ITEM 1. Business
Forward-looking Information
It is important to note that the Company’s actual results could differ materially from those projected in forward-looking statements. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in “Item 1A.
ITEM 1A. Risk Factors
The following are certain risk factors that could affect the Company’s business, financial results and results of operations. In addition, refer to the risk factors disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Forward-looking Information”, listed on page of this report for certain important factors that may cause our financial condition and results of operations to differ materially from current expectations. The risks that the Company has highlighted in these two sections of this report are not the only ones that the Company faces. In this discussion, the Company is also referred to as “our”, “we” and “us”.
The Company’s business involves various risks and uncertainties which are based on the lines of business the Company writes as well as more global risks associated with the general business and insurance industry environments.
The insurance industry is highly regulated.
We are subject to extensive regulation and supervision in the jurisdictions in which we do business. Each jurisdiction has a unique and complex set of laws and regulations. Furthermore, certain federal laws impose additional requirements on businesses, including insurers. Regulation generally is designed to protect the interests of policyholders, as opposed to stockholders and non-policyholder creditors. Such regulations, among other things, impose restrictions on the amount and type of investments our subsidiaries may hold. Certain states also regulate the rates insurers may charge for certain property and casualty products. Legislation and voter initiatives have expanded, in some instances, the states’ regulation of rates and have increased data reporting requirements. Consumer-related pressures to roll back rates, even if not enacted by legislation or upheld upon judicial appeal, may affect our ability to obtain timely rate increases or operate at desired levels of profitability. Changes in insurance regulations, including those affecting the ability of our insurance subsidiaries to distribute cash to us and those affecting the ability of our insurance subsidiaries to write profitable property and casualty insurance policies in one or more states, may adversely affect the financial condition and results of operations of our insurance subsidiaries. Our ability to comply with these laws and regulations, at a reasonable cost, and to obtain necessary regulatory action in a timely manner, is and will continue to be critical to our success.
Examples of governmental regulation that has adversely affected the operations of our insurance subsidiaries include:
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the adoption in several states of legislation and other regulatory action intended to reduce the premiums paid for automobile and homeowners insurance by residents of those states;
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restrictions on a company’s ability to achieve pricing adequacy and/or reduce their volume of business in catastrophe prone areas; and
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requirements that insurance companies:
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pay assessments to support associations that fund state-sponsored insurance operations, or
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involuntarily issue policies for high-risk automobile drivers.
Regulation that could adversely affect our insurance subsidiaries also includes statutory surplus and risk-based capital requirements. Maintaining appropriate levels of surplus, as measured by statutory accounting principles, is considered important by state insurance regulatory authorities and the private agencies that rate insurers’ claims-paying abilities and financial strength. The failure of an insurance subsidiary to maintain levels of statutory surplus that are sufficient for the amount of its insurance written could result in increased regulatory scrutiny, action by state regulatory authorities or a downgrade by rating agencies.
Similarly, the NAIC has adopted a system of assessing minimum capital adequacy that is applicable to our insurance subsidiaries. This system, known as risk-based capital, is used to identify companies that may merit further regulatory action by analyzing the adequacy of the insurer’s surplus in relation to statutory requirements.
Because state legislatures remain concerned about the availability and affordability of property and casualty insurance and the protection of policyholders, our insurance subsidiaries expect that they will continue to face efforts by those legislatures to expand regulations to cover these concerns. For example, in the January 2007 special session, the Florida legislature passed a bill that would essentially allow the state to assume most of the catastrophe reinsurance exposure in Florida at below market rates and also to increase its participation in the personal homeowners insurance market. Legislation such as this could adversely affect the financial condition and results of operations of our insurance subsidiaries.
In the event of the insolvency, liquidation or other reorganization of any of our insurance subsidiaries, our creditors and stockholders would have no right to proceed against any such insurance subsidiary or to cause the liquidation or bankruptcy of any such insurance subsidiary under federal or state bankruptcy laws. The insurance laws of the domiciliary state would govern such proceedings and the relevant insurance commissioner would act as liquidator or rehabilitator for the insurance subsidiary. Creditors and policyholders of any such insurance subsidiary would be entitled to payment in full from the assets of the insurance subsidiary before we, as a stockholder, would be entitled to receive any distribution.
The financial position of our insurance subsidiaries also may be affected by court decisions that expand insurance coverage beyond the intention of the insurer at the time it originally issued an insurance policy.
The insurance industry is highly cyclical.
The results of companies in the insurance industry historically have been subject to significant fluctuations due to competition, economic conditions, interest rates and other factors. In particular, companies in the property and casualty insurance segment of the industry historically have experienced pricing and profitability cycles. With respect to these cycles, the factors having the greatest impact include intense price competition, less restrictive underwriting standards, aggressive marketing and increased advertising, which have resulted in higher industry-wide combined loss and expense ratios.
The personal lines insurance and annuity markets are highly competitive and our financial condition and results of operations may be adversely affected by competitive forces.
We operate in a highly competitive environment and compete with numerous insurance companies, as well as mutual fund families, independent agent companies and financial planners. In some instances and geographic locations, competitors have specifically targeted the educator marketplace with specialized products and programs. We compete in our target market with a number of national providers of personal automobile and homeowners insurance and life insurance and annuities.
The insurance industry consists of a large number of insurance companies, some of which have substantially greater financial resources, more diversified product lines and lower cost marketing approaches, such as direct marketing, mail, Internet and telemarketing, compared to us. In our target market, we believe that the principal competitive factors in the sale of property and casualty insurance products are price, service, name recognition and education association sponsorships. We believe that the principal competitive factors in the sale of life insurance and annuity products are product features, perceived stability of the insurer, service, name recognition, price and education association sponsorships.
Particularly in the property and casualty business, our insurance subsidiaries have experienced, and expect to experience in the future, periods of intense competition during which they are unable to increase prices sufficiently to cover costs. The inability of an insurance subsidiary to compete successfully in the property and casualty business would adversely affect its financial condition and results of operations and its resulting ability to distribute cash to us.
For our annuity business, in addition to insurance companies, mutual funds and banks are increasingly strong competitors in the 403(b) and tax deferred annuity products markets. The inability of an insurance subsidiary to compete successfully in these markets would adversely affect its financial condition and results of operations and its resulting ability to distribute cash to us.
Litigation may harm our financial strength or reduce our profitability.
Companies in the insurance industry have been subject to substantial litigation resulting from claims, disputes and other matters. Most recently, they have faced expensive claims, including class action lawsuits, alleging, among other things, improper sales practices and improper claims settlement procedures. Negotiated settlements of certain such actions have had a material adverse effect on many insurance companies. The resolution of such claims against any of our insurance subsidiaries, including the potential adverse effect on our reputation and charges against the earnings of our insurance subsidiaries as a result of legal defense costs, a settlement agreement or an adverse finding or findings against our insurance subsidiaries in such a claim, could materially adversely affect the financial condition and results of operations of our insurance subsidiaries.
A reduction or elimination of the tax advantages of life and annuity products could make our products less attractive to clients and adversely affect our operating results.
A significant part of our annuity business involves fixed and variable 403(b) tax-qualified annuities, which are annuities purchased voluntarily by individuals employed by public school systems or other tax-exempt organizations. Our financial condition and results of operations could be adversely affected by changes in federal and state laws and regulations that affect the relative tax and other advantages of our life and annuity products to customers, including adverse changes in IRS regulations governing 403(b) plans such as those currently being proposed.
Current federal income tax laws generally permit the tax-deferred accumulation of earnings on the premiums paid by the holders of annuities and life insurance products. Taxes, if any, are payable on income attributable to a distribution under the contract for the year in which the distribution is made. From time to time, Congress has considered legislation that would reduce or eliminate the benefit of such deferral of taxation on the accretion of value with life insurance and non-qualified annuity contracts. Enactment of this legislation, including a simplified “flat tax” income structure with an exemption from taxation for investment income, could result in fewer sales of our life insurance and annuity products.
Our property and casualty loss reserves may not be adequate.
Our property and casualty insurance subsidiaries maintain loss reserves to provide for their estimated ultimate liability for losses and loss adjustment expenses with respect to reported and unreported claims incurred as of the end of each accounting period. If these loss reserves prove inadequate, we will record a loss measured by the amount of the shortfall and, as a result, the financial condition and results of operations of our insurance subsidiaries will be adversely affected, potentially affecting their ability to distribute cash to us.
Reserves do not represent an exact calculation of liability. Reserves represent estimates, generally involving actuarial projections at a given time, of what our insurance subsidiaries expect the ultimate settlement and adjustment of claims will cost, net of salvage and subrogation. Estimates are based on assessments of known facts and circumstances, assumptions related to the ultimate cost to settle such claims, estimates of future trends in claims severity and frequency, changing judicial theories of liability and other factors. These variables are affected by both internal and external events, including changes in claims handling procedures, economic inflation, unpredictability of court decisions, plaintiffs’ expanded theories of liability, risks inherent in major litigation and legislative changes. Many of these items are not directly quantifiable, particularly on a prospective basis. Significant reporting lags may exist between the occurrence of an insured event and the time it is actually reported. Our insurance subsidiaries adjust their reserve estimates regularly as experience develops and further claims are reported and settled.
Due to the inherent uncertainty in estimating reserves for losses and loss adjustment expenses, we cannot be certain that the ultimate liability will not exceed amounts reserved, with a resulting adverse effect on our financial condition and results of operations.
Deviations from assumptions regarding future persistency, mortality, morbidity, interest spreads and market appreciation used in calculating life and annuity reserves and deferred policy acquisition expense amounts could have a material adverse impact on our net income.
The process of calculating reserve and deferred policy acquisition expense amounts for our life and annuity businesses involve the use of a number of assumptions, including those related to persistency (how long a contract stays with the company), mortality (the relative incidence of death over a given period of time), morbidity (the relative incidence of disability resulting from disease or physical impairment), interest spreads (the interest rates expected to be received on investments less the rate of interest credited to contractholders) and market appreciation (the rate of growth in market value of the underlying variable annuity subaccounts due to price appreciation). We periodically review the adequacy of these reserves and deferred policy acquisition expenses on an aggregate basis and, if future experience differs significantly from assumptions, adjustments to reserves and deferred policy acquisition expenses may be required which could have a material adverse effect on our financial condition and results of operations.
Any downgrade in or decline in outlook for our claims-paying, financial strength or credit ratings could adversely affect our financial condition and results of operations.
Claims-paying and financial strength ratings have become an increasingly important factor in establishing the competitive position of insurance companies. In the evolving 403(b) annuity market, school districts may be placing increased emphasis on the relative financial strength ratings of competing companies. Each rating agency reviews its ratings periodically and from time to time may modify its rating criteria including, among other factors, its expectations regarding
capital adequacy, profitability and revenue growth. A downgrade in the ratings or adverse change in the ratings outlook of any of our insurance subsidiaries by a major rating agency could result in a substantial loss of business for that subsidiary if school districts, policyholders or independent agents move their business to other companies having higher claims-paying and financial strength ratings than we do. This loss of business could have a material adverse effect on the financial condition and results of operations of that subsidiary.
A downgrade in our holding company debt rating could also adversely impact our cost and flexibility of borrowing which could have an adverse impact on our liquidity, financial condition and results of operations.
Reduction of the statutory surplus of our insurance subsidiaries could adversely affect their ability to write insurance business.
Insurance companies write business based, in part, upon guidelines including a ratio of premiums to surplus for property and casualty insurance companies and a ratio of reserves to surplus for life insurance companies. If our insurance subsidiaries cannot maintain profitability in the future, they may be required to draw on their surplus in order to pay dividends to us to enable us to meet our financial obligations. As their surplus is reduced by the payment of dividends, continuing losses or both, our insurance subsidiaries’ ability to write business and maintain acceptable financial strength ratings could also be reduced. This could have a material adverse effect upon the business volume and profitability of our insurance subsidiaries.
If we are not able to effectively develop and expand our agency operations, including our agent force and their licensed product specialists and support staff, our financial condition and results of operations could be adversely affected.
Our success in marketing and selling our products is largely dependent upon the efforts of our exclusive sales force of full-time employee agents and the success of their agency operations. As we expand our business, we may need to expand our agencies to market our products. If we are unable to hire additional agents, fail to retain our current agents or are unable to increase the productivity of our agency operations, sales of our products would likely decline and our financial condition and results of operations would be adversely affected.
In 2006, we began transitioning from a single-person agent operation to our new Agency Business Model, with agents in outside offices with support personnel and licensed product specialists, designed to remove capacity constraints and increase productivity. If we and our agency force are unable to successfully implement this approach to expanding our points of distribution and further increasing the productivity of our agents, our financial condition and results of operations could be adversely affected.
If we are not able to maintain and secure 1) product sponsorships and other relationships with the educational community and 2) payroll reduction authorizations, our financial condition and results of operations could be adversely affected.
Horace Mann has had a long relationship with the NEA, the nation’s largest confederation of state and local teachers’ associations, and many of the state and local education associations affiliated with the NEA. In addition to these organizations, we have established relationships with various other educator, principal and school administrator groups. These contacts and endorsements help to establish our brand name and presence in the educational community and to enhance our access to educators.
In addition, one of the keys to the successful sale of our 403(b) tax-qualified annuity products is our ability to obtain payroll reduction authorization from school districts and product sponsorships from local, state and national education associations. In late 2004, the IRS issued proposed regulations regarding Section 403(b) arrangements, including annuities. The proposed regulations would alter the nature of 403(b) arrangements to an employer-sponsored plan. This would be a potentially significant change from the historical view of 403(b) arrangements being individual plans funded by salary reduction. This could prompt school district sponsors of 403(b) arrangements to reconsider the companies permitted to offer products to fund such arrangements within their district, and potentially reduce the number of authorized providers. Such actions present the threat of losing certain current payroll reduction authorizations and sponsorships, and the potential for lost sales and resulting revenues in those school districts, as well as the opportunity to increase penetration in school districts where we remain as one of a reduced number of approved providers. If these proposed regulations are adopted, our ability to maintain and grow our share of the 403(b) market will depend on our ability to successfully adapt our products, services offered, and administrative systems, which could potentially increase our cost of doing business in this market. School districts may also place additional emphasis on the relative financial strength ratings of competing companies. At the time of this Annual Report on Form 10-K, we anticipate that the proposed changes would not occur prior to January 1, 2008. Also, the final form of any changes, their timing or their impact on the Section 403(b) market is unknown.
Catastrophic events can have a material adverse effect on our financial condition and results of operations.
Underwriting results of property and casualty insurers are subject to weather and other conditions prevailing in an accident year. While one year may be relatively free of major weather or other disasters, another year may have numerous such events causing results for such a year to be materially worse than for other years.
Our property and casualty insurance subsidiaries have experienced, and we anticipate that in the future they will continue to experience, catastrophe losses. A catastrophic event or a series of multiple catastrophic events could have a material adverse effect on the financial condition and results of operations of our insurance subsidiaries.
Various events can cause catastrophes, including hurricanes, windstorms, earthquakes, hail, terrorism, explosions, severe winter weather and wildfires. The frequency and severity of these catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposures in the area affected by the event and the severity of the event. Although catastrophes can cause losses in a variety of property and casualty lines, most of the catastrophe-related claims of our insurance subsidiaries are related to homeowners’ coverages. Our ability to provide accurate estimates of ultimate catastrophe costs is based on several factors, including:
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the proximity of the catastrophe occurrence date to the date of our estimate;
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potential inflation of property repair costs in the affected area;
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the occurrence of multiple catastrophes in a geographic area over a relatively short period of time; and
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the outcome of litigation which may be filed against the Company by policyholders, state attorneys general and other parties relative to loss coverage disputes and loss settlement payments.
Based on 2006 direct premiums earned, approximately 57% of the total annual premiums for our property and casualty business were for policies issued in the ten largest states in which our insurance subsidiaries write property and casualty coverage. Included in this top ten group are certain states which are considered to be more prone to catastrophe occurrences: Florida, California, North Carolina, Texas, Louisiana and South Carolina.
As an ongoing practice, but particularly following the significant catastrophic claims from hurricanes in 2005 and 2004, we attempt to manage our exposure to catastrophes. Reductions in property and casualty business written in catastrophe-prone areas may have a negative impact on near-term business growth and earnings.
In addition to the potential impact on our property and casualty subsidiaries, our life subsidiary could experience claims of a catastrophic magnitude from events such as pandemics; terrorism; nuclear, biological or chemical explosions; or other acts of war.
Our insurance subsidiaries seek to reduce their exposure to catastrophe losses through their underwriting strategies and the purchase of catastrophe reinsurance. Nevertheless, reinsurance may prove inadequate if:
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a major catastrophic loss exceeds the reinsurance limit;
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a series of major catastrophic events in a single year exhaust the reinsurance coverage; or
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an insurance subsidiary incurs multiple, smaller catastrophic losses which, individually, do not exceed the subsidiary’s loss retention level.
Uncollectible reinsurance, as well as reinsurance availability and pricing, can have a material adverse effect upon our business volume and profitability.
Reinsurance is a contract by which one insurer, called a reinsurer, agrees to cover a portion of the losses incurred by a second insurer in the event a claim is made under a policy issued by the second insurer. Our insurance subsidiaries obtain reinsurance to help manage their exposure to property, casualty and life insurance risks. Although a reinsurer is liable to our insurance subsidiaries according to the terms of its reinsurance policy, the insurance subsidiaries remain primarily liable as the direct insurers on all risks reinsured. As a result, reinsurance does not eliminate the obligation of our insurance subsidiaries to pay all claims, and each insurance subsidiary is subject to the risk that one or more of its reinsurers will be unable or unwilling to honor its obligations.
