terms.
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The following tables set forth performing and nonperforming commercial mortgage loans by property type:
The following tables set forth impaired commercial mortgage loans identified in management’s specific review of probable loan losses and the related allowance:
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Changes in the carrying value of impaired commercial mortgage loans can result from a change in the number of commercial mortgage loans with a specific loan loss allowance. As of December 31, 2014 and December 31, 2013, the Company did not have any commercial mortgage loans greater than 90 days delinquent that were accruing interest. See “Note 1-Summary of Significant Accounting Policies-Investment Valuations-Commercial Mortgage Loans” for the policies regarding interest income for delinquent commercial mortgage loans.
A modification is considered to be a troubled debt restructuring when the debtor is experiencing financial difficulties and the restructured terms constitute a concession. Granting payment forbearance is not a modification of the loan if the payment forbearance is considered to be an insignificant timing difference associated with the borrowing. The Company evaluates all restructured commercial mortgage loans for indications of troubled debt restructurings and the potential losses related to these restructurings. If a loan is considered a troubled debt restructuring, the Company impairs the loan and records a specific allowance for estimated losses. In some cases, the recorded investment in the loan may increase post-restructuring. The Company assessed all restructurings that occurred during the period to determine if they were troubled debt restructurings. The Company did not identify any troubled debt restructurings that were not already considered impaired.
The following tables set forth information related to the troubled debt restructurings of financing receivables:
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There were no troubled debt restructurings identified in the previous 12 months that subsequently defaulted during 2014.
The following table sets forth the average recorded investment in impaired commercial mortgage loans before specific allowances for losses:
The amount of interest income recognized on impaired commercial mortgage loans was $5.3 million, $4.2 million and $4.1 million for 2014, 2013 and 2012, respectively. The cash received by the Company in payment of interest on impaired commercial mortgage loans was $4.8 million, $3.8 million and $4.0 million for 2014, 2013 and 2012, respectively. See “Note 1-Summary of Significant Accounting Policies-Investment Valuations-Commercial Mortgage Loans” for policies regarding interest income for delinquent commercial mortgage loans.
The following tables set forth the aging of commercial mortgage loans by property type:
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The Company closely monitors all past due commercial mortgage loans. Additional attention is given to those loans at least 60 days past due. Commercial mortgage loans that have been granted forbearance are not considered to be past due and totaled $5.2 million and $40.1 million at December 31, 2014 and 2013, respectively. Commercial mortgage loans that were at least 60 days past due totaled $8.6 million and $15.2 million at December 31, 2014 and 2013, respectively. The Company’s current level of past due commercial mortgage loans is lower than its historical levels due to an improving commercial real estate market. Commercial mortgage loans that were at least 60 days past due were 0.16% of the commercial mortgage loan portfolio at December 31, 2014, compared to 0.28% at December 31, 2013.
Net Investment Income
The following table sets forth net investment income summarized by investment type:
Realized Gross Capital Gains and Losses
The following table sets forth gross capital gains and losses by investment type:
Securities Deposited as Collateral
Securities deposited for the benefit of policyholders in various states, in accordance with state regulations, amounted to $7.2 million and $7.4 million at December 31, 2014 and 2013, respectively.
Standard is a member of the FHLB of Seattle. Standard issues collateralized funding agreements to the FHLB of Seattle and invests the cash received from advances to support various spread-based businesses and enhance its asset-liability management. Membership also provides an additional funding source and access to financial services that can be used as an alternative source of liquidity. At December 31, 2014, Standard had $139.0 million outstanding under funding agreements with the FHLB of Seattle and pledged $174.4 million of commercial mortgage loans as collateral for its outstanding advances. Standard had no outstanding funding agreements or pledged collateral with the FHLB of Seattle at December 31, 2013. The FHLB of Des Moines and the FHLB of Seattle have announced that they have entered into a definitive agreement to merge the two banks. The merger agreement has been
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unanimously approved by the boards of directors of both banks and by the FHFA. The potential merger must be approved by the members of both banks through a voting process that is expected to take place in the first half of 2015. The Company does not expect the merger to have a material effect on our business, financial position, results of operations or cash flows.
11. DERIVATIVE FINANCIAL INSTRUMENTS
The Company uses derivative financial instruments to mitigate business risks including interest rate risk exposure. The Company has the following derivatives on its consolidated balance sheets: interest rate swaps, index-based guarantees and S&P 500 Index options.
Interest Rate Swaps
In 2014, the Company began the use of interest rate swaps to reduce risks from changes in interest rates, to manage interest rate exposures arising from asset and liability mismatches, and to protect the value of investments held on the consolidated balance sheets. The interest rate swaps used by the Company are designed to qualify for hedge accounting. Therefore, recognized changes in the fair value of the interest rate swaps and the changes in fair value of the hedged items attributable to the hedged risk, are offset in net capital gains and losses. Valuations for interest rate swaps are sensitive to changes in the interest rate environment.
Interest income, interest expense and fees related to interest rate swaps are recorded as a component of net investment income.
Interest rate swaps are recognized as either other invested assets or other liabilities in the consolidated balance sheets and are reported at fair value. To qualify for hedge accounting, the Company formally documents the risk management objective and strategy for undertaking the hedging transaction and the designation of the hedge as either a fair value hedge or a cash flow hedge at the inception of the hedging transaction. Included in this documentation is how the interest rate swap is expected to hedge the designated risk related to specific assets or liabilities on the balance sheet as well as a description of the method that will be used to retrospectively and prospectively assess the hedge effectiveness, the method that will be used to measure ineffectiveness and how this ineffectiveness will be recorded.
A derivative instrument designated as part of a hedging relationship must be assessed as being highly effective in offsetting the designated risk of the hedged item. Hedge effectiveness is formally assessed at inception and periodically throughout the life of the designated hedging relationship, using qualitative and quantitative methods. Qualitative methods include comparison of critical terms of the derivative to the hedged item. Quantitative methods include regression or other statistical analysis of changes in the fair value or cash flows associated with the hedge relationship.
In the event a hedged item is disposed, the Company will terminate the related interest rate swap and recognize the gain or loss on termination in the consolidated statements of income.
Cash settlement activity of derivative contracts is reported in the consolidated statements of cash flows as a component of proceeds from or acquisition of other invested assets.
Index-based Interest Guarantees
The Company sells indexed annuities, which permit the holder to elect a fixed interest rate return or an indexed return, where interest credited to the contracts is based on the performance of the S&P 500 Index, subject to an upper limit or cap and minimum guarantees. The index-based interest guarantees do not qualify for hedge accounting. Policyholders may elect to rebalance between interest crediting options at renewal dates annually. At each renewal date, the Company has the opportunity to re-price the indexed component by changing the cap, subject to minimum guarantees. The Company estimates the fair value of the index-based interest guarantees for the current period and for all future reset periods until contract maturity. Changes in the fair value of the index-based interest guarantees are recorded to interest credited. The liability represents an estimate of the cost of the options to be purchased in the future to manage the risk related to the index-based interest guarantees. The liability for index-based interest guarantees is the present value of future cash flows attributable to the projected index growth that is in excess of cash flows attributable to fixed interest rates guarantees. The excess cash flows are discounted back to the date of the balance sheet using current market indicators for future interest rates and option costs. Cash flows depend on actuarial estimates for policyholder lapse behavior and management’s discretion in setting renewal index-based interest guarantees.
S&P 500 Index Options
The Company purchases S&P 500 Index options for its interest crediting strategy used in its indexed annuity product. The S&P 500 Index options do not qualify for hedge accounting. The S&P 500 Index options are purchased from investment banks and are selected in a manner that supports the amount of interest that is expected to be credited in the current year to annuity policyholder accounts that are dependent on the performance of the S&P 500 Index. The purchase of S&P 500 Index options is a pivotal part of the Company’s risk management strategy for indexed annuity products. The S&P 500 Index options are exclusively used for risk management. While valuations of the S&P 500 Index options are sensitive to a number of variables, valuations for S&P 500 Index options purchased are most sensitive to changes in the S&P 500 Index value and the implied volatilities of this index. Changes in the fair value of the S&P 500 Index options are recorded to net investment income. The Company generally purchases two S&P 500 Index option contracts per month, which have expiry dates of one year from the date of purchase.
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Option premiums paid for the Company’s index option contracts were $9.3 million and $9.4 million for 2014 and 2013, respectively. The Company received $20.1 million and $19.3 million for options exercised in 2014 and 2013, respectively.
The following table sets forth the fair value of the Company’s derivative assets and liabilities:
(1) The underlying factors for index-based guarantees vary by contract and other criteria, such as floors and ceilings on rates and future payouts.
The following table sets forth the gross amounts of derivative instruments recorded on the consolidated balance sheets and the collateral pledged related to the derivative instruments:
The following table sets forth the amount of gains or losses recognized in the consolidated statements of income from the change in fair value of the Company’s derivative assets and liabilities:
Fluctuations in the fair value of the interest rate swaps are driven by changes in the interest rate environment. Fluctuations in the fair value of the S&P 500 Index options are related to the volatility of the S&P 500 Index. Changes in fair value of the index-based interest guarantees are sensitive to a number of variables, but are most sensitive to changes in the interest rate environment.
As a result of the Company’s annual update of the key assumptions used to value index-based interest guarantees, a process known as “unlocking,” interest credited decreased $4.0 million and $4.1 million for 2014 and 2013, respectively.
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The ineffective portion of derivatives accounted for using hedge accounting was not material to the results of operations of the Company for 2014 and 2013 and 2012.
Counterparty Credit Risk
Interest rate swaps
As the Company uses a central counterparty (“CCP”) to clear all of its interest rate swaps, the Company is only exposed to the default of the CCP. Transactions with the CCP require the Company to pledge initial and variation margin collateral. At December 31, 2014, the Company pledged $12.2 million of cash and cash equivalents on its consolidated balance sheets as collateral to the CCP.
S&P 500 Index options
The Company is exposed to the credit worthiness of the institutions from which it purchases its S&P 500 Index options and these institutions’ continued abilities to perform according to the terms of the contracts. The current values for the credit exposure have been affected by fluctuations in the S&P 500 Index. The Company’s maximum credit exposure would require an increase of 4.5% in the value of the S&P 500 Index. The maximum credit risk is calculated using the cap strike price of the Company’s S&P 500 Index options less the floor price, multiplied by the notional amount of the S&P 500 Index options.
The following table sets forth the fair value of the Company’s S&P 500 Index options and its maximum credit risk exposure related to these instruments:
12. DAC, VOBA AND OTHER INTANGIBLE ASSETS
DAC, VOBA and other acquisition related intangible assets are generally originated through the issuance of new business or the purchase of existing business, either by purchasing blocks of insurance policies from other insurers or by the outright purchase of other companies. The Company’s other intangible assets consist of certain customer lists from Asset Management business acquired and an individual disability marketing agreement. See “Note 1-Summary of Significant Accounting Policies-DAC, VOBA and Other Intangible Assets” for additional information.