Although we limit participation in our reinsurance programs to reinsurers with high financial strength ratings, our insurance subsidiaries cannot guarantee that their reinsurers will pay in a timely fashion, if at all. Reinsurers may become financially unsound by the time that they are called upon to pay amounts due, which may not occur for many years. In the case of the Florida Hurricane Catastrophe Fund, financial deficits may require additional assessments against participating insurers. Additionally, the availability and cost of reinsurance are subject to prevailing market conditions beyond our control. For example, the significant level of losses from hurricanes in 2005 and 2004 and the terrorist attacks of September 11, 2001 have had a significant adverse impact on the reinsurance market.
If one of our insurance subsidiaries is unable to obtain adequate reinsurance at reasonable rates, that insurance subsidiary would have to increase its risk exposure and/or reduce the level of its underwriting commitments, which could have a material adverse effect upon the business volume and profitability of the subsidiary. Alternately, the insurance subsidiary could elect to pay the higher than reasonable rates for reinsurance coverage, which could have a material adverse effect upon its profitability until policy premium rates could be raised to incorporate this additional cost.
Losses due to defaults by others could reduce our profitability or negatively affect the value of our investments.
Third parties that owe us money, securities or other assets may not pay or perform their obligations. These parties may include the issuers whose securities we hold, borrowers under mortgage loans, customers, trading counterparties, counterparties under swaps and other derivative contracts, reinsurers, clearing agents, exchanges, clearing houses and other financial intermediaries. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, downturns in the economy or real estate values, operational failure or other reasons.
The default of a major market participant could disrupt the securities markets or clearance and settlement systems in the U.S. or abroad. A failure of a major market participant could cause some clearance and settlement systems to assess members of that system, including our broker-dealer subsidiary, or could lead to a chain of defaults that could adversely affect us. A default of a major market participant could disrupt various markets, which could in turn cause market declines or volatility and negatively impact our financial condition and results of operations.
If our investment strategy is not successful, we could suffer unexpected losses.
The success of our investment strategy is crucial to the success of our business. Specifically, our fixed income portfolio is subject to a number of risks including:
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market value risk, which is the risk that our invested assets will decrease in value due to a change in the yields realized on our assets and prevailing market yields for similar assets, an unfavorable change in the liquidity of the investment or an unfavorable change in the financial prospects or a downgrade in the credit rating of the issuer of the investment;
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credit risk, which is the risk that the value of certain investments becomes impaired due to deterioration in financial condition of one or more issuers of those instruments and, ultimately, the risk of permanent loss in the event of default by an issuer;
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reinvestment risk, which is the risk that interest rates will decline and funds reinvested will earn less than expected;
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concentration risk, which is the risk that the portfolio may be too heavily concentrated in the securities of one or more issuers, sectors or industries, which could result in a significant decrease in the value of the portfolio in the event of deterioration in the financial condition of those issuers or the market value of their securities; and
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liquidity risk, which is the risk that liabilities are surrendered or mature sooner than anticipated requiring us to sell assets at an undesirable time to provide for policyholder surrenders, withdrawals or claims.
We attempt to mitigate these risks through product pricing, product features and the establishment of policy reserves, but we cannot provide assurance that assets will be properly matched to meet anticipated liabilities or that our investments will provide sufficient returns to enable us to satisfy our guaranteed fixed benefit obligations.
From time to time, we could also enter into foreign currency, interest rate and credit derivatives and other hedging transactions in an effort to manage risks. We cannot provide assurance that we will successfully structure those derivatives and hedges so as to effectively manage these risks. If our calculations are incorrect, or if we do not properly structure our derivatives or hedges, we may have unexpected losses and our assets may not be adequate to meet our needed reserves, which could adversely affect our financial condition and results of operations.
The result of any investment activity is determined to a significant degree by general economic conditions, which may adversely affect the markets for interest rate sensitive securities, including the level and volatility of interest rates and the extent and timing of investor participation in these markets. Unexpected volatility or illiquidity in the markets in which we hold positions could adversely affect us.
Declining financial markets could also cause the value of the investments in our defined benefit pension plan to decrease, resulting in additional pension expense and an increase in required contributions to the defined benefit pension plan.
Our financial condition and results of operations may be adversely affected by declining financial market conditions.
Conditions in the U.S. and international financial markets affect the sale and profitability of our annuity products. In general, sales of variable annuities decrease when financial markets are declining over an extended period of time. Therefore, weak financial market performance may adversely affect sales of our variable annuity products to potential customers, may cause current customers to withdraw or reduce the amounts invested in our variable annuity products and may reduce the market value of existing customers’ investments in our variable annuity products, in turn reducing the amount of variable annuity fee revenues generated. In addition, some of our variable annuity contracts offer guaranteed minimum death benefits features, which provide for a benefit if the annuitant dies and the contract value is less than a specified amount. A decline in the financial markets could cause the contract value to fall below this specified amount, increasing our exposure to losses from variable annuity products featuring guaranteed minimum death benefits. Declining financial markets may also impact the valuations of deferred policy acquisition costs and value of acquired insurance in force.
Interest rate fluctuations could negatively affect the income we derive from the difference between the interest rates we earn on our investments and the interest we pay under our annuity contracts.
Significant changes in interest rates expose us to the risk of not earning income or experiencing losses based on the differences between the interest rates earned on our investments and the credited interest rates paid on our outstanding annuity contracts. Significant changes in interest rates may affect:
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the unrealized gains and losses in our investment portfolio and the related after-tax effect on our shareholders’ equity and total capital;
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the book yield of our investment portfolio; and
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the ability of our insurance subsidiaries to maintain appropriate interest rate spreads over the fixed rates guaranteed in their life and annuity products.
Both rising and declining interest rates can negatively affect the income we derive from these interest rate spreads. During periods of falling interest rates, our investment earnings will be lower because new investments in fixed maturity securities will likely bear lower interest rates. We may not be able to fully offset the decline in investment earnings with lower crediting rates on our annuity contracts. During periods of rising interest rates, there may be competitive pressure to increase the crediting rates on our annuity contracts. We may not, however, have the ability immediately to acquire investments with interest rates sufficient to offset an increase in crediting rates under our annuity contracts. Although we develop and maintain asset/liability management programs and procedures designed to reduce the volatility of our income when interest rates are rising or falling, changes in interest rates can affect our interest rate spreads.
Changes in interest rates may also affect our business in other ways. For example, a rapidly changing interest rate environment may result in less competitive crediting rates on certain of our fixed-rate products which could make those products less attractive, leading to lower sales and/or increases in the level of life insurance and annuity product surrenders and withdrawals. Interest rate fluctuations may also impact the valuations of deferred policy acquisition costs and value of acquired insurance in force.
ITEM 1B.
ITEM 1B.
Unresolved Staff Comments
None.
ITEM 2.
ITEM 2. Properties
HMEC’s home office property at 1 Horace Mann Plaza in Springfield, Illinois, consists of an office building totaling approximately 214,000 square feet which is owned by the Company. The Company also owns buildings with an aggregate of approximately 24,000 square feet at other locations in Springfield. The Company leases buildings in Springfield with an aggregate of approximately 91,000 square feet. In addition, the Company leases office space in other states related to claims and agency offices which are smaller in size. These properties, which are utilized by all of the Company’s operating segments, are adequate and suitable for the Company’s current and anticipated future needs.
ITEM 3.
ITEM 3. Legal Proceedings
The Company is not currently party to any material pending legal proceedings other than routine litigation incidental to its business.
ITEM 4.
ITEM 4. Submission of Matters to a Vote of Security Holders
None.
PART II
ITEM 5.
ITEM 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information and Dividends
HMEC’s common stock began trading on the NYSE in November 1991 under the symbol of HMN at a price of $9 per share. The following table sets forth the high and low sales prices of the common stock on the NYSE Composite Tape and the cash dividends paid per share of common stock during the periods indicated.
The payment of dividends in the future is subject to the discretion of the Board of Directors and will depend upon general business conditions, legal restrictions and other factors the Board of Directors of HMEC may deem to be relevant. See also “Business - Cash Flow”.
Stock Price Performance Graph
The graph below compares cumulative total return* of Horace Mann Educators Corporation, the S&P 500 Insurance Index and the S&P 500 Index. The graph assumes $100 invested on December 31, 2001 in HMEC, the S&P 500 Insurance Index and the S&P 500 Index.
* The S&P 500 Index and the S&P 500 Insurance Index, as published by Standard and Poor’s Corporation (“S&P”), assume an annual reinvestment of dividends in calculating total return. Horace Mann Educators Corporation assumes reinvestment of dividends when paid.
Holders and Shares Issued
As of February 1, 2007, the approximate number of holders of HMEC’s common stock was 4,000.
During 2006, options were exercised for the issuance of 114,400 shares, 0.3% of the Company’s common stock shares outstanding at December 31, 2005. The Company received $1.9 million as a result of these option exercises, including related federal income tax benefits.
The equity compensation plan information required by Item 201(d) of Regulation S-K is incorporated by reference to the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders.
ITEM 6.
ITEM 6. Sel ected Financial Data
The information required by Item 301 of Regulation S-K is contained in the table in Item 1 - “Business - Selected Historical Consolidated Financial Data”.
ITEM 7.
ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The information required by Item 303 of Regulation S-K is listed on page of this report.
ITEM 7A.
ITEM 7A.
Quantitative and Qualitative Disclosures About Market Risk
The information required by Item 305 of Regulation S-K is contained in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” listed on page of this report.
ITEM 8.
ITEM 8. Consolidated Financial Statements and Supplementary Data
The Company’s consolidated financial statements, financial statement schedules, the report of its independent registered public accounting firm and the selected quarterly financial data required by Item 302 of Regulation S-K are listed on page of this report.
ITEM 9.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
ITEM 9A.
ITEM 9A. Controls and Procedures
a.) Management’s Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures
Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we conducted an evaluation of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) of the Securities and Exchange Act of 1934 as amended (the “Exchange Act”). Based on this evaluation, our chief executive officer and our chief financial officer concluded that our disclosure controls and procedures were effective as of December 31, 2006, the end of the period covered by this Annual Report on Form 10-K.
b.) Management’s Annual Report on Internal Control Over Financial Reporting
Management of Horace Mann is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) of the Exchange Act. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that:
(i) Pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;
(ii) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and
(iii) 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 consolidated financial statements.
Management of Horace Mann conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control - Integrated Framework. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Based on this evaluation, management, including our chief executive officer and our chief financial officer, determined that, as of December 31, 2006, the Company maintained effective internal control over financial reporting.
KPMG LLP, an independent registered public accounting firm, has issued an audit report on management’s assessment of the effectiveness of internal control over financial reporting as of December 31, 2006, as stated in their report, which is included herein.
c.) Independent Registered Public Accounting Firm’s Report on Internal Control Over Financial Reporting
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
Horace Mann Educators Corporation:
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting (Item 9A.b.) that Horace Mann Educators Corporation and subsidiaries (the Company) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). 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. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. 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 U.S. 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 consolidated financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of the Company as of December 31, 2006 and 2005, and the related consolidated statements of operations and comprehensive income, changes in shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2006, and our report dated February 28, 2007 expressed an unqualified opinion on those consolidated financial statements.
/s/ KPMG LLP
KPMG LLP
Chicago, Illinois
February 28, 2007
d). Changes in Internal Control Over Financial Reporting
In the fourth quarter of 2006, the Company implemented a federal income tax provision software application to further strengthen the internal controls over this process. There were no other changes in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
ITEM 9B.
ITEM 9B. Other Information
None.
PART III
ITEM 10.
ITEM 10. Directors, Executive Officers and Corporate Governance
The information required by Items 401, 405, 407(d)(4) and 407(d)(5) of Regulation S-K is incorporated by reference to the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders.
Horace Mann Educators Corporation has adopted a code of ethics that applies to its principal executive officer, principal financial officer, principal accounting officer and all other employees of the Company. In addition, the Board of Directors of Horace Mann Educators Corporation has adopted the code of ethics for its Board members as it applies to each Board member’s business conduct on behalf of the Company. The code of ethics is posted on the Company’s website, www.horacemann.com, under “Investor Relations - Corporate Governance”.
ITEM 11.
ITEM 11.
Executive Compensation
The information required by Items 402, 407(e)(4) and 407(e)(5) of Regulation S-K is incorporated by reference to the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders.
ITEM 12.
ITEM 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The information required by Items 201(d) and 403 of Regulation S-K is incorporated by reference to the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders.
ITEM 13.
ITEM 13. Certain Relationships and Related Transactions, and Director Independence
The information required by Items 404 and 407(a) of Regulation S-K is incorporated by reference to the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders.
ITEM 14.
ITEM 14. Principal Accounting Fees and Services
The information required by Item 9(e) of Schedule 14A is incorporated by reference to the Company’s Proxy Statement for the 2007 Annual Meeting of Shareholders.
PART IV
ITEM 15.
ITEM 15.
Exhibits and Financial Statement Schedules
(a)(1) The following consolidated financial statements of the Company are contained in the Index to Financial Information on Page of this report:
Consolidated Balance Sheets as of December 31, 2006 and 2005.
Consolidated Statements of Operations and Comprehensive Income for the Years Ended December 31, 2006, 2005 and 2004.
Consolidated Statements of Changes in Shareholders’ Equity for the Years Ended December 31, 2006, 2005 and 2004.
Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, 2005 and 2004.
(a)(2) The following financial statement schedules of the Company are contained in the Index to Financial Information on page of this report:
Schedule I-Summary of Investments-Other than Investments in Related Parties.
Schedule II-Condensed Financial Information of Registrant.
Schedules III and VI Combined-Supplementary Insurance Information and Supplemental Information Concerning Property and Casualty Insurance Operations.
Schedule IV-Reinsurance.
(a)(3) The following items are filed as Exhibits. Management contracts and compensatory plans are indicated by an asterisk (*).
Copies of Exhibits, Horace Mann Educators Corporation’s Code of Ethics and charters of the committees of the Board of Directors are available through the Investor Relations section of the Company’s Internet website, www.horacemann.com. Copies also may be obtained by writing to Investor Relations, Horace Mann Educators Corporation, 1 Horace Mann Plaza, C-120, Springfield, Illinois 62715-0001.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Horace Mann Educators Corporation has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
HORACE MANN EDUCATORS CORPORATION
/s/ Louis G. Lower II
Louis G. Lower II
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of Horace Mann Educators Corporation and in the capacities and on the date indicated.
Principal Executive Officer:
Directors:
/s/ Louis G. Lower II
/s/ Joseph J. Melone
Louis G. Lower II
President,
Chief Executive Officer and a Director
Joseph J. Melone, Chairman of the
Board of Directors
/s/ William W. Abbott
William W. Abbott, Director
/s/ Mary H. Futrell
Principal Financial Officer:
Mary H. Futrell, Director
/s/ Peter H. Heckman
/s/ Stephen J. Hasenmiller
Peter H. Heckman
Executive Vice President and
Chief Financial Officer
Stephen J. Hasenmiller, Director
/s/ Jeffrey L. Morby
Jeffrey L. Morby, Director
/s/ Shaun F. O’Malley
Shaun F. O’Malley, Director
Principal Accounting Officer:
/s/ Charles A. Parker
Charles A. Parker, Director
/s/ Bret A. Conklin
/s/ Roger J. Steinbecker
Bret A. Conklin
Senior Vice President and Controller
Roger J. Steinbecker, Director
Dated: February 28, 2007
HORACE MANN EDUCATORS CORPORATION
INDEX TO FINANCIAL INFORMATION
MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(Dollars in millions, except per share data)
Forward-looking Information
Statements made in the following discussion that state the Company’s or management’s intentions, hopes, beliefs, expectations or predictions of future events or the Company’s future financial performance are forward-looking statements and involve known and unknown risks, uncertainties and other factors. Horace Mann is not under any obligation to (and expressly disclaims any such obligation to) update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. It is important to note that the Company’s actual results could differ materially from those projected in forward-looking statements due to, among other risks and uncertainties inherent in the Company’s business, the following important factors:
•
Changes in the composition of the Company’s assets and liabilities which may result from occurrences such as acquisitions, divestitures, impairment in asset values or changes in estimates of insurance reserves.
•
Fluctuations in the market value of securities in the Company’s investment portfolio and the related after-tax effect on the Company’s shareholders’ equity and total capital through either realized or unrealized investment losses. In addition, the impact of fluctuations in the financial markets on the Company’s defined benefit pension plan assets and the related after-tax effect on the Company’s operating expenses, shareholders’ equity and total capital.
•
The impact of fluctuations in the financial markets on the Company’s variable annuity fee revenues, valuations of deferred policy acquisition costs and value of acquired insurance in force, and the level of guaranteed minimum death benefit reserves.
•
The impact of fluctuations in the capital markets on the Company’s ability to refinance outstanding indebtedness or repurchase shares of the Company’s common stock.
•
Defaults on interest or dividend payments in the Company’s investment portfolio due to credit issues and the resulting impact on investment income.
•
Prevailing interest rate levels, including the impact of interest rates on (i) unrealized gains and losses in the Company’s investment portfolio and the related after-tax effect on the Company’s shareholders’ equity and total capital, (ii) the book yield of the Company’s investment portfolio, (iii) the Company’s ability to maintain appropriate interest rate spreads over the fixed rates guaranteed in the Company’s life and annuity products and (iv) valuations of deferred policy acquisition costs and value of acquired insurance in force.
•
The cyclicality of the insurance industry and the related effects of changes in price competition and industry-wide underwriting results.
•
The frequency and severity of catastrophes such as hurricanes, earthquakes, storms and wildfires and the ability of the Company to provide accurate estimates of ultimate catastrophe costs in its consolidated financial statements in light of such factors as: the proximity of the catastrophe occurrence date to the date of the consolidated financial statements; potential inflation of property repair costs in the affected area; the occurrence of multiple catastrophes in a geographic area over a relatively short period of time; the outcome of litigation which may be filed against the Company by policyholders, state attorneys general and other parties relative to loss coverage disputes and loss settlement payments; and the ability of state insurance facilities to assess participating insurers when financial deficits occur.