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The following table sets forth activity for DAC, VOBA and other intangible assets:
The following table sets forth the amount of DAC and VOBA balances amortized in proportion to expected gross profits and the percentage of the total balance of DAC and VOBA amortized in proportion to expected gross profits:
The value of DAC and VOBA is dependent on key assumptions. See “Note 1-Summary of Significant Accounting Policies-DAC, VOBA and Other Intangible Assets” for a discussion of the key assumptions used to determine the values of DAC and VOBA. These assumptions are modified to reflect actual experience when appropriate. Although a change in a single assumption may have an impact on the calculated amortization of DAC or VOBA for balances associated with investment contracts, it is the relationship of that change to the changes in other key assumptions that determines the ultimate impact on DAC or VOBA amortization. Because actual results and trends related to these assumptions vary from those assumed, the Company revises these assumptions annually to reflect its current best estimate of expected gross profits. As a result of this process, known as “unlocking”, the cumulative balances of DAC and VOBA are adjusted with an offsetting increase or decrease to income to reflect changes in the period of the revision. An unlocking event generally occurs as a result of actual experience or future expectations differing from previous estimates. The Company recorded a decrease to VOBA of $1.0 million in 2013 and $0.8 million in 2012 due to changes in expected gross profits related to the block of claims assumed. The Company did not record an adjustment to VOBA as a result of unlocking in 2014. As a result of unlocking, the amortization schedule for future periods is also adjusted.
The following table sets forth the impact of unlocking on DAC and VOBA balances:
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Significant, unanticipated changes in key assumptions, which affect the determination of expected gross profits, may result in a large unlocking event that could have a material effect on the Company’s financial position or results of operations. However, future changes in DAC and VOBA due to changes in underlying assumptions are not expected to be material.
The accumulated amortization of VOBA was $71.0 million and $68.7 million at December 31, 2014 and 2013, respectively. The accumulated amortization of other intangible assets was $48.4 million and $42.6 million at December 31, 2014 and 2013, respectively. See “Note 1-Summary of Significant Accounting Policies-DAC, VOBA and Other Intangible Assets” for a discussion on the amortization policies for VOBA and other intangible assets.
The following table sets forth the estimated net amortization of VOBA and other intangible assets for each of the next five years:
13. LIABILITY FOR UNPAID CLAIMS, CLAIM ADJUSTMENT EXPENSES AND OTHER POLICYHOLDER FUNDS
The liability for unpaid claims, claim adjustment expenses and other policyholder funds includes liabilities for insurance offered on products such as group long term and short term disability, individual disability, group dental and group vision, and group AD&D. The liability for unpaid claims and claim adjustment expenses is established when a claim is incurred or is estimated to have been incurred but not yet reported to the Company and, as prescribed by GAAP, equals the Company’s best estimate of the present value of the liability of future unpaid claims and claim adjustment expenses. This liability is included in future policy benefits and claims on the consolidated balance sheets.
The following table sets forth the change in the liability for unpaid claims and claim adjustment expenses:
Classified as future policy benefits and claims, but excluded from the table above are amounts recorded for group and individual life reserves, group and individual annuity reserves, and individual disability active life reserves.
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The following table sets forth the reconciliation of amounts above to future policy benefits and claims as presented on the consolidated balance sheets:
The majority of the net liability balances are related to long term disability insurance claims on which interest earned on assets backing the reserves is a key component of reserving and pricing. The year to year development of incurred claims related to prior years is therefore broken out into an interest portion and remaining incurred portion.
The changes in amounts incurred related to prior years are not the result of a significant change in an underlying assumption or method used to determine the estimate. Instead the Company expects these amounts to change over time as a result of the growth in the size of the Company’s in-force insurance business and the actual claims experience with respect to that business during the time periods captured for claims with an incurred date in years prior to the year of valuation. Interest is also a key component in the year to year development of the reserves and therefore the positive changes in amounts incurred related to prior years should not be taken as an indicator of the adequacy or inadequacy of the reserves held. In each of the years captured, there was a decrease in incurred amounts associated with prior years after the effect of interest is taken into account, indicating that claim experience was favorable compared to the assumptions used to establish the associated reserves. Significant changes to assumptions regarding unpaid claims and claims adjustment expenses for prior periods in the group long term disability insurance reserves were not made in 2014, 2013 and 2012 primarily due to the long-term nature of this product and the materiality of other factors including the potential impact of the economic uncertainty in 2014, 2013 and 2012. The Company carefully monitors trends in reserve assumptions and when these trends become credible and are expected to persist, the Company incorporates these factors into its reserves to ensure best estimates are established.
The following table sets forth the composition of other policyholder funds:
The primary components of other policyholder funds are retirement plan stable asset funds for which the Company provides recordkeeping services, individual fixed-rate annuity funds, investment only stable asset funds and indexed annuity funds. The remaining balance is comprised primarily of premiums on deposits, advanced premiums and experience-related liabilities.
14. REINSURANCE
In order to limit its losses from large claim exposures, the Company enters into reinsurance agreements with other insurance companies. The Company reviews its retention limits based on size and experience. The maximum retention limit per individual for group life and AD&D is $750,000. The Company’s maximum retention limit for group disability insurance is $15,000 of monthly benefit per individual. The Company’s maximum retention limit for individual disability insurance is $7,500 of monthly benefit per individual.