•
The Company’s risk exposure to catastrophe-prone areas. Based on 2006 property and casualty direct earned premiums, the Company’s ten largest states represented 57% of the segment total. Included in this top ten group are certain states which are considered more prone to catastrophe occurrences: Florida, California, North Carolina, Texas, Louisiana and South Carolina.
•
The potential near-term, adverse impact of underwriting actions to mitigate the Company’s risk exposure to catastrophe-prone areas on premium, policy and earnings growth.
•
The ability of the Company to maintain a favorable catastrophe reinsurance program considering both availability and cost; and the collectibility of reinsurance receivables.
•
Adverse development of property and casualty loss and loss adjustment expense reserve experience and its impact on estimated claims and claim settlement expenses for losses occurring in prior years.
•
Adverse changes in business persistency, policyholder mortality and morbidity rates, interest spreads and market appreciation and the resulting impact on both estimated reserves and the valuations of deferred policy acquisition costs and value of acquired insurance in force.
•
Changes in insurance regulations, including (i) those affecting the ability of the Company’s insurance subsidiaries to distribute cash to the holding company and (ii) those impacting the Company’s ability to profitably write property and casualty insurance policies in one or more states.
•
Changes in federal income tax laws and changes resulting from federal tax audits affecting corporate tax rates or taxable income.
•
Changes in federal and state laws and regulations, which affect the relative tax and other advantages of the Company’s life and annuity products to customers, including, but not limited to, changes in IRS regulations governing Section 403(b) plans.
•
The resolution of legal proceedings and related matters including the potential adverse impact on the Company’s reputation and charges against the Company’s earnings resulting from legal defense costs, a settlement agreement and/or an adverse finding or findings against the Company from the proceedings.
•
The Company’s ability to maintain favorable claims-paying ability, financial strength and debt ratings.
•
The competitive impact of entrants such as mutual funds and banks into the tax-deferred annuity products markets, and the Company’s ability to profitably expand its property and casualty business in highly competitive environments.
•
The Company’s ability to develop and expand its agency operations, including its agent force and their licensed product specialists and support staff, as well as the Company’s ability to maintain and secure sponsorships by local, state and national education associations.
•
The Company’s dated and complex information systems, which are more prone to error than advanced technology systems.
•
Disruptions of the general business climate, investments, capital markets and consumer attitudes caused by pandemics or geopolitical acts such as terrorism, war or other similar events. Such events, which could be catastrophic in magnitude, also potentially could result in a significant increase in insurance claims and have a substantial, adverse financial impact on the Company.
Executive Summary
Horace Mann Educators Corporation (“HMEC”; and together with its subsidiaries, the “Company” or “Horace Mann”) is an insurance holding company. Through its subsidiaries, HMEC markets and underwrites personal lines of property and casualty and life insurance and retirement annuities in the U.S. The Company markets its products primarily to educators and other employees of public schools and their families.
For 2006, the Company’s net income significantly exceeded the prior year primarily due to lower catastrophe losses for 2006 compared to the significant level experienced in 2005. Net income in 2005 benefited by approximately $10.1 million from a reduction in contingent tax liabilities and interest on income tax refunds, with no similar items in 2006. In 2006, earnings from the property and casualty segment continued to benefit from underwriting and pricing actions taken in recent years, ongoing improvements in claims processes, cost containment initiatives, and low non-catastrophe claim frequencies, somewhat offset by the increased costs of the Company’s enhanced catastrophe reinsurance program. Net income in 2006 also benefited from a higher amount of favorable development of prior years’ property and casualty claim reserves compared to 2005. The property and casualty combined ratio was 87.6% for 2006 compared to 95.6% for 2005. Annuity segment net income decreased compared to 2005, while life segment net income improved over the same period.
Premiums written and contract deposits decreased slightly compared to 2005. In 2006, the additional costs associated with the Company’s enhanced property and casualty catastrophe reinsurance program represented a $10.8 million decrease to full year premiums, while 2005 reflected a reduction of $9.9 million due to additional ceded premiums to reinstate its property and casualty catastrophe reinsurance coverage following hurricane catastrophe recoveries. In addition to the effect of reinsurance costs, the 2006 decrease in property and casualty premiums written reflected a slight decline in the number of policies that were in force throughout the year and a decrease in average automobile premium per policy - primarily due to the continued improvement in the quality of this book of business. As a result of recent initiatives, new automobile sales units increased 8% in 2006 compared to 2005. This sales growth, along with continued improvements in policy retention, resulted in sequential increases in voluntary automobile policies in force for the second, third and fourth quarters, and a year-over-year increase compared to December 31, 2005. The automobile policies in force growth was driven primarily by an increase in educator policies. Annuity contract deposits for 2006 increased 2% compared to 2005 and life segment insurance premiums and contract deposits decreased 2% compared to the prior year.
For the Company, and for the property and casualty insurance industry, catastrophe costs were significant in both 2005 and 2004 as reflected in the Company’s net income for both of those years. However, the Company’s catastrophe costs for 2005 were lower than those for 2004 - 2004 set the Company’s record level for catastrophe costs - and net income in 2005 also reflected improvements in non-catastrophe underwriting results for the property and casualty segment which continued into 2006.
Critical Accounting Policies
The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires the Company’s management to make estimates and assumptions based on information available at the time the consolidated financial statements are prepared. These estimates and assumptions affect the reported amounts of the Company’s consolidated assets, liabilities, shareholders’ equity and net income. Certain accounting estimates are particularly sensitive because of their significance to the Company’s consolidated financial statements and because of the possibility that subsequent events and available information may differ markedly from management’s judgements at the time the consolidated financial statements were prepared. Management has discussed with the Audit Committee the quality, not just the acceptability, of the Company’s accounting principles as applied in its financial reporting. The discussions generally included such matters as the consistency of the Company’s accounting policies and their application, and the clarity and completeness of the Company’s consolidated financial statements, which include related disclosures. For the Company, the areas most subject to significant management judgements include: liabilities for property and casualty claims and claim settlement expenses, liabilities for future policy benefits, deferred policy acquisition costs, value of acquired insurance in force for annuity and interest-sensitive life products, valuation of investments and valuation of assets and liabilities related to the defined benefit pension plan.
Liabilities for Property and Casualty Claims and Claim Settlement Expenses
Underwriting results of the property and casualty segment are significantly influenced by estimates of the Company’s ultimate liability for insured events. There is a high degree of uncertainty inherent in the estimates of ultimate losses underlying the liability for unpaid claims and claim settlement expenses. This inherent uncertainty is particularly significant for liability-related exposures due to the extended period, often many years, that transpires between a loss event, receipt of related claims data from policyholders and ultimate settlement of the claim. Reserves for property and casualty claims include provisions for payments to be made on reported claims (“case reserves”), claims incurred but not yet reported (“IBNR”) and associated settlement expenses (together “loss reserves”). The process by which these reserves are established requires reliance upon estimates based on known facts and on interpretations of circumstances, including the Company’s experience with similar cases and historical trends involving claim payments and related patterns, pending levels of unpaid claims and product mix, as well as other factors including court decisions, economic conditions and public attitudes.
Reserves are reestimated quarterly. Changes to reserves are recorded in the period in which development factor changes result in reserve reestimates. Detailed discussion of the process utilized to estimate loss reserves, risk factors considered and the impact of adjustments recorded during recent years is included in “Notes to Consolidated Financial Statements - Note 3 - Property and Casualty Unpaid Claims and Claim Expenses” listed on page of this report. Due to the nature of the Company’s personal lines business, the Company has no exposure to claims for toxic waste cleanup, other environmental remediation or asbestos-related illnesses other than claims under homeowners insurance policies for environmentally related items such as mold.
Based on the Company’s products and coverages, historical experience, and modeling of various actuarial methodologies used to develop reserve estimates, the Company estimates that the potential variability of the property and casualty loss reserves, excluding the unprecedented hurricane losses experienced in 2005 and 2004, within a reasonable probability of other possible outcomes, may be approximately plus or minus 6%, or plus or minus approximately $12 million in net income. Although this evaluation reflects the most likely outcomes, it is possible the final outcome may fall below or above these estimates.
There are a number of assumptions involved in the determination of the Company’s property and casualty loss reserves. Among the key factors affecting recorded loss reserves for both long-tail and short-tail related coverages, claim severity is of particular significance. Management estimates that a 2% change in claim severity for the most recent 36-month period is a reasonably likely scenario based on recent experience and would result in a change in the estimated loss reserves of between $6.0 million and $10.0 million for long-tail liability related exposures (automobile liability coverages) and between $3.0 million and $4.0 million impact in the estimated loss reserves for short-tail liability related exposures (homeowners and automobile physical damage coverages). Actual results may change, depending on the magnitude and direction of the deviation.
The Company’s liabilities for property and casualty unpaid claims and claim settlement expenses were as follows:
(1) These amounts are gross, before reduction for ceded reinsurance reserves.
The facts and circumstances leading to the Company’s reestimate of reserves relate to revisions to the development factors used to predict how losses are likely to develop from the end of a reporting period until all claims have been paid. Reestimates occur because actual loss amounts are different than those predicted by the estimated development factors used in prior reserve estimates. At December 31, 2006, the impact of a reserve reestimation resulting in a 1% increase in net reserves would be a decrease of approximately $2 million in net income. A reserve reestimation resulting in a 1% decrease in net reserves would increase net income by approximately $2 million.
Favorable reserve reestimates increased net income by approximately $12.5 million in 2006 reflecting emergence of favorable claim trends, primarily for accident years 2005 and 2004, for the voluntary automobile line of business related primarily to claim frequencies, which were more favorable than previously estimated.
Favorable reserve reestimates increased net income by approximately $8.5 million in 2005 reflecting favorable loss emergence trends in both the voluntary automobile and property lines of business. The favorable loss emergence trends included claim frequencies which were more favorable than previously estimated as well as declining claim severities which were the result of improved claims handling processes.
Unfavorable reserve reestimates decreased net income by approximately $2.5 million in 2004 primarily as the result of reflecting additional medical information related to a single liability claim that occurred over 15 years previously.
Information regarding the Company’s property and casualty claims and claims settlement expense reserve development table is located in “Business - Property and Casualty Segment - Property and Casualty Reserves”.
Liabilities for Future Policy Benefits
Liabilities for future benefits on life and annuity policies are established in amounts adequate to meet the estimated future obligations on policies in force. Liabilities for future policy benefits on certain life insurance policies are computed using the net level premium method and are based on assumptions as to future investment yield, mortality and withdrawals. Mortality and withdrawal assumptions for all policies have been based on actuarial tables which are consistent with the Company’s own experience. Liabilities for future benefits on annuity contracts and certain long-duration life insurance contracts are carried at accumulated policyholder values without reduction for potential surrender or withdrawal charges. In the event actual experience varies from the estimated liability assumptions, adjustments are charged or credited to income for the period in which the adjustments are made.
Deferred Policy Acquisition Costs and Value of Acquired Insurance in Force for Annuity and Interest-Sensitive Life Products
Policy acquisition costs, consisting of commissions, policy issuance and other costs, which vary with and are primarily related to the production of business, are capitalized and amortized on a basis consistent with the type of insurance coverage. For all investment (annuity) contracts, acquisition costs, and also the value of annuity business acquired in the 1989 acquisition of the Company (“Annuity VIF”), are amortized over 20 years in proportion to estimated gross profits. Capitalized acquisition costs for interest-sensitive life contracts are also amortized over 20 years in proportion to estimated gross profits.
The most significant assumptions that are involved in the estimation of annuity gross profits include interest rate spreads, future financial market performance, business surrender/lapse rates, expenses and the impact of realized investment gains and losses. For the variable deposit portion of the annuity segment, the Company amortizes policy acquisition costs and the Annuity VIF utilizing a future financial market performance assumption of a 10% reversion to the mean approach with a 200 basis point corridor around the mean. At December 31, 2006, the ratio of capitalized annuity policy acquisition costs and the Annuity VIF asset to the total annuity accumulated cash value was approximately 4%.
In the event actual experience differs significantly from assumptions or assumptions are significantly revised, the Company may be required to record a material charge or credit to amortization expense for the period in which the adjustment is made. As noted above, there are key assumptions involved in the valuation of capitalized policy acquisition costs and the Annuity VIF. In terms of the sensitivity of this amortization to two of the more significant assumptions, assuming all other assumptions are met, (1) a 10 basis point deviation in the annual targeted interest rate spread assumption would currently impact amortization between $0.25 million and $0.35 million and (2) a 1% deviation from the targeted financial market performance for the underlying mutual funds of the Company’s variable annuities would currently impact amortization between $0.15 million and $0.25 million. These results may change depending on the magnitude
and direction of the deviations but represent a range of reasonably likely experience for the noted assumptions. Detailed discussion of the impact of adjustments to the amortization of capitalized acquisition costs and Annuity VIF is included in “Results of Operations for the Three Years Ended December 31, 2006 - Amortization of Policy Acquisition Expenses and Intangible Assets”.
Valuation of Investments
The Company’s methodology of assessing other-than-temporary impairments is based on security-specific facts and circumstances as of the date of the reporting period. Based on these facts, if management believes it is probable that amounts due will not be collected according to the contractual terms of a debt security not impaired at acquisition, or if the Company does not have the ability and intent to hold a debt security with an unrealized loss until it matures or recovers in value, an other-than-temporary impairment shall be considered to have occurred. As a general rule, if the fair value of a debt security has fallen below 80% of book value for more than six months, this security will be reviewed for an other-than-temporary impairment. Additionally, if events become known that call into question whether the security issuer has the ability to honor its contractual commitments, whether or not such security has been trading above an 80% fair value to book value relationship, such security holding will be evaluated to determine whether or not such security has suffered an other-than-temporary decline in value.
The Company reviews the fair value of all investments in its portfolio on a monthly basis to assess whether an other-than-temporary decline in value has occurred. These reviews, in conjunction with the Company’s investment managers’ monthly credit reports and relevant factors such as (1) the financial condition and near-term prospects of the issuer, (2) the Company’s ability and intent to retain the investment long enough to allow for the anticipated recovery in fair value, (3) the stock price trend of the issuer, (4) the market leadership position of the issuer, (5) the debt ratings of the issuer and (6) the cash flows of the issuer, are all considered in the impairment assessment. A write-down of an investment is recorded when a decline in the fair value of that investment is deemed to be other-than-temporary, with a realized investment loss charged to income for the period.
A decline in fair value below amortized cost is not assumed to be other-than-temporary for fixed maturity investments with unrealized losses due to market conditions or industry-related events where there exists a reasonable expectation that fair value will recover versus historical cost and the Company has the intent and ability to hold the investment until maturity or a market recovery is realized. An other-than-temporary impairment loss will be recognized based upon all relevant facts and circumstances for each investment, as appropriate.
Valuation of Assets and Liabilities Related to the Defined Benefit Pension Plan
Effective April 1, 2002, participants stopped accruing benefits under the defined benefit pension plan but continue to retain the benefits they had accrued to date.
The Company’s cost estimates for its defined benefit pension plan are determined annually based on assumptions which include the discount rate, expected return on plan assets, anticipated retirement rate and estimated lump sum distributions. A discount rate of 5.65% was used by the Company for estimating accumulated benefits under the plan at December 31, 2006, which was based on the average yield for long-term, high grade securities having maturities generally consistent with the defined benefit pension payout period. To set its discount rate, the Company looks to leading indicators, including Moody’s Aa long-term bond index. The expected annual return on plan assets assumed by the Company at December 31, 2006 was 7.5%. The
assumption for the long-term rate of return on plan assets was determined by considering actual investment experience during the lifetime of the plan, balanced with reasonable expectations of future growth considering the various classes of assets and percentage allocation for each asset class. Management believes that it has adopted reasonable assumptions for investment returns, discount rates and other key factors used in the estimation of pension costs and asset values.
To the extent that actual experience differs from the Company’s assumptions, subsequent adjustments may be required, with the effects of those adjustments charged or credited to income and/or shareholders’ equity for the period in which the adjustments are made. Generally, a change of 50 basis points in the discount rate would inversely impact pension expense and accumulated other comprehensive income (“AOCI”) by approximately $0.1 million and $1.5 million, respectively. In addition, for every $1 million increase (decrease) in the value of pension plan assets, there is a comparable increase (decrease) in AOCI.
Results of Operations for the Three Years Ended December 31, 2006
Insurance Premiums and Contract Charges
Insurance Premiums Written and Contract Deposits
(Includes annuity and life contract deposits)
(1) The amount for the year ended December 31, 2004 was reduced by $4.0 million of previously escrowed premiums returned to North Carolina automobile policyholders.
Insurance Premiums and Contract Charges Earned
(Excludes annuity and life contract deposits)
For 2006, the Company’s premiums written and contract deposits decreased 0.3% compared to 2005. In 2006, the additional costs associated with the Company’s enhanced property and casualty catastrophe reinsurance program represented a $10.8 million decrease to current year premiums, while 2005 reflected a decrease of $9.9 million due to additional ceded premiums to reinstate its property and casualty catastrophe reinsurance coverage following hurricane catastrophe recoveries. For 2005, the Company’s premiums written and contract deposits decreased 2.6% compared to 2004, as increases in average voluntary automobile and homeowners premium per policy - which were moderated to some extent by the improvement in
the quality of the books of business - were more than offset by the decline in policies in force in these lines. Also, property and casualty catastrophe reinsurance reinstatement premiums were higher in 2005 compared to 2004, representing 0.5 percentage point of the decline. In addition to the decline in property and casualty premiums written in 2005, new annuity single premium and rollover deposit receipts declined compared to 2004. Voluntary property and casualty business represents policies sold through the Company’s marketing organization and issued under the Company’s underwriting guidelines. Involuntary property and casualty business consists of allocations of business from state mandatory insurance facilities and assigned risk business.