Standard maintains a strategic marketing alliance with Ameritas Life Insurance Corp. (“Ameritas”) that offers Standard’s policyholders flexible dental coverage options and access to Ameritas’ nationwide preferred provider organization panel of dentists. As part of this alliance, Standard and Ameritas entered into a reinsurance agreement. In 2014, the agreement provided for 26.1% of the net dental premiums written by Standard and the risk associated with this premium to be ceded to Ameritas.
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Standard participates in a reinsurance and third-party administration arrangement with Northwestern Mutual Life Insurance Company (“Northwestern Mutual”) under which Northwestern Mutual group long term and short term disability products are sold using Northwestern Mutual’s agency distribution system. Generally, Standard assumes 60% of the risk and receives 60% of the premiums for the policies issued. If Standard were to become unable to meet its obligations, Northwestern Mutual would retain the reinsured liabilities. Therefore, in accordance with an agreement with Northwestern Mutual, Standard established a trust for the benefit of Northwestern Mutual with the market value of assets in the trust equal to Northwestern Mutual’s reinsurance receivable from Standard. The market value of assets required to be maintained in the trust at December 31, 2014, was $241.1 million. Premiums assumed by Standard for the Northwestern Mutual business accounted for approximately 3% of the Standard’s total premiums for each of the three years 2014, 2013 and 2012. In addition to assuming risk, Standard provides product design, pricing, underwriting, legal support, claims management and other administrative services under the arrangement.
Effective September 30, 2014, StanCap Insurance Company entered into a reinsurance agreement with Standard to reinsure Standard’s group life and AD&D business. This reinsurance agreement between StanCap Insurance Company and Standard replaced the yearly renewable term group life reinsurance agreement with Canada Life Assurance Company, which was terminated effective September 30, 2014. The intercompany transactions between Standard and StanCap Insurance Company are eliminated in consolidation.
The Company also maintains reinsurance coverage for certain catastrophe losses related to group life and AD&D with partial coverage of nuclear, biological and chemical acts of terrorism and is part of a catastrophe reinsurance pool with other insurance companies.
This pool spreads catastrophe losses from group life and AD&D over 18 participating members. The annual fee paid by the Company to participate in the pool was less than $30,000 for 2014. As a member of the pool, the Company is exposed to maximum potential losses experienced by other participating members of up to $104.6 million for a single event for losses submitted by a single company and a maximum of $261.5 million for a single event for losses submitted by multiple companies. The Company’s percentage share of losses experienced by pool members will change over time as it is a function of the Company’s group life and AD&D in-force relative to the total group life and AD&D in-force for all pool participants. The catastrophe reinsurance pool does not exclude war or nuclear, biological and chemical acts of terrorism. Through a combination of reinsurance and its participation in the catastrophe reinsurance pool, the Company has coverage of up to $484.7 million per catastrophic event. In February 2015, the Company was notified of the termination of the catastrophe reinsurance pool effective June 2015. The Company is exploring its options in the market for catastrophe reinsurance coverage.
The Terrorism Risk Insurance Act of 2002 (“TRIA”), which has been extended through 2020, provides for federal government assistance to property and casualty insurers in the event of material losses due to terrorist acts on behalf of a foreign person or foreign interest. Due to the concentration of risk present in group life insurance and the fact that group life insurance is not covered under TRIA, an occurrence of a significant catastrophe or a change in the on-going nature and availability of reinsurance and catastrophe reinsurance could have a material adverse effect on the Company.
The following table sets forth reinsurance information:
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Recoveries recognized under reinsurance agreements were $92.8 million, $79.8 million and $74.0 million for 2014, 2013 and 2012, respectively. Amounts recoverable from reinsurers were $994.2 million and $988.1 million at December 31, 2014 and 2013, respectively. Of these amounts, $781.4 million and $791.0 million for 2014 and 2013, respectively, were from the reinsurance transaction with Protective Life Insurance Company (“Protective Life”) effective January 1, 2001. Effective February 1, 2015, Protective Life was acquired by The Dai-ichi Life Insurance Company, Limited (“Dai-ichi Life”) and is a wholly-owned subsidiary of Dai-ichi Life. ”See “Note 15-Reinsurance of Blocks of Business.”
15. REINSURANCE OF BLOCKS OF BUSINESS
Effective October 1, 2000, Standard assumed, through a reinsurance agreement, the individual disability insurance business of Minnesota Life. Standard paid a ceding commission of approximately $55 million and received approximately $500 million in assets and corresponding statutory liabilities. If Standard were to become unable to meet its obligations, Minnesota Life would retain the reinsured liabilities. Therefore, in accordance with the agreement with Minnesota Life, Standard established a trust for the benefit of Minnesota Life with the market value of assets in the trust equal to Minnesota Life’s reinsurance receivable from Standard. The market value of assets required to be maintained in the trust is determined quarterly. The market value of assets required to be maintained in the trust at December 31, 2014, was $562.3 million. Accompanying the transaction was a national marketing agreement that provides access to Minnesota Life agents, some of whom now market Standard’s individual disability insurance products. The national marketing agreement is renewed annually.