The Company’s exclusive agent force totaled 848 at December 31, 2006, reflecting a decrease of 0.8% compared to 855 agents at December 31, 2005. At December 31, 2004, the Company had 800 agents. The decline in the number of agents during 2006 was due in part to the strategic restructuring of the Company’s agencies in catastrophe-prone areas of Florida and Louisiana. At the time of this Annual Report on Form 10-K, management anticipates growth in the number of career agency points of distribution in 2007, not only due to growth in the number of agents but also from the addition of licensed product specialists that will be supporting agents who adopt the Agency Business Model. Of the December 31, 2006 total, 260 agents were in their first 24 months with the Company, reflecting an increase of 2.0% compared to December 31, 2005. Terminations of agents in their first 24 months with the Company were at a higher level than was experienced in 2005; however, this was more than offset by new hires. The number of experienced agents in the agent force, 588, decreased 2.0% compared to a year earlier.
In 2006, the Company began the transition from a single-person agent operation to its new Agency Business Model, with agents in outside offices with support personnel and licensed product specialists, designed to remove current capacity constraints and increase productivity. The first Agency Business School session was conducted in October 2006, beginning the formal roll-out of this model. See additional description in “Business - Corporate Strategy and Marketing - Exclusive Agency Force”.
For full year 2006, total new business sales increased 4.8% compared to 2005. New automobile sales units increased 8% in 2006, for both the fourth quarter and full year, compared to 2005. A 5.5% increase in annuity new business reflected a 4.8% increase in annuity business from the Company’s career agents, primarily due to a higher volume of partner company products. In total, career agent sales for 2006 increased 4.2% compared to 2005, reflecting an increase in average overall productivity per agent. Average agent productivity is measured as new sales premiums from the exclusive agent force per the average number of exclusive agents for the period.
Total voluntary automobile and homeowners premium written decreased 1.6%, or $8.6 million, in 2006 compared to 2005, with the components of catastrophe reinsurance costs impacting premiums being nearly comparable in amount in both years as described above. Total voluntary automobile and homeowners premium written decreased 3.1% in 2005 with approximately 1 percentage point of the decline attributable to the higher level of catastrophe reinsurance reinstatement premiums in 2005 compared to 2004. In 2006, the automobile average written premium per policy decreased while the homeowners average premium increased compared to 2005, with the change in average premium for both lines adversely impacted by the improved quality of the books of business. In addition, written premium was impacted by the slight decline in the average number of policies in force in 2006 compared to 2005. At December 31, 2006, there were 533,000 voluntary automobile and 266,000 homeowners policies in force, for a total of 799,000 policies, compared to a total of 797,000 policies at December 31, 2005 and 818,000 at December 31, 2004.
To curtail the decline in automobile policies in force, in 2005 the Company implemented both short- and medium-term initiatives to increase new business and improve policy retention. Based on policies in force, the total property and casualty 12-month retention rate for new and renewal policies was 86% at December 31, 2006 compared to 85% at December 31, 2005 and 84% at December 31, 2004. In 2006, approved rate increases for the Company’s automobile and homeowners business were minimal, similar to rate actions in 2005.
Voluntary automobile premium written decreased 3.4% ($13.1 million) compared to 2005. In 2005, voluntary automobile insurance premium written decreased 4.3% ($17.1 million) compared to 2004. Average written premium per policy decreased 3% in 2006 and was flat in 2005. Average earned premium per policy decreased 3% in 2006 and increased 1% in 2005. Automobile policies in force at December 31, 2006 increased by 2,000 compared to December 31, 2005, which had decreased 12,000 compared to December 31, 2004, with the improved trend in 2006 primarily reflecting the increase in educator policies in each of the preceding seven quarters.
Homeowners premium written increased 2.9% ($4.5 million) compared to 2005 including the components of catastrophe reinsurance costs described above. Compared to 2004, homeowners premium decreased 0.1% ($0.2 million) including a decrease of $4.9 million due to the higher level of catastrophe reinsurance reinstatement premiums in 2005. Average written premium per policy increased 3% for homeowners in 2006 and 5% in 2005. Average earned premium per policy increased 3% in 2006 and 9% in 2005. Homeowners policies in force at December 31, 2006 were equal to a year earlier after decreasing by 7,000 during 2005, as growth in the number of educator policies was offset by expected reductions, primarily in non-educator policies, due to the Company’s pricing and underwriting actions, including actions in catastrophe-prone coastal areas.
In 2005, the Company was assessed $1.8 million and $1.3 million from the Citizens Property Insurance Corporation (“Florida Citizens”) and Louisiana Citizens Fair and Coastal Plan (“Louisiana Citizens”), respectively, as a result of extensive hurricane catastrophe losses in both states. Both of these assessments were paid in 2005 (reflected as a component of benefits, claims and settlement expenses). Beginning in May 2006, the Company is assessing its Florida and Louisiana property policyholders over the following 12-24 months to recoup these amounts. In 2006, the Company was assessed and paid an additional $0.6 million to Florida Citizens, which will be recouped in a similar manner. Also during 2006, the Florida Insurance Guaranty Association (“FIGA”) assessed the Company $0.4 million to cover losses due to liquidation of an insurance company and $0.4 million for an additional emergency assessment. Starting in 2007, the Company will be assessing its Florida policyholders over 12-24 months to recoup both of these amounts. The Company continues to evaluate and implement actions to further mitigate its risk exposure in hurricane-prone areas. Such actions could include, but are not limited to, non-renewal of homeowners policies, restricted agent geographic placement, limitations on agent new business sales and further tightening of underwriting standards.
In June 2006, the Florida Office of Insurance Regulation issued an order to all insurers authorized to write property and casualty business in that state regarding an emergency assessment to offset obligations of the Florida Hurricane Catastrophe Fund and the Florida Hurricane Catastrophe Corporation. Insurers will be required to collect the assessment, equal to 1% of direct written premiums on property and casualty lines of business with limited exceptions, on all Florida policies written or renewed on or after January 1, 2007. On a quarterly basis, insurers will then remit to Florida all collected assessments. In September 2006, Louisiana Citizens issued an emergency assessment equal to 3.6% of direct written premiums effective January 1, 2007. This assessment will be collected by insurers from property and casualty policyholders and remitted to Louisiana in a process similar to the one described for Florida. These emergency assessments will not impact the Company’s financial results.
The primary component of involuntary and other property and casualty premiums, which represented less than 2% of total property and casualty premiums in 2006, is educator excess professional liability insurance purchased by the NEA for all of its members. The NEA’s contract to purchase this insurance from the Company will expire in August 2007. At the time of this Annual Report on Form 10-K, management anticipates that the NEA will not renew this contract.
New annuity deposits increased 1.7% in 2006 and decreased 2.1% in 2005. In 2006, single premium and rollover deposits as well as new scheduled annuity deposits increased slightly compared to 2005. New deposits to fixed accounts increased 2.7%, or $4.9 million, compared to 2005, and new deposits to variable accounts increased 0.5%, or $0.7 million. While new deposits to fixed accounts in 2005 decreased 6.5%, or $12.7 million, due to the interest rate environment, new deposits to variable accounts increased 4.4%, or $5.8 million, compared to 2004.
The Company utilizes a nationwide network of independent agents who comprise a supplemental distribution channel for the Company’s 403(b) tax-qualified annuity products. The independent agent distribution channel included 735 authorized agents at December 31, 2006. During 2006, this channel generated $38.7 million in annualized new annuity sales for the Company compared to $35.4 million in 2005 and $38.0 million in 2004.
Total annuity accumulated cash value of $3.6 billion at December 31, 2006 increased 8.6% compared to a year earlier, reflecting the increase from new business, continued favorable retention and improved financial market performance over the 12 months. Total annuity accumulated cash value of $3.3 billion at December 31, 2005 increased 7.0% compared to the end of 2004. At December 31, 2006, the number of annuity contracts outstanding of 165,000 increased 1.9%, or 3,000 contracts, compared to December 31, 2005 and 3.8%, or 6,000 contracts, compared to December 31, 2004.
Variable annuity accumulated balances were 12.1% higher at December 31, 2006 than at December 31, 2005 and annuity segment contract charges earned increased 10.1%, or $1.8 million, in 2006. Variable annuity accumulated balances were 6.3% higher at December 31, 2005 than at December 31, 2004, while annuity segment contract charges earned in 2005 increased 7.2%, or $1.2 million.
Life segment premiums and contract deposits declined 1.6%, or $1.7 million, in 2006. Life segment premiums and contract deposits declined 3.2%, or $3.5 million, in 2005. The ordinary life insurance in force lapse ratio was 5.7% for the 12 months ended December 31, 2006 compared to 6.5% and 7.2% for the twelve months ended December 31, 2005 and 2004, respectively.
In 2006, the Company introduced new Horace Mann manufactured and branded products to better address the financial planning needs of educators. In February 2006, the Company introduced Life by Design, a new portfolio of life insurance products. In March 2006, the Company introduced new fixed and variable annuity products and in May 2006, the Company added 12 new investment options to its variable annuity products. See additional description of these new products in “Business - Life Segment” and “Business - Annuity Segment”.
Net Investment Income
Pretax investment income of $209.0 million for 2006 increased 7.4%, or $14.4 million, (6.9%, or $9.2 million, after tax) compared to 2005. The increase reflects growth in the size of the investment portfolio and a slight increase in the portfolio yield. Pretax investment income of $194.6 million for 2005 increased 1.7%, or $3.2 million, (1.5%, or $2.0 million, after tax) compared to 2004. Growth in the size of the investment portfolio and an increase in the portfolio yield more than offset a decrease of approximately $4.0 million pretax in prepayment income. Average invested assets (excluding securities lending collateral) increased 6.5% over the past 12 months. The average pretax yield on the investment portfolio was 5.40% (3.68% after tax) for 2006, compared to a pretax yield of 5.35% (3.66% after tax) and 5.68% (3.89% after tax) for 2005 and 2004, respectively.
Net Realized Investment Gains
Net realized investment gains (pretax) were $10.9 million for 2006 compared to net realized investment gains of $9.8 million in 2005 and $12.2 million in 2004. Net realized investment gains in 2006 included $5.1 million of litigation proceeds on previously impaired WorldCom, Inc. debt securities. In 2006, the Company recorded an impairment of $0.1 million related to fixed income securities from one issuer. In 2005, the Company recorded a fixed income security impairment of $1.8 million related to securities from one automobile industry issuer. There were no impairment charges from the Company’s fixed income security portfolio in 2004. Net realized investment gains in 2006 included $0.3 million from sales of securities for which impairment charges were recorded in the fourth quarter of 2005 and the securities impaired in 2006 were later sold at the impaired value. Gains realized in 2005 included $1.9 million from sales of securities for which impairment charges were recorded in 2003. The net gains for 2006, 2005 and 2004 also reflected gains and losses realized from ongoing investment portfolio management activity.
The table below presents the Company’s fixed maturity securities portfolio as of December 31, 2006 by major asset class, including the ten largest sectors of the Company’s corporate bond holdings.
* Less than $0.1 million.
(1) The All Other Corporates category contains 18 additional industry classifications. Real estate; defense; broadcasting and media; technology; retail; and cable represented $294.2 million of fair value at December 31, 2006, with the remaining 12 classifications each representing less than $37 million.
(2) All of the collateralized debt obligation securities were rated investment grade by Standard and Poor’s Corporation and/or Moody’s Investors Service, Inc. at December 31, 2006.
At December 31, 2006, the Company’s diversified fixed maturity portfolio consisted of 1,253 investment positions, issued by 1,034 entities, and totaled approximately $3.8 billion in fair value. The portfolio was 94.5% investment grade, based on fair value, with an average quality rating of A+. At December 31, 2006, the portfolio had $43.8 million pretax of total gross unrealized losses related to 538 positions. At December 31, 2005, the portfolio had $39.3 million pretax of total gross unrealized losses related to 545 positions. The following table provides information regarding fixed maturity securities that had an unrealized loss at December 31, 2006, including the length of time that the securities have continuously been in an unrealized loss position.
Investment Positions With Unrealized Losses Segmented by Quality
and Period of Continuous Unrealized Loss
As of December 31, 2006
* Less than $0.1 million.
Of the investment positions with unrealized losses, no issuers had pretax unrealized losses greater than $1.1 million. No fixed maturity securities were trading below 80% of book value at December 31, 2006. The Company views the decrease in value of all of the securities with unrealized losses at December 31, 2006 as temporary, expects recovery in fair value, anticipates continued payments under the terms of the securities, and has the intent and ability to hold these securities until maturity or a recovery in fair value occurs. Therefore, no impairment of these securities was recorded at December 31, 2006. Future changes in circumstances related to these and other securities could require subsequent recognition of other-than-temporary impairment losses. The Company’s investment guidelines generally limit single corporate issuer concentrations to 1.0% of invested assets for “AA” or “AAA” rated securities, 0.75% of invested assets for “A” rated securities, 0.5% of invested assets for “BBB” rated securities, and 0.2% of invested assets for non-investment grade securities.
Benefits, Claims and Settlement Expenses
(1) See footnote (2) to the table below.
Property and Casualty Claims and Claim Expenses (“losses”)
(1) Shows the amounts by which the Company increased or decreased its reserves in each of the periods indicated for claims occurring in previous periods to reflect subsequent information on such claims and changes in their projected final settlement costs.
(2) The year ended December 31, 2006 included development of prior years’ reserves for catastrophe losses in captions related to catastrophe losses/costs as well as captions related to prior years’ reserve development as follows: total property and casualty, unfavorable development of $1.4 million; voluntary automobile, favorable development of $1.5 million; and total property, unfavorable development of $2.9 million.
In 2006, the Company’s benefits, claims and settlement expenses decreased compared to 2005, primarily reflecting a decrease in catastrophe losses, the decrease in estimated reserves for property and casualty claims occurring in prior years and favorable current year voluntary automobile claim frequency. Benefits, claims and settlement expenses for 2005 decreased compared to 2004 for similar reasons. The Company’s catastrophe losses decreased compared to 2005 and 2004, primarily reflecting the significant level of hurricane losses incurred in each of those years. 2006 did, however, reflect higher non-hurricane related catastrophe losses, including third quarter hail storms in Minnesota, as well as increased severity of non-hurricane losses primarily from wind damage. Catastrophe losses in 2006 included $1.4 million of adverse development of prior years’ catastrophe loss reserves (recorded in the second quarter), primarily due to increases in ultimate net settlement cost related to two third quarter 2005 events: a severe hail storm in Minnesota and Hurricane Katrina. In 2006, the gross loss and loss adjustment expense estimate for Hurricane Katrina was increased to $82 million, which now exceeds the Company’s reinsurance limit of $80 million in effect during 2005. Excluding the adverse development of prior years’ catastrophe reserves, development of prior years’ property and casualty reserves had a $20.6 million favorable effect on benefits, claims and settlement expenses in 2006 compared to $13.1 million of favorable development in 2005 and $3.8 million of adverse development in 2004. The 2006 favorable development was the result of actual and
remaining projected losses for prior years, primarily accident years 2005 and 2004, being below the level anticipated in the December 31, 2005 loss reserve estimate for the voluntary automobile line of business, which was driven primarily by emerging claim trends related to frequency.
For 2006, the voluntary automobile loss ratio of 65.3% decreased by 2.9 percentage points compared to 2005, including a 2.5 percentage point improvement due to the change in development of prior years’ reserves excluding the favorable development of prior years’ catastrophe reserves. The homeowners loss ratio of 55.6% for 2006 decreased 24.9 percentage points compared to 2005, primarily reflecting the higher level of catastrophe costs in 2005 partially offset by the effect of the increase in ceded premium in 2006 as a result of the Company’s enhanced catastrophe reinsurance program which added approximately 3.6 percentage points to the 2006 ratio. Catastrophe costs, including adverse development of prior years’ catastrophe reserves in 2006, represented 11.2 percentage points of the homeowners loss ratio for 2006 compared to 37.9 percentage points for 2005, representing a decrease of 26.7 percentage points. For 2004, the voluntary automobile loss ratio was 70.6%, including 0.9 percentage point due to adverse development of prior years’ reserves, and the homeowners loss ratio was 96.9%, including 46.9 percentage points due to catastrophe costs.
For the annuity segment, benefits increased by a minimal amount compared to 2005 and the 2005 amount was comparable to 2004. The Company’s guaranteed minimum death benefits (“GMDB”) reserve was $0.7 million at both December 31, 2006 and 2005, compared to $0.1 million at December 31, 2004.
For the life segment, benefits were greater in 2006 reflecting increased mortality costs compared to 2005 and 2004.
Interest Credited to Policyholders
Compared to 2005, the 2006 increase in annuity segment interest credited reflected a 6.8% increase in average accumulated fixed deposits, partially offset by a 3 basis point decline in the average annual interest rate credited to 4.37%. Compared to 2004, the 2005 increase in annuity segment interest credited reflected a 9.0% increase in average accumulated fixed deposits, partially offset by a 5 basis point decline in the average annual interest rate credited to 4.40%. Life insurance interest credited increased in both 2006 and 2005 as a result of the growth in interest-sensitive life insurance reserves.
The net interest spread on fixed annuity account value on deposit measures the difference between the rate of income earned on the underlying invested assets and the rate of interest which policyholders are credited on their account values. Fixed annuity crediting rates were lowered in recent years to reflect the decline in the rate of income on invested assets caused by lower investment rates on new and reinvested funds. The net interest spreads for the years ended December 31, 2006 and 2005 were 126 basis points and 128 basis points, respectively.
As of December 31, 2006, fixed annuity account values totaled $2.1 billion, including $1.8 billion of deferred annuities. Approximately 15% of the deferred annuity account values had minimum guaranteed interest rates of 3% or lower while approximately 73% of account values had minimum guaranteed rates of 4.5% or greater. For $1.6 billion of the deferred annuity account values, the credited interest rate was equal to the minimum guaranteed rate. While the decline in the annuity net interest spread moderated to only 2 basis points in 2006, due to limitations on the Company’s ability to further lower interest crediting rates, the Company may experience additional fixed annuity spread compression in future periods.
Operating Expenses
In 2006, operating expenses decreased 1.6%, or $2.1 million, compared to 2005, primarily reflecting benefits from the Company’s expense control initiatives. The property and casualty expense ratio of 24.3% for 2006 increased 1.1 percentage points compared to 2005, including the effect on this ratio of a reduced level of premiums earned. In 2005, operating expenses decreased 1.1%, or $1.5 million, compared to 2004, primarily reflecting benefits from the Company’s expense control initiatives partially offset by timing differences between periods. The property and casualty expense ratio was 23.2% in 2005 and 22.2% in 2004.
The Company offers long-term care insurance, variable and fixed interest rate universal life policies (“Life Partner Products”), and equity indexed annuities and single premium immediate annuities (“Annuity Partner Products”), with three third-party vendors underwriting and bearing the risk of such insurance, and the Company receiving a commission on the sale of that business. The volume of Life Partner Product sales by the Company’s agents increased approximately $0.3 million during 2006. Sales of Annuity Partner products were $23.6 million in 2006, compared to $12.6 million in 2005 when these products were first introduced. The amount of Life Partner Product and Annuity Partner Product commissions received by the Company in 2006, in excess of costs for agent commissions and commission-related expenses, was approximately $2.6 million, $1.7 million and $1.5 million for the years ended December 31, 2006, 2005 and 2004, respectively.
In July 2006, the Company announced that effective January 1, 2007 it would eliminate the existing health care benefits for retirees 65 years of age and over and establish a Health Reimbursement Account (“HRA”) for each eligible participant. Health care benefits for eligible retirees under 65 years of age will continue to be provided as a bridge to Medicare eligibility. Eligible participants will receive a one-time credit of $10 thousand to their HRA account to use for covered expenses incurred on or after age 65. Also, the new plan does not provide life insurance benefits to individuals who retired in 1994 or later. As a result of the changes in the plan for other postretirement benefits, a reduction in expenses of approximately $2.3 million was recognized in 2006 and the Company anticipates a reduction in its expenses of approximately $4.5 million and $2.3 million in 2007 and 2008, respectively.
Amortization of Policy Acquisition Expenses and Intangible Assets
For 2006, the combined amortization of policy acquisition expenses and intangible assets was $80.1 million compared to $76.6 million recorded in 2005 and $76.0 million recorded in 2004. Amortization of intangible assets was $6.1 million, $5.1 million and $6.0 million for the years ended December 31, 2006, 2005 and 2004, respectively. The December 31, 2006 valuation of Annuity VIF resulted in a $0.7 million increase in amortization compared to a $0.2 million decrease at December 31, 2005 and a $0.9 million increase at December 31, 2004. The increase in 2006 amortization of Annuity VIF was primarily attributable to revised assumptions related to the annual targeted interest rate spreads, which negatively impacted the estimation of annuity future gross profits.
Amortized policy acquisition expenses were $74.0 million for 2006 compared to $71.5 million and $70.0 million for the years ended December 31, 2005 and 2004, respectively. The December 31, 2006 valuation of annuity deferred policy acquisition costs resulted in a $0.5 million increase in amortization compared to a $1.8 million increase in amortization resulting from a similar valuation at December 31, 2005. The increase in 2006 amortization of annuity policy acquisition expenses was primarily attributable to revised assumptions related to the annual targeted interest rate spreads, which was partially offset by actual financial market performance in excess of target. For the life segment, the December 31, 2006 valuation of deferred policy acquisition costs resulted in a $0.6 million increase in amortization compared to a $0.7 million decrease from the 2005 valuation. The increase in 2006 amortization of life policy acquisition expenses was primarily attributable to revised annual targeted interest rate spreads, which negatively impacted the estimation of life future gross profits. The December 31, 2004 valuations of annuity and life deferred policy acquisition costs resulted in increases of $1.2 million and $0.4 million, respectively. The remaining increases in amortized policy acquisition costs were due to scheduled amortization of capitalized costs.
Income Tax Expense
The effective income tax rate on the Company’s pretax income, including net realized investment gains, was 29.7%, 17.8% and 19.2% for the years ended December 31, 2006, 2005 and 2004, respectively. Income from investments in tax-advantaged securities reduced the effective income tax rate 5.6, 8.0 and 11.5 percentage points for the years ended December 31, 2006, 2005 and 2004, respectively. While the amount of income from tax-advantaged securities was comparable for each of the three years, the increasing level of taxable income has resulted in this having a declining impact on the effective income tax rate during this period.
As previously disclosed, in 2005, the Company’s federal income tax expense reflected a reduction of $9.1 million as a result of closing tax years 1996 through 2001 with favorable resolution of the contingent tax liabilities. The Company also received interest on income tax refunds of $1.4 million, which was recorded by the Company as pretax income in the second quarter of 2005. No similar reductions to federal income tax expense were recorded in 2006 or 2004.
The Company records contingent tax liabilities for exposures from uncertain tax filing positions based upon management’s assessment of the amounts that are probable of being sustained upon Internal Revenue Service (“IRS”) audit. These liabilities are reevaluated routinely and are adjusted appropriately based upon changes in facts or law. The Company has no unrecorded contingent tax exposures.
At December 31, 2006, the Company had federal income tax returns for the 2002 through 2005 tax years still open and subject to adjustment upon IRS examination. The Company has recorded $4.2 million of contingent tax liabilities related to those open tax years.
Net Income
For 2006, the Company’s net income significantly exceeded the prior year primarily due to lower catastrophe losses for 2006 compared to the significant level experienced in 2005. Net income in 2005 benefited by approximately $10.1 million from a reduction in contingent tax liabilities and interest on income tax refunds, with no similar items in 2006. In 2006, earnings from the property and casualty segment continued to benefit from underwriting and pricing actions taken in recent years, ongoing improvements in claims processes, cost containment initiatives, and low non-catastrophe claim frequencies, somewhat offset by the increased costs of the Company’s enhanced catastrophe reinsurance program. Net income in 2006 also benefited from a higher amount of favorable development of prior years’ property and casualty claim reserves compared to 2005. The property and casualty combined ratio was 87.6% for 2006 compared to 95.6% for 2005. Annuity segment net income decreased compared to 2005, while life segment net income improved over the same period.
For 2005, the Company’s net income was significantly affected by catastrophe costs, yet still increased compared to the prior year, primarily reflecting improved property and casualty segment earnings. This improvement was driven by lower catastrophe costs, tightened underwriting standards and pricing actions taken in recent years, ongoing improvements in claims processes, cost containment initiatives and generally favorable non-catastrophe claims frequency trends. Net income in 2005 also benefited from favorable development of prior years’ property and casualty claim reserves and the favorable resolution of tax liabilities for prior years, as described above.
For 2004, the Company’s net income reflected improved property and casualty segment non-catastrophe earnings, partially offset by the record high level of catastrophe costs in 2004. This improvement was driven by pricing and underwriting actions taken over several preceding quarters, continuing favorable non-catastrophe claims frequency trends, ongoing improvements in claims processes and cost containment initiatives, along with minimal adverse development of prior years’ reserves.
Net income by segment and net income per share were as follows:
(1) The corporate and other segment includes interest expense on debt, realized investment gains and losses, certain public company expenses and other corporate level items. The Company does not allocate the impact of corporate level transactions to the insurance segments, consistent with how management evaluates the results of those segments.
For the three years ended December 31, 2006, net income for the property and casualty segment increased as described above.
Compared to the prior year, annuity segment net income for 2006 decreased, primarily reflecting the favorable resolution of contingent tax liabilities and tax refund interest received in 2005, with no similar benefit in 2006. Annuity segment net income increased in 2005 primarily as a result of the contingent income tax liability reduction of $3.6 million, which more than offset a decline in the interest margin and the negative effect of valuations of deferred policy acquisition costs and the increase in GMDB reserves.
Life segment net income for 2006 increased compared to 2005. Life segment pretax income was equal to 2005, as growth in investment income was offset by higher mortality costs and increased amortization of deferred policy acquisition costs. Life segment net income for 2005 decreased compared to the prior year primarily as a result of an increase in the effective income tax rate recorded in 2005. Mortality was comparable in both 2005 and 2004.
The decline in net income for the corporate and other segment in 2006 was due primarily to the $5.5 million reduction in federal income tax expense in 2005 from the elimination of the contingent tax liability for the 1996 through 2001 tax years as well as the 2006 increase in debt interest expense. For 2005, the increase in the corporate and other segment net income was driven by the reduction in federal income tax expense described above.
Return on shareholders’ equity based on net income was 17%, 13% and 10% for the years ended December 31, 2006, 2005 and 2004, respectively.
At the time of this Annual Report on Form 10-K, based on results for the full year 2006, management estimates that 2007 full year net income before realized investment gains and losses will be within a range of $1.80 to $1.95 per share. This projection anticipates a modest increase in the property and casualty combined ratio - to between 90% and 92% - partially offset by a double-digit increase in annuity profit margins. Included in the earnings estimate are additional costs, compared to 2006, totaling approximately $0.15 per share associated with the Company’s 2007 catastrophe reinsurance program, as described in “Business - Property and Casualty Segment - Property and Casualty Reinsurance”, and an increased level of investment in strategic growth initiatives, including the Agency Business Model. As described in “Critical Accounting Policies”, certain of the Company’s significant accounting measurements require the use of estimates and assumptions. As additional information becomes available, adjustments may be required. Those adjustments are charged or credited to income for the period in which the adjustments are made and may impact actual results compared to management’s current estimate. A projection of net income including realized investment gains and losses is not accessible on a forward-looking basis because it is not possible to provide a reliable forecast of realized investment gains and losses, which can vary substantially from one period to another and may have a significant impact on net income.
Liquidity and Financial Resources
Special Purpose Entities
At December 31, 2006, 2005 and 2004, the Company did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As such, the Company is not exposed to any financing, liquidity, market or credit risk that could arise if the Company had engaged in such relationships.
Related Party Transactions
The Company does not have any contracts or other transactions with related parties that are required to be reported under the applicable securities laws and regulations.
Ariel Capital Management, Inc., HMEC’s largest shareholder with 18.2% of the common shares outstanding per their SEC filing on Form 13G as of December 31, 2006, is the investment adviser for two of the mutual funds offered to the Company’s annuity customers.
Investments
Information regarding the Company’s investment portfolio, which is comprised primarily of investment grade, fixed income securities, is located in “Results of Operations for the Three Years Ended December 31, 2006 - Net Realized Investment Gains and Losses”, “Business - Investments” and in the “Notes to Consolidated Financial Statements - Note 2 - Investments” listed on page of this report.
Cash Flow
The short-term liquidity requirements of the Company, within a 12-month operating cycle, are for the timely payment of claims and benefits to policyholders, operating expenses, interest payments and federal income taxes. Cash flow generated from operations has been, and is expected to be, adequate to meet the Company’s operating cash needs in the next 12 months. Cash flow in excess of operational needs has been used to fund business growth, retire short-term debt, pay dividends to shareholders and repurchase shares of the Company’s common stock. Long-term liquidity requirements, beyond one year, are principally for the payment of future insurance policy claims and benefits and retirement of long-term debt.
Operating Activities
As a holding company, HMEC conducts its principal operations in the personal lines segment of the property and casualty and life insurance industries through its subsidiaries. HMEC’s insurance subsidiaries generate cash flow from premium and investment income, generally well in excess of their immediate needs for policy obligations, operating expenses and other cash requirements. Cash provided by operating activities primarily reflects net cash generated by the insurance subsidiaries. For 2006, net cash provided by operating activities increased compared to 2005 including a decline in claim payments, due largely to a reduction in catastrophe-related payments partially offset by a decline in premiums received and an increase in federal income tax payments.
Payment of principal and interest on debt, dividends to shareholders and parent company operating expenses are dependent upon the ability of the insurance subsidiaries to pay cash dividends or make other cash payments to HMEC, including tax payments pursuant to tax sharing agreements. Historical payments for the share repurchase program also had this dependency. The insurance subsidiaries are subject to various regulatory restrictions which limit the amount of annual dividends or other distributions, including loans or cash advances, available to HMEC without prior approval of the insurance regulatory authorities. Dividends which may be paid by the insurance subsidiaries to HMEC during 2007 without prior approval are approximately $106 million. Although regulatory restrictions exist, dividend availability from subsidiaries has been, and is expected to be, adequate for HMEC’s capital needs.
Investing Activities
HMEC’s insurance subsidiaries maintain significant investments in fixed maturity securities to meet future contractual obligations to policyholders. In conjunction with its management of liquidity and other asset/liability management objectives, the Company, from time to time, will sell fixed maturity securities prior to maturity and reinvest the proceeds in other investments with different interest rates, maturities or credit characteristics. Accordingly, the Company has classified the entire fixed maturity securities portfolio as “available for sale”.
Financing Activities
Financing activities include primarily payment of dividends, the receipt and withdrawal of funds by annuity contractholders, repurchases of the Company’s common stock, fluctuations in bank overdraft balances, and borrowings, repayments and repurchases related to its debt facilities.
In March, April and July 2006, the Company repurchased a portion of the outstanding Senior Convertible Notes ($175.9 million aggregate principal amount, $83.6 million carrying value) at an aggregate cost of $82.8 million. The March and April repurchases were initially funded by $74.0 million in borrowings under the Company’s Bank Credit Facility and the July repurchase was funded with cash proceeds from the issuance of the Senior Notes due 2016.
In April 2006, the Company issued $125.0 million aggregate principal amount of 6.85% senior notes, which will mature on April 15, 2016 (“Senior Notes due 2016”), at a discount of 0.305%. As of December 31, 2006, $74.0 million of the net proceeds were used to repay in full the balance then outstanding on the Bank Credit Facility and $9.4 million of the net proceeds was used in July 2006 for additional repurchase of Senior Convertible Notes. See “Capital Resources” for a description of management’s anticipated utilization of the remaining net proceeds.
For the year ended December 31, 2006, receipts from annuity contracts increased 1.7% compared to 2005. Annuity contract benefits and withdrawals increased $23.2 million, or 18.3%, compared to 2005. Cash value retentions for variable and fixed annuity options were 91.5% and 93.7%, respectively, for the 12 month period ended December 31, 2006. Net transfers to variable annuity accumulated cash values decreased $2.7 million, or 2.2%, compared to 2005.
Contractual Obligations
(1) This information represents estimates of both the amounts to be paid to policyholders and the timing of such payments.
(2) Includes principal and interest.
(3) The Company may redeem the Senior Convertible Notes, in whole or in part, at any time on or after May 14, 2007 and holders of the Senior Convertible Notes may require HMEC to purchase all or a portion of their Senior Convertible Notes on either May 14, 2007, 2012, 2017, 2022, or 2027 as further described in “Notes to Consolidated Financial Statements - Note 4 - Debt” listed on page of this report.
(4) The Company has entered into various operating lease agreements, primarily for real estate (agency and claims offices across the country and portions of the home office complex) and also for computer equipment and copy machines.
Estimated Future Policy Benefit and Claim Payments-Life and Annuity Segments
The following table duplicates information above and summarizes the Company’s life and annuity contractual obligations and commitments as of December 31, 2006 expected to be paid in the periods presented. Payment amounts reflect the Company’s estimate of undiscounted cash flows related to these obligations and commitments. Balance sheet amounts were determined in accordance with GAAP and in many cases differ significantly from the summation of undiscounted cash flows. The most significant difference relates to future policy benefits related to life insurance, which includes discounting.
A significant portion of policy contract benefits to be paid do not have stated contractual maturity dates and may not result in any ultimate payment obligation. Amounts reported herein represent estimated undiscounted cash flows out of the Company’s general account related to death, surrender, annuity and other benefit payments under policy contracts in force at December 31, 2006. Separate account payments are not reflected herein due to the matched nature of these obligations and the fact that the contract owners maintain the investment risk of such deposits. Estimated payment amounts reported herein were developed based on review of historical results experienced by the Company and the related contractual provisions. Significant assumptions incorporated in the reported amounts include: future policy lapse rates (including the impact of customer decisions to make future premium payments to keep the related policies in force), coverage levels remaining unchanged from those provided under contracts in force at December 31, 2006, future interest crediting rates, and the estimated timing of payments. Actual amounts will vary, potentially in a significant manner, from the amounts indicated due to deviations between assumptions and actual results and the addition of new business in future periods.
Assumptions for future interest crediting levels have been made based on processes consistent with the Company’s past practices, which are at the discretion of the Company, subject to guaranteed minimum crediting rates in many cases and/or subject to contractually obligated rates for specified periods of time. Many of the contracts with potentially accelerated timing of payments are subject to surrender charges which are generally calculated as a percentage of account values withdrawn and are assessed at declining rates during the first five to ten years after contract issuance. Amounts disclosed herein include an estimate of those accelerated payments, net of applicable surrender charges. See “Note 1 - Summary of Significant Accounting Policies - Future Policy Benefits, Interest-sensitive Life Contract Liabilities and Annuity Contract Liabilities” listed on page of this report for a description of the Company’s method for establishing life and annuity reserves in accordance with GAAP.
For annuity estimated payments, certain assumptions have been made about distribution and surrender patterns in the amounts reported. Actual payouts may differ significantly from those projected. For example, actual retirement patterns may result in earlier or later withdrawal of contract funds, which could cause the timing of the obligations reported to vary significantly. In addition, contractual surrender provisions exist on an immaterial portion of these contracts that could decrease and/or accelerate those obligations presented.
Estimated Claims and Claim Related Payments-Property and Casualty Segment
The table below duplicates information above and presents the amount and estimated future timing of claims and claim related payments for property and casualty insurance. Both the total liability and the estimated payments are based on actuarial projection techniques, at a given accounting date. These estimates include assumptions of the ultimate settlement and administrative costs based on the Company’s assessment of facts and circumstances then known, review of historical settlement patterns, estimates of trends in claims severity, frequency and other factors. Variables in the reserve estimation process can be affected by both internal and external events, such as changes in claims handling procedures, economic inflation, legal trends and legislative changes. Many of these items are not directly quantifiable, particularly on a prospective basis. Additionally, there may be significant reporting lags between the occurrence of a claim and the time it is actually reported to the Company. The future cash flows related to the items contained in the table below required estimation of both amount (including severity considerations) and timing. Amount and timing are frequently estimated separately. An estimation of both amount and timing of future cash flows related to claims and claim related payments is generally reliable only in the aggregate with some unavoidable estimation uncertainty.