Effective January 1, 2001, Standard ceded to Protective Life, through a reinsurance agreement, Standard’s individual life insurance product line. Standard received a ceding commission of approximately $90 million and transferred to Protective Life approximately $790 million in assets and corresponding statutory liabilities. If Protective Life were to become unable to meet its obligations, Standard would retain the reinsured liabilities. Therefore, the liabilities remain on Standard’s consolidated balance sheets, and an equal amount is recorded as a recoverable from the reinsurer. In accordance with the agreement, Protective Life established a trust for the benefit of Standard with assets in the trust required to be equal to Standard’s reinsurance receivable from Protective Life. The Company evaluates the collectability of the amounts recoverable from reinsurers by monitoring the value of assets held in trust and the credit quality of Protective Life. Effective February 1, 2015, Protective Life was acquired by Dai-ichi Life and is a wholly-owned subsidiary of Dai-ichi Life. The amount of assets required to be maintained in the trust is determined quarterly.
Effective October 1, 2002, Standard entered into a reinsurance agreement with TIAA to assume TIAA’s group disability and group life insurance business. This business included approximately 1,800 group insurance contracts, representing 650,000 insured individuals. Standard paid a ceding commission of approximately $75 million and received approximately $705 million in assets and corresponding statutory liabilities. If Standard were to become unable to meet its obligations, TIAA would retain the reinsured liabilities. Therefore, in accordance with the agreement with TIAA, Standard established a trust for the benefit of TIAA with the market value of assets in the trust equal to TIAA’s reinsurance receivable from Standard. The market value of assets required to be maintained in the trust is determined quarterly. The market value of assets required to be maintained in the trust at December 31, 2014, was $190.1 million. Approximately $60.0 million in VOBA was recorded related to the reinsurance agreement.
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16. INSURANCE INFORMATION
The following table sets forth insurance information:
(1) See “Note 1-Summary of Significant Accounting Policies-DAC, VOBA and Other Intangible Assets” And “Note 12-DAC, VOBA and Other Intangible Assets.”
(2) Other operating expenses include operating expenses, commissions and bonuses, premium taxes, interest expense and the net increase in DAC, VOBA and other intangible assets.
17. REGULATORY MATTERS
Standard and The Standard Life Insurance Company of New York prepare their statutory financial statements in accordance with accounting practices prescribed or permitted by their states of domicile. Prescribed statutory accounting practices include state laws, regulations, and general administrative rules, as well as the Statements of Statutory Accounting Principles set forth in publications of the National Association of Insurance Commissioners (“NAIC”). Standard and the Standard Life Insurance Company of New York did not use any prescribed or permitted statutory accounting practices that are different than the statutory accounting practices promulgated by the NAIC for the years ended 2014, 2013 or 2012.
Statutory accounting practices differ in some respects from GAAP. The principal statutory accounting practices that differ from GAAP are:
•
Bonds and commercial mortgage loans are reported principally at amortized cost and adjusted carrying value, respectively.
•
Asset valuation and the interest maintenance reserves are provided as prescribed by the NAIC.
•
Certain assets designated as non-admitted, principally deferred tax assets, furniture, equipment, and unsecured receivables are not recognized as assets, resulting in a charge to statutory surplus.
•
Annuity considerations with life contingencies, or purchase rate guarantees, are recognized as revenue when received.
•
Reserves for life and disability policies and contracts are reported net of ceded reinsurance and calculated based on statutory requirements, including required discount rates.
•
Commissions, including initial commissions and expense allowance paid for reinsurance assumed, and other policy acquisition expenses are expensed as incurred.
•
Initial commissions and expense allowance received for a block of reinsurance ceded net of taxes are reported as deferred gains in surplus and recognized as income in subsequent periods.
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•
Federal income tax expense includes current income taxes defined as current year estimates of federal income taxes and tax contingencies for current and all prior years and amounts incurred or received during the year relating to prior periods, to the extent not previously provided.
•
Deferred tax assets, net of deferred tax liabilities, which will be realized within three years, are considered admitted assets and are included in the regulatory financial statements.
•
Surplus notes are classified as a component of surplus for statutory reporting and are classified as a liability for GAAP reporting.
Standard and The Standard Life Insurance Company of New York are subject to statutory restrictions that limit the maximum amount of dividends and distributions that they could declare and pay to StanCorp without prior approval of the states in which the subsidiaries are domiciled. Standard’s ability to pay dividends to StanCorp is affected by factors deemed relevant by Standard’s Board of Directors and by Oregon law, which limits Standard’s dividend payments and other distributions to the earned surplus arising from its business. If the proposed dividend or other distribution exceeds certain statutory limitations, Standard must receive prior approval of the Director of the Oregon Department of Consumer and Business Services-Insurance Division (“Oregon Insurance Division”). The current statutory dividend limitations are the greater of (a) 10% of Standard’s combined capital and surplus as of December 31 of the preceding year, or (b) the net gain from operations after dividends to policyholders and federal income taxes and before realized capital gains or losses for the 12-month period ended on the preceding December 31. In each case, the limitation must be determined under statutory accounting practices. Oregon law gives the Oregon Insurance Division broad discretion to approve or decline requests for dividends and other distributions in excess of these limits. As of December 31, 2014, Standard’s net gain from operations after dividends to policyholders and federal income taxes and before capital gains or losses for the 12-month period then ended was $208.5 million and capital and surplus was $1.15 billion. Based upon Standard’s results for 2014, the amount of ordinary dividends and other distributions available in 2015, without additional approval from the Oregon Insurance Division is $208.5 million. As of December 31, 2013, Standard’s net gain from operations after dividends to policyholders and federal income taxes and before capital gains or losses for the 12-month period then ended was $195.1 million and capital and surplus was $1.29 billion. Based upon Standard’s results for 2013, the amount of ordinary dividends and other distributions available in 2014, without additional approval from the Oregon Insurance Division was $195.1 million.
During 2014 and 2013, Standard made distributions to StanCorp totaling $390.0 million and $130.0 million, respectively. The 2014 distributions included a $240 million extraordinary distribution that was used to capitalize StanCap Insurance Company. Effective September 30, 2014, StanCap Insurance Company entered into a reinsurance agreement with Standard to reinsure Standard’s group life and AD&D business. This reinsurance agreement between StanCap Insurance Company and Standard replaced the yearly renewable term group life reinsurance agreement with Canada Life Assurance Company, which was terminated effective September 30, 2014. As a result of the extraordinary distribution in 2014, future dividends will require approval from the Oregon Insurance Division through September 2015 and will be considered extraordinary.
State insurance departments require insurance enterprises to adhere to minimum Risk-based Capital (“RBC”) requirements promulgated by the NAIC. At December 31, 2014 and 2013, the insurance subsidiaries’ capital and surplus levels were significantly in excess of that which would require corrective action by the insurance subsidiaries or regulatory agencies. The Authorized Control Level RBC was $149.6 million and $186.6 million at December 31, 2014 and 2013, respectively. At December 31, 2014, the capital and surplus of the Company’s insurance subsidiaries was approximately 445% of the Company Action Level RBC required by regulators, which was approximately 890% of the Authorized Control Level RBC required by the Company’s states of domicile. At December 31, 2013, the capital of the Company’s insurance subsidiaries was approximately 398% of the Company Action Level RBC required by regulators, which was approximately 796% of the Authorized Control Level RBC required by the Company’s states of domicile.
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The following table reconciles the statutory capital and surplus of the insurance subsidiaries based on statutory filings with applicable insurance regulatory authorities to the Company’s GAAP equity:
The following table reconciles statutory net income based on statutory filings with applicable insurance regulatory authorities to the Company’s GAAP net income:
18. LONG-TERM DEBT
On August 10, 2012, the Company issued $250 million of 5.00%, 10-year senior notes (“Senior Notes’’), which mature on August 15, 2022. Interest is payable semi-annually on February 15 and August 15.
The Company has $252.9 million of 6.90%, junior subordinated debentures (“Subordinated Debt”), which matures on June 1, 2067 and is non-callable prior to June 1, 2017. In the first quarter of 2014, the Company repurchased $47.1 million in principal amount of Subordinated Debt. The remaining principal amount of the Subordinated Debt is payable at final maturity. Interest is payable semi-annually on June 1 and December 1 for the first 10 years up to June 1, 2017, and quarterly thereafter at a floating rate equal to three-month LIBOR plus 2.51%. StanCorp has the option to defer interest payments for up to five years. The declaration and payment of dividends to shareholders would be restricted if the Company elected to defer interest payments on its Subordinated Debt. If elected, the restriction would be in place during the interest deferral period. StanCorp is currently not deferring interest on the Subordinated Debt.
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The following table sets forth the Company’s long-term debt:
19. COMMITMENTS AND CONTINGENCIES
Litigation Contingencies
In the normal course of business, the Company is involved in various legal actions and other state and federal proceedings. A number of actions or proceedings were pending at December 31, 2014. In some instances, lawsuits include claims for punitive damages and similar types of relief in unspecified or substantial amounts, in addition to amounts for alleged contractual liability or other compensatory damages. In the opinion of management, the ultimate liability, if any, arising from the actions or proceedings is not expected to have a material effect on the Company’s business, financial position, results of operations or cash flows.
Senior Unsecured Revolving Credit Facility (“Facility”) Contingencies
The Company maintains a $250 million Facility. Upon the request of StanCorp and with the consent of the lenders under the Facility, the Facility can be increased to $350 million. The termination date of the Facility is June 22, 2018. The Company expects to use the Facility for working capital, general corporate purposes and for the issuance of letters of credit.
Under the agreement, the Company is subject to two financial covenants, which are based on the Company’s ratio of total debt to total capitalization and consolidated net worth. The Company is also subject to covenants that limit subsidiary indebtedness. The Facility is subject to pricing levels based upon the Company’s publicly announced debt ratings and includes an interest rate option at the election of the borrower of a base rate plus the applicable margin or LIBOR plus the applicable margin, plus facility and utilization fees. At December 31, 2014, the Company was in compliance with all financial covenants under the Facility and had no outstanding balance on the Facility.
Operating Lease Commitments
The Company leases certain buildings and equipment under non-cancelable operating leases that expire in various years through 2023. Most of these leases have renewal options for periods ranging from one to ten years.
The following table sets forth future minimum payments under the leases:
Total rent expense was $13.3 million, $13.7 million and $15.2 million for the years ended December 31, 2014, 2013 and 2012, respectively.
The following table sets forth the minimum future rental receivables on non-cancelable leases of retail and office space with initial terms of one year or more:
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Other Financing Obligations
The Company’s financing obligations include long-term debt and capital lease payment obligations as well as commitments to fund commercial mortgage loans.
The Company’s debt obligations consisted primarily of the $250 million of 5.00% Senior Notes and the $252.9 million of 6.90% Subordinated Debt. See “Note 18-Long-Term Debt” for additional information.
At December 31, 2014, the Company had $62.6 million of commitments to fund tax-advantaged investment partnerships. The commitments are recorded as other liabilities on the Company’s consolidated balance sheets with a corresponding recognition to other invested assets.