The following table includes estimated future claims and claims related payments at December 31, 2006. The amounts reported in the table are presented on a nominal basis, have not been discounted and represent the estimated timing of future payments for both reported and unreported claims incurred and related claim adjustment expenses.
Capital Resources
The Company has determined the amount of capital which is needed to adequately fund and support business growth, primarily based on risk-based capital formulas including those developed by the National Association of Insurance Commissioners (“NAIC”). Historically, the Company’s insurance subsidiaries have generated capital in excess of such needed capital. These excess amounts have been paid to HMEC through dividends. HMEC has then utilized these dividends and its access to the capital markets to service and retire long-term debt, pay dividends to its shareholders, fund growth initiatives, repurchase shares of its common stock and for other corporate purposes. Management anticipates that the Company’s sources of capital will continue to generate capital in excess of the needs for business growth, debt interest payments and shareholder dividends.
The total capital of the Company was $889.1 million at December 31, 2006, including $232.0 million of long-term debt and no short-term debt outstanding. Total debt represented 26.4% of total capital excluding unrealized investment gains and losses (26.1% including unrealized investment gains and losses) at December 31, 2006, which was modestly above the Company’s long-term target of 25%.
Shareholders’ equity was $657.1 million at December 31, 2006, including a net unrealized gain in the Company’s investment portfolio of $11.1 million after taxes and the related impact on deferred policy acquisition costs and the value of acquired insurance in force associated with annuity and interest-sensitive life policies. The market value of the Company’s common stock and the market value per share were $870.4 million and $20.20, respectively, at December 31, 2006. Book value per share was $15.25 at December 31, 2006 ($14.99 excluding investment fair value adjustments).
As of December 31, 2006, the Company had outstanding $68.6 million aggregate principal amount of 1.425% Senior Convertible Notes (“Senior Convertible Notes”), which will mature on May 14, 2032, issued at a discount of 52.5% resulting in an effective yield of 3.0%. Interest on the Senior Convertible Notes is payable semi-annually at a rate of 1.425% from November 14, 2002 until May 14, 2007. After that date, cash interest will not be paid on the Senior Convertible Notes prior to maturity unless contingent cash interest becomes payable. From May 15, 2007 through maturity of the Senior Convertible Notes, interest will be recognized at the effective rate of 3.0% and will represent the accrual of discount, excluding any contingent cash interest that may become payable. The Company may redeem the Senior Convertible Notes, in whole or in part, at any time on or after May 14, 2007. Holders of the Senior Convertible Notes may require HMEC to purchase all or a portion of their Senior Convertible Notes on either May 14, 2007, 2012, 2017, 2022, or 2027. As of the date of this Annual Report on Form 10-K, management intends to redeem all of its outstanding Senior Convertible Notes on May 14, 2007 utilizing available excess proceeds from the 2006 issuance of the Senior Notes due 2016. Detailed information regarding the contingent cash interest, conversion and redemption terms of the Senior Convertible Notes is contained in the “Notes to Consolidated Financial Statements - Note 4 - Debt” listed on page of this report.
In September 2002, the Company’s Board of Directors authorized the Company to repurchase, from time to time, for cash or other consideration, its Senior Convertible Notes. As described in “Cash Flow - Financing Activities”, the Company repurchased $175.9 million aggregate principal amount, $83.6 million carrying value, of the outstanding Senior Convertible Notes in March, April and July 2006. See discussion regarding Senior Notes due 2016 below.
The Senior Convertible Notes have an investment grade rating from Standard & Poor’s Corporation (“S&P”) (BBB), Moody’s Investors Service, Inc. (“Moody’s”) (Baa3), and A.M. Best Company, Inc. (“A.M. Best”) (bbb-). See also “Financial Ratings”. The Senior Convertible Notes are traded in the open market (HMN 1.425).
As of December 31, 2006, the Company had outstanding $75.0 million aggregate principal amount of 6.05% Senior Notes (“Senior Notes due 2015”), which will mature on June 15, 2015, issued at a discount resulting in an effective yield of 6.1%. Interest on the Senior Notes due 2015 is payable semi-annually at a rate of 6.05%. Detailed information regarding the redemption terms of the Senior Notes due 2015 is contained in the “Notes to Consolidated Financial Statements - Note 4 - Debt” listed on page of this report.
The Senior Notes due 2015 have an investment grade rating from S&P (BBB), Moody’s (Baa3), and A.M. Best (bbb-). See also “Financial Ratings”. The Senior Notes due 2015 are traded in the open market (HMN 6.05).
On April 21, 2006, the Company issued $125.0 million aggregate principal amount of 6.85% Senior Notes (“Senior Notes due 2016”), which will mature on April 15, 2016, issued at a discount of 0.305% resulting in an effective yield of 6.893%. Interest on the Senior Notes due 2016 is payable semi-annually at a rate of 6.85%. Detailed information regarding the redemption terms of the Senior Notes due 2016 is contained in “Notes to Consolidated Financial Statements - Note 4 - Debt” listed on page of this report. A portion of the net proceeds was used to repay in full the $74.0 million balance then outstanding on the Bank Credit Facility and $9.4 million was used in July 2006 for additional repurchases of Senior Convertible Notes. Remaining net proceeds are anticipated by management to be used to redeem the outstanding Senior Convertible Notes on May 14, 2007 and for general corporate purposes.
The Senior Notes due 2016 have an investment grade rating from S&P (BBB), Moody’s (Baa3), and A.M. Best (bbb-). See also “Financial Ratings”. The Senior Notes due 2016 are traded in the open market (HMN 6.85).
As of December 31, 2006, the Company had no balance outstanding under its Bank Credit Facility. Effective December 19, 2006, the Bank Credit Facility agreement was amended and restated to 1) extend the commitment termination date to December 19, 2011 from the previous termination date of May 30, 2009, 2) increase the commitment amount to $125.0 million from the previous limit of $100.0 million, 3) decrease the interest rate spread relative to Eurodollar base rates, and 4) decrease the variable commitment fee on the unused portion of the Bank Credit Facility by 5 basis points. Interest accrues at varying spreads relative to corporate or Eurodollar base rates and is payable monthly or quarterly depending on the applicable base rate. The unused portion of the Bank Credit Facility is subject to a variable commitment fee, which was 0.125% on an annual basis at December 31, 2006. To initially fund the repurchases of the Senior Convertible Notes, the Company borrowed $67.0 million in March 2006 and $7.0 million in April 2006 under the Bank Credit Facility and subsequently repaid this balance in full on April 21, 2006 utilizing a portion of the proceeds from the issuance of the Senior Notes due 2016, described above.
To provide additional capital management flexibility, the Company filed a “universal shelf” registration on Form S-3 with the SEC in December 2003. The registration statement, which registers the offer and sale by the Company from time to time of up to $300 million of various securities, which may include debt securities, preferred stock, common stock and/or depositary shares, was declared effective on December 30, 2003. The $75.0 million face amount of Senior Notes due 2015 and $125.0 million face amount of Senior Notes due 2016 were issued utilizing this registration statement. No other securities associated with the registration statement have been issued as of the date of this Annual Report on Form 10-K.
The Company’s ratio of earnings to fixed charges (with fixed charges including interest credited to policyholders on interest-sensitive contracts) for the years ended December 31, 2006, 2005 and 2004 was 2.0x, 1.8x and 1.6x, respectively. See also “Exhibit 12 - Statement Regarding Computation of Ratios”. The Company’s ratio of earnings before interest expense to interest expense was 11.7x, 11.6x and 11.2x for the years ended December 31, 2006, 2005 and 2004, respectively.
Total shareholder dividends were $18.3 million for the year ended December 31, 2006. In March, May, September and December 2006, the Board of Directors announced regular quarterly dividends of $0.105 per share.
Information regarding the reinsurance program for the Company’s property and casualty segment is located in “Business - Property and Casualty Segment - Property and Casualty Reinsurance”.
Information regarding the reinsurance program for the Company’s life segment is located in “Business - Life Segment”.
Financial Ratings
The Company’s principal insurance subsidiaries are rated by Standard & Poor’s Corporation (“S&P”), Moody’s Investors Service, Inc. (“Moody’s”) and A.M. Best Company, Inc. (“A.M. Best”). These rating agencies have also assigned ratings to the Company’s long-term debt securities.
Assigned ratings as of February 23, 2007 were as follows (the insurance financial strength ratings for the Company’s property and casualty insurance subsidiaries and the Company’s principal life insurance subsidiary are the same):
(1) This agency has not yet rated Horace Mann Lloyds.
The ratings above were unchanged from the disclosure in the Company’s Annual Report on Form 10-K for 2005. In April 2006, all three of the rating agencies affirmed their debt ratings as they assigned a rating to the Senior Notes due 2016.
Market Value Risk
Market value risk, the Company’s primary market risk exposure, is the risk that the Company’s invested assets will decrease in value. This decrease in value may be due to (1) a change in the yields realized on the Company’s assets and prevailing market yields for similar assets, (2) an unfavorable change in the liquidity of the investment, (3) an unfavorable change in the financial prospects of the issuer of the investment, or (4) a downgrade in the credit rating of the issuer of the investment. See also “Results of Operations for the Three Years Ended December 31, 2006 - Net Realized Investment Gains and Losses”.
Significant changes in interest rates expose the Company to the risk of experiencing losses or earning a reduced level of income based on the difference between the interest rates earned on the Company’s investments and the credited interest rates on the Company’s insurance liabilities. See also “Results of Operations for the Three Years Ended December 31, 2006 - Interest Credited to Policyholders”.
The Company seeks to manage its market value risk by coordinating the projected cash inflows of assets with the projected cash outflows of liabilities. For all its assets and liabilities, the Company seeks to maintain reasonable durations, consistent with the maximization of income without sacrificing investment quality, while providing for liquidity and diversification. The investment risk associated with variable annuity deposits and the underlying mutual funds is assumed by those contractholders, and not by the Company. Certain fees that the Company earns from variable annuity deposits are based on the market value of the funds deposited.
Through active investment management, the Company invests available funds with the objective of funding future obligations to policyholders, subject to appropriate risk considerations, and maximizing shareholder value. This objective is met through investments that (1) have similar characteristics to the liabilities they support; (2) are diversified among industries, issuers and geographic locations; and (3) are predominately investment-grade fixed maturity securities classified as available for sale. No derivatives are used to manage the exposure to interest rate risk in the investment portfolios. At December 31, 2006, approximately 20% of the fixed investment portfolio represented investments supporting the property and casualty operations and approximately 80% supported the life and annuity business. For discussions regarding the Company’s investments see “Results of Operations for the Three Years Ended December 31, 2006 - Net Realized Investment Gains and Losses” and “Business - Investments”.
The Company’s life and annuity earnings are affected by the spreads between interest yields on investments and rates credited or accruing on life and fixed annuity insurance liabilities. Although substantially all credited rates on fixed annuities may be changed annually (subject to minimum guaranteed rates), competitive pricing and other factors, including the impact on the level of surrenders and withdrawals, may limit the Company’s ability to adjust or to maintain crediting rates at levels necessary to avoid narrowing of spreads under certain market conditions. See also “Results of Operations for the Three Years Ended December 31, 2006 - Interest Credited to Policyholders”.
Using financial modeling and other techniques, the Company regularly evaluates the appropriateness of investments relative to the characteristics of the liabilities that they support. Simulations of cash flows generated from existing business under various interest rate scenarios measure the potential gain or loss in fair value of interest-rate sensitive assets and liabilities. Such estimates are used to closely match the duration of assets to the duration of liabilities. The overall duration of liabilities of the Company’s multiline insurance operations combines the characteristics of its long duration interest-sensitive life and annuity liabilities with its short duration non-interest-sensitive property and casualty liabilities. Overall, at December 31, 2006, the duration of both the fixed income securities portfolio and the Company’s insurance liabilities was estimated to be approximately 5 years.
The life and annuity operations participate in the cash flow testing procedures imposed by statutory insurance regulations, the purpose of which is to insure that such liabilities are adequate to meet the Company’s obligations under a variety of interest rate scenarios. Based on these procedures, the Company’s assets and the investment income expected to be received on such assets are adequate to meet the insurance policy obligations and expenses of the Company’s insurance activities in all but the most extreme circumstances.
The Company periodically evaluates its sensitivity to interest rate risk. Based on commonly used models, the Company projects the impact of interest rate changes, assuming a wide range of factors, including duration and prepayment, on the fair value of assets and liabilities. Fair value is estimated based on the net present value of cash flows or duration estimates. At December 31, 2006, assuming an immediate decrease of 100 basis points in interest rates, the net fair value of the Company’s assets and liabilities would increase by approximately $17 million after tax, or 3% of shareholders’ equity. A 100 basis point increase would decrease the fair value of assets and liabilities by approximately $42 million after tax, or 6% of shareholders’ equity. At December 31, 2005, assuming an immediate decrease of 100 basis points in interest rates, the net fair value of the Company’s assets and liabilities would increase by approximately $17 million after tax, or 3% of shareholders’ equity. A 100 basis point increase would decrease the fair value of assets and liabilities by approximately $31 million after tax, or 5% of shareholders’ equity. In each case, these changes in interest rates assume a parallel shift in the yield curve.
While the Company believes that these assumed market rate changes are reasonably possible, actual results may differ, particularly as a result of any management actions that would be taken to mitigate such hypothetical losses in fair value of shareholders’ equity. Based on the Company’s overall exposure to interest rate risk, the Company believes that these changes in interest rates would not materially affect its consolidated near-term financial position, results of operations or cash flows.
Recent Accounting Changes
SFAS No. 159
In February 2007, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115”. This standard will be effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007, which for the Company will be January 1, 2008. SFAS No. 159 permits all entities to choose to elect, at specified election dates, to measure eligible financial instruments, as defined in SFAS No. 159, at fair value. Changes in unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings at each subsequent reporting date and upfront costs and fees related to those items will be reported in earnings as incurred and not deferred. At adoption, for those financial assets and financial liabilities which management has elected to carry at fair value, an entity shall report the effect of the first remeasurement to fair value as a cumulative-effect adjustment to the opening balance of retained earnings. Management is currently assessing the impact of this SFAS to determine whether it will elect to measure any of its eligible financial assets or financial liabilities at fair value. An election to measure any or all of its eligible financial instruments at fair value could have a material effect on the results of operations or financial position of the Company. In any event, the Company will not be electing to early adopt SFAS No. 159 and, as a result, retrospective application will be prohibited.
The Pension Protection Act of 2006
In the third quarter of 2006, the federal government enacted the Pension Protection Act of 2006 (the “Act”) which changes the manner in which pension funding is determined. The new rules are effective for funding beginning in 2008. Management does not expect the Act to have a material impact on the Company’s funding activity.
The Company’s funding policy for the defined benefit pension plan is to contribute amounts which are actuarially determined to provide the plan with sufficient assets to meet future benefit payments consistent with the funding requirements of federal laws and regulations. There was no minimum funding requirement for the defined benefit pension plan as of December 31, 2006.
The Company’s obligations have not changed as a result of these developments. The pension and other postretirement plans are subject to revision at the discretion of management. Any revisions could result in significant changes to the Company’s pension plan obligations and the obligation to fund the plans.
SFAS No. 157
In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”. This standard will be effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Generally, the provisions of this statement are to be applied prospectively as of the beginning of the fiscal year of adoption. SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. This pronouncement does not require any new fair value measurements. Management is currently assessing the impact of this SFAS but anticipates that its adoption will not have a material effect on the results of operations or financial position of the Company.
FIN 48
In July 2006, the FASB issued FASB Interpretation (“FIN”) No. 48, “Accounting for Uncertainty in Income Taxes”. This standard will be effective as of the beginning of the first fiscal year beginning after December 15, 2006. FIN 48 provides recognition of tax benefits from tax return positions only if it is more likely than not the position will be sustainable, upon examination, on its technical merits and any relevant administrative practices or precedents. The amount of the tax benefit to be recognized is the greatest amount of benefit that is cumulatively greater than 50% likely of being recognized based upon the probabilities of amounts that could be realized upon ultimate settlement. In addition, FIN 48 requires tabular disclosure of beginning and ending balances of unrecognized tax benefits and an evaluation of any possible ultimate settlement in the next 12 months. Based on an evaluation as of December 31, 2006, management believes that implementation of FIN 48 will not have a material effect on the Company’s results of operations or financial position.
SOP 05-1
In October 2005, the American Institute of Certified Public Accountants issued Statement of Position (“SOP”) 05-1, “Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts”. SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs (“DAC”) on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97, “Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments”. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement or rider to a contract, or by the election of a feature or coverage within a contract. This SOP will be effective for internal replacements occurring in fiscal years beginning after December 15, 2006. Management has completed its assessment of the impact of the SOP and has concluded that its adoption will not have a material effect on the results of operations or financial position of the Company.
Other Matters
In 2002, the Company began providing fixed and variable annuity options to Chicago Public School (“CPS”) employees through the CPS 403(b) program. Based on advice of counsel, the Company did not believe that registration with the SEC was required. When it came to light that the issue was not free from doubt, management consulted current counsel and the SEC. As a result of those consultations, the Company registered the CPS group variable annuity product and the CPS Separate Account with the SEC and was notified by the SEC that the registrations were declared effective on October 16, 2006. With the registration complete, the Company is in compliance with applicable law and regulation. At the time of this Annual Report on Form 10-K, management believes that resolution of the matter will not have a material impact on the Company’s results of operations or financial position.