At December 31, 2014, the Company had $139.0 million outstanding under funding agreements with the FHLB of Seattle, with fixed interest rates ranging from 0.38% to 3.79% that mature in 1 to 15 years. The funding agreements with the FHLB of Seattle are recorded as other policyholder funds on the Company’s consolidated balance sheets. The FHLB of Des Moines and the FHLB of Seattle have announced that they have entered into a definitive agreement to merge the two banks. The merger agreement has been unanimously approved by the boards of directors of both banks and by the FHFA. The potential merger must be approved by the members of both banks through a voting process that is expected to take place in the first half of 2015. The Company does not expect the merger to have a material effect on our business, financial position, results of operations or cash flows.
In the normal course of business, the Company commits to fund commercial mortgage loans generally up to 90 days in advance. At December 31, 2014, the Company had outstanding commitments to fund commercial mortgage loans totaling $134.8 million, with fixed interest rates ranging from 4.00% to 6.00%. These commitments generally have fixed expiration dates. A small percentage of commitments expire due to the borrower’s failure to deliver the requirements of the commitment by the expiration date. In these cases, the Company will retain the commitment fee and good faith deposit. Alternatively, if the Company terminates a commitment due to the disapproval of a commitment requirement, the commitment fee and good faith deposit may be refunded to the borrower, less an administrative fee.
20. ACCUMULATED OTHER COMPREHENSIVE INCOME
The following table sets forth the changes in accumulated other comprehensive income (loss) by component:
(1) Net of tax benefit of $111.1 million for net unrealized losses on fixed maturity securities and net of tax expense of $22.2 million for employee benefits.
(2) Net of tax benefits of $3.1 million for net unrealized gains on fixed maturity securities and $3.2 million for employee benefits, respectively.
(3) Net of tax expense of $24.6 million for net unrealized gains on fixed maturity securities and net of tax benefit of $37.9 million for employee benefits.
(4) Net of tax benefit of $1.1 million for net unrealized gains on fixed maturity securities and net of tax expense of $0.9 million for employee benefits.
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21. SEVERANCE, TRANSITION COSTS AND LEASE TERMINATIONS
During 2013, the Company implemented expense management initiatives to offset the negative effects of the continued low interest rate environment and lower Employee Benefits premiums compared to prior periods. In addition to severance, transition costs and lease terminations, the Company incurred $2.3 million in other project initiatives in 2013.
The following tables set forth expenses incurred related to the expense management initiatives:
(1) Amounts relate to restructuring charges implemented by the Company during 2011.
22. SUBSEQUENT EVENTS
In January 2015, StanCorp reached an agreement to sell certain assets of its private client wealth management business within StanCorp Investment Advisers to a third party. StanCorp expects the sale to be completed during the first half of 2015. StanCorp Investment Advisers will remain a wholly-owned subsidiary of StanCorp and will continue to provide performance analysis, fund selection support, model portfolios and investment management services to its retirement plan clients and subsidiaries of StanCorp. The assets under administration associated with the private client wealth management business totaled $884.4 million at December 31, 2014, which represents 3.3% of the Company’s total assets under administration. As a result of this sale, the Company does not expect a material gain or loss, nor a material impact to net income.
112 STANCORP FINANCIAL GROUP, INC.
SUPPLEMENTARY DATA
Quarterly Financial Information (Unaudited)
The following tables set forth select unaudited financial information by calendar quarter:
Item 9.
Item 9. Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. CONTROLS AND PROCEDURES
Management of StanCorp Financial Group, Inc. (the “Company”) has evaluated, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, the effectiveness of the design and operation of the Company’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 (the “Exchange Act”) Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report. Based on this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were effective at December 31, 2014, and designed to provide reasonable assurance that material information relating to the Company and its consolidated subsidiaries is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, and is accumulated and communicated to management, including the Company’s Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in Internal Control Over Financial Reporting
There have not been any changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
Management’s Annual Report on Internal Control Over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control system was designed to provide reasonable assurance regarding the reliability of financial reporting and preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the
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United States of America. All internal control systems, no matter how well designed, have inherent limitations and may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation. Company management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2014. In making this assessment, it used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework (2013). Company management concluded that based on its assessment, the Company’s internal control over financial reporting was effective as of December 31, 2014. The effectiveness of the Company’s internal control over financial reporting as of December 31, 2014 was audited by Deloitte & Touche LLP, an independent registered public accounting firm, as stated in their report, which is included below.
114 STANCORP FINANCIAL GROUP, INC.
Report of the Independent Registered Public Accounting Firm
To the Board of Directors and Shareholders of
StanCorp Financial Group, Inc.
Portland, Oregon
We have audited the internal control over financial reporting of StanCorp Financial Group, Inc. and subsidiaries (the “Company”) as of December 31, 2014, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on 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, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, 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 by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel 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 the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the 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, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2014, based on the criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2014 of the Company and our report dated February 26, 2015 expressed an unqualified opinion on those financial statements.
/s/ DELOITTE & TOUCHE LLP
Portland, Oregon
February 26, 2015
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Item 9B.
Item 9B. Other Information
On December 11, 2014, the Company’s Deferred Compensation Plan For Senior Officers was amended to reflect a change in the timing of deposits of employer’s matching contributions. The fourth amendment is attached hereto and filed herewith as Exhibit 10.24.
On February 23, 2015, the Organization & Compensation Committee of the Board of Directors approved a revised form of long-term incentive award agreement for senior executives to be effective for performance years 2015-2017. A copy of the form of agreement is attached hereto and filed herewith as Exhibit 10.19.
116 STANCORP FINANCIAL GROUP, INC.
Part III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Information required by Item 10 relating to directors of StanCorp Financial Group, Inc. (the “Company”) is set forth under the caption “Election of Directors” in the Company’s 2015 Definitive Proxy Statement to be filed by the Company with the Securities and Exchange Commission pursuant to Regulation 14A within 120 days after December 31, 2014 (the “Proxy Statement”), herein incorporated by reference.
For information on the executive officers of the registrant, see Part I, Item 4A, “Executive Officers of the Registrant.”
Information relating to beneficial ownership reporting compliance by directors and executive officers of the Company pursuant to Section 16(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) is set forth under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement, herein incorporated by reference.
The Company has codes of business ethics for all directors, senior executive officers, including the Chairman, President and Chief Executive Officer, the Senior Vice President and Chief Financial Officer and the Vice President and Controller of StanCorp (its principal executive officer, principal financial officer and principal accounting officer, respectively), and employees of the Company. The codes of business ethics are available on the Company’s investor relations website located at www.stancorpfinancial.com. A copy of the codes of business ethics will be provided without charge to any person who requests them by writing or telephoning the Company’s Shareholder Services Department, StanCorp Financial Group, Inc., 1100 SW Sixth Avenue, Portland, OR 97204, (800) 378-8360. The Company will disclose on its investor relations website any amendments to or waivers from its codes of business ethics applicable to directors or executive officers of StanCorp, including the Chairman, President and Chief Executive Officer, the Senior Vice President and Chief Financial Officer and the Vice President and Controller in accordance with all applicable laws and regulations.
AUDIT COMMITTEE
StanCorp has a separately designated standing Audit Committee established in accordance with Section 3(a)58(A) of the Exchange Act. Information regarding the members of the Audit Committee is reported under the caption “Corporate Governance-Board of Directors and Committee Meetings, Membership, Attendance, Independence and Other Board Matters” in the Company’s 2015 Proxy Statement, herein incorporated by reference.
AUDIT COMMITTEE FINANCIAL EXPERT
Information required by Item 10 regarding the Audit Committee Financial Expert is reported under the caption “Corporate Governance-Board of Directors and Committee Meetings, Membership, Attendance, Independence and Other Board Matters” in the Company’s 2015 Proxy Statement, herein incorporated by reference.
Item 11.
Item 11. Executive Compensation
Information required by Item 11 regarding executive compensation and related matters is reported under the captions “Director Compensation,” “Executive Compensation,” “Compensation Discussion and Analysis” and “Report of the Organization & Compensation Committee” in the Company’s 2015 Proxy Statement, herein incorporated by reference.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information required by Item 12 regarding security ownership of certain beneficial owners and management is reported under the caption “Security Ownership of Certain Beneficial Owners” and “Share Ownership of Directors and Officers” in the Company’s 2015 Proxy Statement, herein incorporated by reference.
EQUITY COMPENSATION PLAN
The Company has two active equity compensation plans, both of which have been approved by shareholders. These are the 2002 Stock Incentive Plan (“2002 Plan”) and the 1999 Employee Share Purchase Plan (“ESPP”).
The following table sets forth the shares to be issued subject to outstanding options and the shares otherwise available for issue under these plans as of December 31, 2014:
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As of December 31, 2014, there were 1,378,369 shares available for issuance under the ESPP and there were 2,694,980 shares available to be issued as options or stock awards under the 2002 Plan. Of the shares available for issuance under the 2002 Plan, 1,059,828 shares are available for issuance as stock award grants. Shares issuable under performance share awards and restricted stock unit awards are not included in calculating the weighted-average price of outstanding options, warrants and rights.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Information required by Item 13 regarding certain relationships and related transactions, and director independence is reported under the captions “Corporate Governance-Director Independence” and “Transactions with Related Parties” in the Company’s 2015 Proxy Statement, herein incorporated by reference.
Item 14.
Item 14. Principal Accountant Fees and Services
Information required by Item 14 regarding principal accounting fees and services is reported under the caption “Proposal 2-Ratify the Appointment of the Independent Registered Public Accounting Firm” in the Company’s 2015 Proxy Statement, herein incorporated by reference.
118 STANCORP FINANCIAL GROUP, INC.
Part IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
The following Documents are filed as part of this annual report:
1. Consolidated Financial Statements
See Item 8, “Financial Statements and Supplementary Data.”
2. Financial Statement Schedules
All schedules for which provision is made in the applicable accounting requirements of the Securities and Exchange Commission are not required or the required information has been included with the consolidated financial statements or the notes thereto.
3. Exhibits Index
The list of exhibits in the Exhibit Index to this annual report is incorporated herein by reference.
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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 in Portland, Oregon on February 26, 2015.
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.
120 STANCORP FINANCIAL GROUP, INC.
EXHIBIT INDEX
2014 ANNUAL REPORT 121
122 STANCORP FINANCIAL GROUP, INC.
2014 ANNUAL REPORT 123
Number
Name
Method of Filing
101.SCH
XBRL Taxonomy Extension Schema Document
Filed herewith
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
Filed herewith
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document
Filed herewith
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
Filed herewith
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document
Filed herewith
* Indicates management contract or compensatory plan or arrangement
124 STANCORP FINANCIAL GROUP, INC.