Effects of Inflation and Changes in Interest Rates
The Company’s operating results are affected significantly in at least three ways by changes in interest rates and inflation. First, inflation directly affects property and casualty claims costs. Second, the investment income earned on the Company’s investment portfolio and the fair value of the investment portfolio are related to the yields available in the fixed-income markets. An increase in interest rates will decrease the fair value of the investment portfolio, but will increase investment income as investments mature and proceeds are reinvested at higher rates. Third, as interest rates increase, competitors will typically increase crediting rates on annuity and interest-sensitive life products, and may lower premium rates on property and casualty lines to reflect the higher yields available in the market. The risk of interest rate fluctuation is managed through asset/liability management techniques, including cash flow analysis.
REPORT OF MANAGEMENT RESPONSIBILITY FOR FINANCIAL STATEMENTS
Horace Mann Educators Corporation
The consolidated balance sheets of Horace Mann Educators Corporation and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations and comprehensive income, changes in shareholders’ equity, and cash flows for the years ended December 31, 2006, 2005 and 2004 have been prepared by management, who is responsible for their integrity and reliability. The statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and include some amounts that are based upon management’s best estimates and judgements. Management has discussed with the Audit Committee the quality, not just the acceptability, of the Company’s accounting principles as applied in its financial reporting. The discussions generally included such matters as the consistency of the Company’s accounting policies and their application, and the clarity and completeness of the Company’s consolidated financial statements, which include related disclosures. The financial information contained elsewhere in this Annual Report on Form 10-K is consistent with that contained in the consolidated financial statements.
Management is responsible for establishing and maintaining a system of internal control designed to provide reasonable assurance as to the integrity and reliability of financial reporting. The concept of reasonable assurance is based on the recognition that there are inherent limitations in all systems of internal control, and that the cost of such systems should not exceed the benefits derived therefrom. A professional staff of internal auditors reviews on an ongoing basis the related internal control system design, the accounting policies and procedures supporting this system and compliance therewith. Management believes this system of internal control effectively meets its objective of reliable financial reporting. See also “Management’s Report on Internal Control Over Financial Reporting” included in “Item 9A. Controls and Procedures” listed in the Index to this Annual Report on Form 10-K.
In connection with their annual audits, the independent registered public accounting firm performs an audit, in accordance with the standards of the Public Company Accounting Oversight Board (United States), which includes the consideration of the system of internal control to the extent necessary to form an independent opinion on the fairness of presentation of the consolidated financial statements prepared by management.
The Board of Directors, through its Audit Committee composed solely of independent directors, is responsible for overseeing the integrity and reliability of the Company’s accounting and financial reporting practices and the effectiveness of its system of internal controls. The independent registered public accounting firm and internal auditors meet regularly with this committee, and have access to this committee with and without management present, to discuss the results of their audit work.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Shareholders
Horace Mann Educators Corporation:
We have audited the accompanying consolidated balance sheets of Horace Mann Educators Corporation and subsidiaries (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of operations and comprehensive income, changes in shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2006. In connection with our audits of the consolidated financial statements, we also have audited financial statement schedules I to IV and VI. These consolidated financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2006 and 2005, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, the Company adopted the fair value method of accounting for stock-based compensation as required by Statement of Financial Accounting Standards No. 123 (R), Share-Based Payment, effective January 1, 2006. As discussed in Note 9 to the consolidated financial statements, the Company adopted the recognition and disclosure provisions of Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, as of December 31, 2006.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 28, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
KPMG LLP
Chicago, Illinois
February 28, 2007
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED BALANCE SHEETS
As of December 31, 2006 and 2005
(Dollars in thousands)
See accompanying notes to consolidated financial statements.
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME
(Dollars in thousands, except per share data)
See accompanying notes to consolidated financial statements.
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(Dollars in thousands, except per share data)
See accompanying notes to consolidated financial statements.
HORACE MANN EDUCATORS CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
See accompanying notes to consolidated financial statements.
HORACE MANN EDUCATORS CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
NOTE 1 - Summary of Significant Accounting Policies
Basis of Presentation
The accompanying consolidated financial statements have been prepared in accordance with United States (“U.S.”) generally accepted accounting principles (“GAAP”) and with the rules and regulations of the Securities and Exchange Commission (“SEC”). The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The consolidated financial statements include the accounts of Horace Mann Educators Corporation and its wholly-owned subsidiaries (“HMEC”; and together with its subsidiaries, the “Company” or “Horace Mann”). HMEC and its subsidiaries have common management, share office facilities and are parties to several intercompany service agreements for management, administrative, data processing, agent commissions, agency services, utilization of personnel and investment advisory services. Under these agreements, costs have been allocated among the companies in conformity with GAAP consistently applied. In addition, certain of the subsidiaries have entered into intercompany reinsurance agreements. HMEC and its subsidiaries file a consolidated federal income tax return, and there are related tax sharing agreements. The tax sharing agreements provide that tax on income is charged to the subsidiaries as if they were filing separate federal income tax returns and the subsidiaries receive the benefits of any losses or tax credits to the extent utilized in the consolidated return. All significant intercompany balances and transactions have been eliminated in consolidation.
The subsidiaries of HMEC market and underwrite tax-qualified retirement annuities and private passenger automobile, homeowners, and life insurance products, primarily to educators and other employees of public schools and their families. The Company’s principal operating subsidiaries are Horace Mann Life Insurance Company, Horace Mann Insurance Company, Teachers Insurance Company, Horace Mann Property & Casualty Insurance Company and Horace Mann Lloyds.
Investments
The Company invests primarily in fixed maturity investments. These securities are classified as available for sale and carried at fair value. The net adjustment for unrealized gains and losses on securities available for sale, carried at fair value, is recorded as a separate component of shareholders’ equity, net of applicable deferred tax asset or liability and the related impact on deferred policy acquisition costs and value of acquired insurance in force associated with interest-sensitive life and annuity contracts.
NOTE 1 - Summary of Significant Accounting Policies-(Continued)
Short-term and other investments are comprised of policy loans, carried at unpaid principal balances; short-term fixed interest securities, carried at cost which approximates fair value; mortgage loans, carried at unpaid principal less a valuation allowance for estimated uncollectible amounts; and equity securities, carried at fair value.
Interest income is recognized as earned. Investment income reflects amortization of premiums and accrual of discounts on an effective-yield basis.
Realized gains and losses arising from the sale or impairment of securities are determined based upon specific identification of securities. The Company reviews the fair value of all investments in its portfolio on a monthly basis to assess whether an other-than-temporary decline in value has occurred. These reviews, in conjunction with the Company’s investment managers’ monthly credit reports and relevant factors such as (1) the financial condition and near-term prospects of the issuer, (2) the Company’s ability and intent to retain the investment long enough to allow for the anticipated recovery in fair value, (3) the stock price trend of the issuer, (4) the market leadership position of the issuer, (5) the debt ratings of the issuer and (6) the cash flows of the issuer, are all considered in the impairment assessment. A write-down of an investment is recorded when a decline in the fair value of that investment is deemed to be other-than-temporary, with a realized investment loss charged to income for the period.
The Company’s methodology of assessing other-than-temporary impairments is based on security-specific facts and circumstances as of the date of the reporting period. Based on these facts, if management believes it is probable that amounts due will not be collected according to the contractual terms of a debt security not impaired at acquisition, or if the Company does not have the ability and intent to hold a security with an unrealized loss until it matures or recovers in value, an other-than-temporary impairment shall be considered to have occurred. As a general rule, if the fair value of a debt security has fallen below 80% of book value for more than six months, this security will be reviewed for an other-than-temporary impairment. Additionally, if events become known that call into question whether the security issuer has the ability to honor its contractual commitments, whether or not such security has been trading above an 80% fair value to book value relationship, such security holding will be evaluated to determine whether or not such security has suffered an other-than-temporary decline in value.
A decline in fair value below amortized cost is not assumed to be other-than-temporary for fixed maturity investments with unrealized losses due to market conditions or industry-related events where there exists a reasonable expectation that fair value will recover versus historical cost and the Company has the intent and ability to hold the investment until maturity or a market recovery is realized. Management believes that its intent and ability to hold a fixed maturity investment with a continuous material unrealized loss due to market conditions or industry-related events for a period of time sufficient to allow a market recovery or to maturity is a decisive factor when considering an impairment loss. In the event that the Company’s intent or ability to hold a fixed maturity investment with a continuous unrealized loss for a period of time sufficient to allow a market recovery or to maturity were to change, an evaluation for other-than-temporary impairment is performed. An other-than-temporary impairment loss will be recognized based upon all relevant facts and circumstances for each investment, as appropriate, in accordance with Securities and Exchange Commission Staff Accounting Bulletin (“SAB”) No. 59, “Accounting for Non-Current Marketable Equity Securities”, and Financial Accounting Standards Board (“FASB”) Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities”, and related guidance.
NOTE 1 - Summary of Significant Accounting Policies-(Continued)
Deferred Policy Acquisition Costs
Policy acquisition costs, consisting of commissions, policy issuance and other costs, which vary with and are primarily related to the production of business, are capitalized and amortized on a basis consistent with the type of insurance coverage. Capitalized acquisition costs for interest-sensitive life contracts are amortized over 20 years in proportion to estimated gross profits. For other individual life contracts, acquisition costs are amortized in proportion to anticipated premiums over the terms of the insurance policies (10, 15, 20 and 30 years). For all investment (annuity) contracts, acquisition costs are amortized over 20 years in proportion to estimated gross profits. For property and casualty policies, acquisition costs are amortized over the terms of the insurance policies (six and twelve months). The Company periodically reviews the assumptions and estimates used in capitalizing policy acquisition costs and also periodically reviews its estimations of gross profits. The most significant assumptions that are involved in the estimation of annuity gross profits include interest rate spreads, future financial market performance, business surrender/lapse rates, expenses and the impact of realized investment gains and losses. In the event actual experience differs significantly from assumptions or assumptions are significantly revised, the Company may be required to record a material charge or credit to amortization expense for the period in which the adjustment is made.
Deferred policy acquisition costs for interest-sensitive life and investment contracts are adjusted for the impact on estimated future gross profits as if net unrealized investment gains and losses had been realized at the balance sheet date. The impact of this adjustment is included in net unrealized gains and losses within shareholders’ equity.
Deferred policy acquisition costs are reviewed for recoverability from future income, including investment income, and costs which are deemed unrecoverable are expensed in the period in which the determination is made. No such costs have been deemed unrecoverable during the periods reported.
Value of Acquired Insurance In Force and Goodwill
When the Company was acquired in 1989, intangible assets were recorded in the application of purchase accounting to recognize the value of acquired insurance in force and goodwill. In addition, goodwill was recorded in 1994 related to the purchase of Horace Mann Property & Casualty Insurance Company. The value of acquired insurance in force is being amortized over the following periods, utilizing the indicated methods for life and annuity, respectively, as follows: 20 years, in proportion to coverage provided; 20 years, in proportion to estimated gross profits.
NOTE 1 - Summary of Significant Accounting Policies-(Continued)
Effective January 1, 2002, the Company adopted SFAS No. 142, “Goodwill and Other Intangible Assets”. The Company’s value of acquired insurance in force is an intangible asset with a definite life and will continue to be amortized under the provisions of SFAS No. 142. Goodwill will remain on the consolidated balance sheet and will not be amortized. SFAS No. 142 established a new method of testing goodwill for impairment. On an annual basis, and when there is reason to suspect that its value may have been diminished or impaired, the goodwill asset must be tested for impairment. The amount of goodwill determined to be impaired will be expensed to current operations. During each year from 2002 through 2006, the Company completed the required testing under SFAS No. 142; no impairment charges were necessary as a result of such assessments.
The allocation of goodwill by segment is as follows:
For the amortization of the value of acquired insurance in force, the Company periodically reviews its estimates of gross profits. The most significant assumptions that are involved in the estimation of gross profits include future financial market performance, interest rate spreads, business surrender/lapse rates and the impact of realized investment gains and losses. In the event actual experience differs significantly from assumptions or assumptions are significantly revised, the Company may be required to record a material charge or credit to amortization expense for the period in which the adjustment is made.
The value of acquired insurance in force for investment contracts is adjusted for the impact on estimated future gross profits as if net unrealized investment gains and losses had been realized at the balance sheet date. The impact of this adjustment is included in net unrealized gains and losses within shareholders’ equity.
The balances of value of acquired insurance in force by segment at December 31, 2006 and 2005 were as follows:
NOTE 1 - Summary of Significant Accounting Policies-(Continued)
Expected amortization of the December 31, 2006 balances of value of acquired insurance in force by segment over the next five years is as follows:
The amount of interest accrued on the unamortized balance of value of acquired insurance in force and the interest accrual rates were as follows:
The accumulated amortization of intangibles as of December 31, 2006 and 2005 was $174,345 and $168,267, respectively.
Property and Equipment
Property and equipment are carried at cost less accumulated depreciation and are included in Other Assets in the Consolidated Balance Sheets. Depreciation and amortization are calculated on the straight-line method based on the estimated useful lives of the assets. The estimated useful lives of property and equipment by asset type are generally as follows: real estate, identified by specific property, 20-45 years; furniture, 10 years; telephones, 5 years; vehicles, 4 years; and data processing hardware and software and personal computers, 2 to 5 years.
Separate Accounts (Variable Annuity) Assets and Liabilities
Separate account (variable annuity) assets, carried at fair value, and liabilities represent variable annuity funds invested in various mutual funds. The investment income, gains and losses of these accounts accrue directly to the policyholders and are not included in the operations of the Company.
NOTE 1 - Summary of Significant Accounting Policies-(Continued)
Future Policy Benefits, Interest-sensitive Life Contract Liabilities and Annuity Contract Liabilities
Liabilities for future benefits on life and annuity policies are established in amounts adequate to meet the estimated future obligations on policies in force. Liabilities for future policy benefits on certain life insurance policies are computed using the net level premium method and are based on assumptions as to future investment yield, mortality and withdrawals. As a result of the application of purchase accounting, future policy benefits for direct individual life insurance policies issued through August 29, 1989 were revalued using interest rates of 9% graded to 8% over 10 years. For policies issued from August 30, 1989 through December 31, 1992, future policy benefits are computed using an interest rate of 6.5%. An interest rate of 5.5% is used to compute future policy benefits for policies issued after December 31, 1992. The Life by Design product portfolio introduced in February 2006 uses an interest rate of 5% for future policy benefits. Mortality and withdrawal assumptions for all policies have been based on actuarial tables which are consistent with the Company’s own experience. Liabilities for future benefits on annuity contracts and certain long-duration life insurance contracts are carried at accumulated policyholder values without reduction for potential surrender or withdrawal charges. The liability also includes provisions for the unearned portion of certain policy charges.
A guaranteed minimum death benefit (“GMDB”) generally provides a benefit if the annuitant dies and the contract value is less than a contractually defined amount. The Company has established a GMDB reserve on variable annuity contracts. Contractually defined amounts vary from contract to contract based on the date the contract was entered into as well as the GMDB feature elected by the contractholder. The Company regularly monitors the GMDB reserve considering fluctuations in the financial markets. At December 31, 2006 and 2005, the GMDB reserve was $693 and $705, respectively. The Company has a relatively low exposure to GMDB because approximately 23% of contract values have no guarantee; approximately 71% have only a return of premium guarantee; and approximately 6% have a guarantee of premium roll-up at an annual interest rate of 3% or 5%. The aggregate in-the-money death benefits under the GMDB provision totaled $19,165 and $24,238 at December 31, 2006 and 2005, respectively.
Unpaid Claims and Claim Expenses
Liabilities for property and casualty unpaid claims and claim expenses include provisions for payments to be made on reported claims, claims incurred but not reported and associated settlement expenses. At December 31, 2006, all of the Company’s reserves for property and casualty unpaid claims and claim expenses were carried at the full value of estimated liabilities and were not discounted for interest expected to be earned on reserves. Estimated amounts of salvage and subrogation on unpaid property and casualty claims are deducted from the liability for unpaid claims. Due to the nature of the Company’s personal lines business, the Company has no exposure to claims for toxic waste cleanup, other environmental remediation or asbestos-related illnesses other than claims under homeowners insurance policies for environmentally related items such as mold.
NOTE 1 - Summary of Significant Accounting Policies-(Continued)
Insurance Premiums and Contract Charges Earned
Property and casualty insurance premiums are recognized as revenue ratably over the related contract periods in proportion to the risks insured. The unexpired portions of these property and casualty premiums are recorded as unearned premiums, using the monthly pro rata method.
Premiums and contract charges for interest-sensitive life and annuity contracts consist of charges for the cost of insurance, policy administration and withdrawals. Premiums for long-term traditional life policies are recognized as revenues when due over the premium-paying period. Annuity and interest-sensitive life contract deposits represent funds deposited by policyholders and are not included in the Company’s premiums or contract charges earned.
Stock Based Compensation
The Company grants stock options to executive officers, other employees and directors. The exercise price of the option is equal to the fair market value of the Company’s common stock on the date of grant. Additional information regarding the Company’s stock-based compensation plans is contained in Note 5 - Shareholders’ Equity and Stock Options. Prior to January 1, 2006, the Company accounted for stock option grants using the intrinsic value based method in accordance with Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees”, and accordingly, recognized no compensation expense for the stock option grants which had an exercise price equal to market price on the date of grant resulting in an intrinsic value of $0.
Effective January 1, 2006, the Company adopted SFAS No. 123(R), “Share-Based Payment”, which requires companies to recognize compensation cost for share-based compensation plans, determined based on the fair value at the grant dates. The Company adopted SFAS No. 123(R) using the modified prospective method.
NOTE 1 - Summary of Significant Accounting Policies-(Continued)
Net income and net income per share recognizing the compensation cost of share-based compensation plans were as follows:
(1) There were 17,250 options granted in 2006 having a weighted average grant date fair value of $5.16. The fair market value of options granted was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions: risk-free interest rate of 4.6%; expected dividend yield of 2.2%; expected life of 5.5 years; and expected volatility (based on historical volatility) of 30.5%. The weighted average fair value of nonvested options outstanding on January 1, 2006 was $5.43. Total unrecognized compensation expense relating to the nonvested options outstanding as of December 31, 2006 was approximately $1,600, which will be recognized over the remainder of the vesting period currently scheduled to be completed in May 2010. Expense is reflected on a straight-line basis over the vesting period. The expense amount for the year ended December 31, 2004 also includes the impact of accelerated vesting of outstanding stock options, as described below.
(2) For 2005 and 2004, this represents the pro forma result as if the Company had previously adopted SFAS No. 123, “Accounting for Stock-Based Compensation”.
HMEC’s Board of Directors approved the acceleration of vesting of all outstanding stock options effective June 30, 2004 in an effort to recognize employees’ significant contributions to increasing shareholder value and improving underlying Company operating trends. The Board placed certain restrictions on the transfer of shares obtained by this vesting acceleration for members of the Board of Directors and 10 of HMEC’s key executive officers. At June 30, 2004, the majority of the options vested were out-of-the-money. The accelerated vesting did not have a material effect on the Company’s operating expenses.
Income Taxes
The Company uses the liability method for calculating deferred federal income taxes. Income tax provisions are generally based on income reported for financial statement purposes. The provisions for federal income taxes for the years ended December 31, 2006, 2005 and 2004 include amounts currently payable and deferred income taxes resulting from the cumulative differences in the Company’s assets and liabilities, determined on a tax return versus financial statement basis.
Deferred tax assets and liabilities include provisions for unrealized investment gains and losses as well as the net funded status of pension and other postretirement benefit obligations and minimum pension liability adjustments with the changes for each period included in the respective components of accumulated other comprehensive income (loss) in shareholders’ equity.
NOTE 1 - Summary of Significant Accounting Policies-(Continued)
Earnings Per Share
Basic earnings per share is computed based on the weighted average number of common shares outstanding. Diluted earnings per share is computed based on the weighted average number of common shares and common stock equivalents outstanding, to the extent dilutive. The common stock equivalents relate to outstanding common stock options, Director Stock Plan units, Employee Stock Plan units and Incentive Compensation Plan restricted common stock units. In addition, the Company’s Senior Convertible Notes are common stock equivalents reflecting the implementation of the FASB’s Emerging Issues Task Force (“EITF”) consensus on issue 04-8, “The Effect of Contingently Convertible Instruments on Diluted Earnings per Share”.
The computations of net income per share on both basic and diluted bases, including reconciliations of the numerators and denominators, were as follows:
Options to purchase 2,341,350 shares of common stock at $18.76 to $33.87 per share were granted in 1997 through 2005 but were not included in the computation of 2006 diluted earnings per share because the options’ exercise price was greater than the average market price of the common shares during 2006. The options, which expire in 2007 through 2015, were still outstanding at December 31, 2006.
NOTE 1 - Summary of Significant Accounting Policies-(Continued)
Comprehensive Income
Comprehensive income represents the change in shareholders’ equity during a reporting period from transactions and other events and circumstances from non-shareholder sources. For the Company, comprehensive income is equal to net income plus or minus the change in net unrealized gains and losses on fixed maturities and equity securities, the change in the minimum pension liability adjustment and the change in net funded status of pension and other postretirement benefit obligation for the period as shown in the Statement of Changes in Shareholders’ Equity.
In December 2006, the Company adopted SFAS No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans”. SFAS No. 158 requires the recognition in the balance sheet of the funded status of defined benefit pension plans and other postretirement benefit plans as a component of accumulated other comprehensive income, net of tax.
The components of comprehensive income were as follows:
Statements of Cash Flows
For purposes of the Consolidated Statements of Cash Flows, cash constitutes cash on deposit at banks.
Reclassification
The Company has reclassified the presentation of certain prior period information to conform with the 2006 presentation.
NOTE 2 - Investments
Net Investment Income
The components of net investment income for the following periods were:
Realized Investment Gains (Losses)
Realized investment gains (losses) for the following periods were:
Fixed Maturity Securities (“fixed maturities”)
At December 31, 2006 and 2005, the fair value and gross unrealized losses of investments in debt securities were as follows:
NOTE 2 - Investments-(Continued)
At December 31, 2006, the gross unrealized loss position in the investment portfolio was $43,783 (538 positions and 1% of the investment portfolio). Securities with an investment grade rating represented 96% of the unrealized loss. The largest single unrealized loss was $1,089 on a FNMA mortgage-backed security purchased in June 2003 when interest rates hit 40 year lows. The majority of the unrealized losses were due to changes in interest rates. The portfolio included 350 securities that have been in an unrealized loss position for greater than 12 months, totaling $38,498 (of which $12,920 was from securities purchased in 2003 when interest rates were at record lows). The Company views the decrease in value of all of the securities with unrealized losses at December 31, 2006 as temporary, expects recovery in fair value, anticipates continued payments under the terms of the securities, and has the intent and ability to hold these securities until maturity or a recovery in fair value occurs. Therefore, no impairment of these securities was recorded at December 31, 2006.
The amortized cost, unrealized investment gains and losses, and fair values of fixed maturities as of December 31, 2006 and 2005 were as follows:
(1) Fair value includes securities issued by Federal National Mortgage Association (“FNMA”) of $698,006 and $552,941; Federal Home Loan Mortgage Association (“FHLMA”) of $204,135 and $203,462; and Government National Mortgage Association (“GNMA”) of $31,201 and $33,439 as of December 31, 2006 and 2005, respectively.
The Company’s investment portfolio includes no derivative financial instruments (futures, forwards, swaps, option contracts or other financial instruments with similar characteristics).
NOTE 2 - Investments-(Continued)
Maturities/Sales Of Investments
The amortized cost and fair value of fixed maturities at December 31, 2006, by estimated expected maturity, are shown below. Estimated expected maturities differ from contractual maturities reflecting assumptions regarding borrowers’ utilization of the right to call or prepay obligations with or without call or prepayment penalties. Estimated expected maturities consider broker dealer survey values and are verified for consistency with the interest rate and economic environments.
The average option-adjusted duration for the Company’s fixed maturities portfolio was 5.4 years at December 31, 2006.
Proceeds from sales/maturities of fixed maturities and gross gains and gross losses realized for each year were:
Unrealized Gains (Losses) on Fixed Maturities
Net unrealized gains are computed as the difference between fair value and amortized cost for fixed maturities. A summary of the net increase in unrealized investment gains on fixed maturities, less applicable income taxes, is as follows:
NOTE 2 - Investments-(Continued)
Securities Lending
The Company loans fixed income securities to third parties, primarily major brokerage firms. As of December 31, 2006 and 2005, fixed maturities with a fair value of $289,524 and $189,851, respectively, were on loan. Loans of securities are required at all times to be secured by collateral from borrowers at least equal to 100% of the market value of the securities loaned. The Company maintains effective control over the loaned securities and therefore reports them as Fixed Maturity Securities in the Consolidated Balance Sheets. Securities lending collateral is classified as short-term investments with a corresponding liability in the Company’s Consolidated Balance Sheets.
Investment in Entities Exceeding 10% of Shareholders’ Equity
At December 31, 2006 and 2005, there were no investments which exceeded 10% of total shareholders’ equity in entities other than obligations of the U.S. Government and federally sponsored government agencies and authorities.
Deposits
At December 31, 2006, securities with a carrying value of $16,240 were on deposit with governmental agencies as required by law in various states in which the insurance subsidiaries of HMEC conduct business.
NOTE 3 - Property and Casualty Unpaid Claims and Claim Expenses
The following table sets forth an analysis of property and casualty unpaid claims and claim expenses and provides a reconciliation of beginning and ending reserves for the periods indicated.
(1) Reserves net of anticipated reinsurance recoverables.
(2) Shows the amounts by which the Company increased or decreased its reserves in each of the periods indicated for claims occurring in previous periods to reflect subsequent information on such claims and changes in their projected final settlement costs. Also refer to the paragraphs below for additional information regarding the reserve development recorded in 2006, 2005 and 2004.
(3) Benefits, claims and settlement expenses as reported in the Consolidated Statements of Operations also include life, annuity, group accident and health and corporate amounts of $48,105, $44,695 and $45,144 for the years ended December 31, 2006, 2005 and 2004, respectively, in addition to the property and casualty amounts.
(4) Unpaid claims and claim expenses as reported in the Consolidated Balance Sheets also include life, annuity, and group accident and health reserves of $8,931, $8,100 and $7,445 at December 31, 2006, 2005 and 2004, respectively, in addition to property and casualty reserves.
Underwriting results of the property and casualty segment are significantly influenced by estimates of the Company’s ultimate liability for insured events. There is a high degree of uncertainty inherent in the estimates of ultimate losses underlying the liability for unpaid claims and claim settlement expenses. This inherent uncertainty is particularly significant for liability-related exposures due to the extended period, often many years, that transpires between a loss event, receipt of related claims data from policyholders and ultimate settlement of the claim. Reserves for property and casualty claims include provisions for payments to be made on reported claims (“case reserves”), claims incurred but not yet reported (“IBNR”) and associated settlement expenses (together “loss reserves”). The process by which these reserves are established requires reliance upon estimates based on known facts and on interpretations of circumstances, including the Company’s experience with similar cases and historical trends involving claim payments and related patterns, pending levels of unpaid claims and product mix, as well as other factors including court decisions, economic conditions and public attitudes.
NOTE 3 - Property and Casualty Unpaid Claims and Claim Expenses-(Continued)
The Company believes the property and casualty loss reserves are appropriately established based on available facts, laws, and regulations. The Company calculates and records a single best reserve estimate as of each balance sheet date, in conformity with generally accepted actuarial standards, for each line of business and its components (coverages and perils) for reported losses and for IBNR losses and as a result believes no other estimate is better than the recorded amount. Due to uncertainties involved, the ultimate cost of losses may vary materially from recorded amounts.
The Company continually updates loss estimates using both quantitative and qualitative information from its reserving actuaries and information derived from other sources. Adjustments may be required as information develops which varies from experience, or, in some cases, augments data which previously were not considered sufficient for use in determining liabilities. The effects of these adjustments may be significant and are charged or credited to income for the period in which the adjustments are made.
Numerous risk factors will affect more than one product line. One of these factors is changes in claim department practices, including claim closure rates, number of claims closed without payment, the use of outside claims adjusters and the level of needed case reserve estimated by the adjuster. Other risk factors include changes in claim frequency, changes in claim severity, regulatory and legislative actions, court actions, changes in economic conditions and trends (e.g. medical costs, labor rates and the cost of materials), the occurrence of unusually large or frequent catastrophic loss events, timeliness of claim reporting, the state in which the claim occurred and degree of claimant fraud. The extent of the impact of a risk factor will also vary by coverages within a product line. Individual risk factors are also subject to interactions with other risk factors within product line coverages.
While all product lines are exposed to these risks, there are some loss types or product lines for which the financial effect will be more significant. For instance, the use of outside adjusters for large catastrophe losses adds a level of risk to this loss type not present when employee adjusters handle claims. Also, given the relatively large proportion (approximately 70% at December 31, 2006) of the Company’s reserves that are in the longer-tail automobile liability coverages, regulatory and court actions and changes in economic conditions and trends could be expected to impact this product line more extensively than others.
Reserves are established for claims as they occur for each line of business based on estimates of the ultimate cost to settle the claims. The actual loss results are compared to prior estimates and differences are recorded as reestimates. The primary actuarial techniques (development of paid loss dollars, development of reported loss dollars, methods based on expected loss ratios and methods utilizing frequency and severity of claims) used to estimate reserves and provide for losses are applied to actual paid losses and reported losses (paid losses plus individual case reserves set by claim adjusters) for an accident year or a calendar year to create an estimate of how losses are likely to develop over time. An accident year refers to classifying claims based on the year in which the claim occurred. A calendar year refers to classifying claims based on the year in which the claims are reported. Both classifications are used to prepare estimates of required reserves for payments to be made in the future. For estimating short-tail coverage reserves (e.g. homeowners and automobile physical damage), which comprise approximately 30% of the Company’s total loss reserves at December 31, 2006, the primary actuarial technique utilized is the development of paid loss dollars due to the
NOTE 3 - Property and Casualty Unpaid Claims and Claim Expenses-(Continued)
relatively quick claim settlement period. As it relates to estimating long-tail coverage reserves (e.g. automobile liability), which comprise approximately 70% of the Company’s total loss reserves at December 31, 2006, the primary actuarial technique utilized is the development of reported loss dollars due to the relatively long claim settlement period.
In all of the loss estimation techniques referred to above, a ratio (development factor) is calculated which compares current results to results in the prior period for each accident year. Various development factors, based on historical results, are multiplied by the current experience to estimate the development of losses of each accident year from the current time period into the next time period. The development factors for the next time period for each accident year are compounded over the remaining calendar years to calculate an estimate of ultimate losses for each accident year. Occasionally, unusual aberrations in loss patterns are caused by factors such as changes in claim reporting, settlement patterns, unusually large losses, process changes, legal or regulatory environment changes, and other influences. In these instances, analyses of alternate development factor selections are performed to evaluate the effect of these factors, and actuarial judgment is applied to make appropriate development factor assumptions needed to develop a best estimate of ultimate losses. Paid losses are then subtracted from estimated ultimate losses to determine the indicated loss reserves. The difference between indicated reserves and recorded reserves is the amount of reserve reestimate.
Reserves are reestimated quarterly. When new development factors are calculated from actual losses, and they differ from estimated development factors used in previous reserve estimates, assumptions about losses and required reserves are revised based on the new development factors. Changes to reserves are recorded in the period in which development factor changes result in reserve reestimates.
Numerous actuarial estimates of the types described above are prepared each quarter to monitor losses for each line of business (coverages and perils) and for reported losses and IBNR. Often, several different estimates are prepared for each detailed component, incorporating alternative analyses of changing claim settlement patterns and other influences on losses, from which the Company selects the best estimate for each component, occasionally incorporating additional analyses and actuarial judgment, as described above. These estimates also incorporate the historical impact of inflation into reserve estimates, the implicit assumption being that a multi-year average development factor represents an adequate provision. Based on the Company’s review of these estimates, as well as the review of the independent reserve studies, the best estimate of required reserves for each line of business and its components (coverages and perils) is determined by management and is recorded for each accident year, and the required reserves for each component are summed to create the reserve balances carried on the accompanying consolidated balance sheets.
Based on the Company’s products and coverages, historical experience, and modeling of various actuarial methodologies used to develop reserve estimates, the Company estimates that the potential variability of the property and casualty loss reserves, excluding the unprecedented hurricane losses experienced in 2005 and 2004, within a reasonable probability of other possible outcomes, may be approximately plus or minus 6%, or plus or minus approximately $12 million in net income. Although this evaluation reflects the most likely outcomes, it is possible the final outcome may fall below or above these estimates.
NOTE 3 - Property and Casualty Unpaid Claims and Claim Expenses-(Continued)
Net favorable development of total reserves for property and casualty claims occurring in prior years was $19,210 in 2006 reflecting emergence of favorable claim trends, primarily for accident years 2005 and 2004, for the voluntary automobile line of business related primarily to claim frequencies, which were more favorable than previously estimated. Net favorable development of total reserves for property and casualty claims occurring in prior years was $13,100 in 2005 reflecting favorable loss emergence trends in both the voluntary automobile and property lines of business. The favorable loss emergence trends included claim frequencies which were more favorable than previously estimated as well as declining claim severities which were the result of improved claims handling processes. Net adverse development of total reserves for property and casualty claims occurring in prior years was $3,815 in 2004 reflecting additional information related to a single liability claim that occurred over 15 years ago.
The Company completes a detailed study of property and casualty reserves based on information available at the end of each quarter and year. Trends of reported losses (paid amounts and case reserves on claims reported to the Company) for each accident year are reviewed and ultimate loss costs for those accident years are estimated. For 2001 through 2005, the Company engaged an independent property and casualty actuarial consulting firm to prepare an independent study of the Company’s property and casualty reserves at June 30 and December 31 of each year. Beginning in 2006, the independent actuarial consulting firm prepares an independent study of reserves at December 31, supplemented by other analyses throughout the year. The result of the independent actuarial study at December 31, 2006 was consistent with management’s analyses and selected estimates and did not result in any adjustments to the Company’s recorded property and casualty reserves.
Based on an assessment of the relative weight given to emerging trends resulting from recent business process changes, pricing, underwriting and claims handling, at both December 31, 2006 and 2005 the Company recorded property and casualty reserves toward the higher end (upper quartile) of a reasonable range of reserve estimates, due primarily to reserves related to the automobile liability coverages.
At the time each of the reserve analyses were performed, the Company believed that each estimate was based upon sound and correct methodology and such methodology was appropriately applied and that there were no trends which indicated the likelihood of future loss reserve development. The financial impact of the net reserve development was therefore accounted for in the period that the development was determined.
No other unusual adjustments were made in the determination of the liabilities during the periods covered by these consolidated financial statements. Management believes that, based on data currently available, it has reasonably estimated the Company’s ultimate losses.
NOTE 4 - Debt
Indebtedness and scheduled maturities at December 31, 2006 and 2005 consisted of the following:
Credit Agreement with Financial Institutions (“Bank Credit Facility”)
On May 31, 2005, HMEC entered into a new Bank Credit Agreement (the “Current Bank Credit Facility”). Effective December 19, 2006, the Current Bank Credit Facility agreement was amended and restated to 1) extend the commitment termination date to December 19, 2011 from the previous termination date of May 30, 2009, 2) increase the commitment amount to $125,000 from the previous limit of $100,000, 3) decrease the interest rate spread relative to Eurodollar base rates, and 4) decrease the variable commitment fee on the unused portion of the Current Bank Credit Facility by 5 basis points. Interest accrues at varying spreads relative to corporate or Eurodollar base rates and is payable monthly or quarterly depending on the applicable base rate. The unused portion of the Current Bank Credit Facility is subject to a variable commitment fee, which was 0.125% on an annual basis at December 31, 2006. In March and April 2006, the Company borrowed a total of $74,000 and subsequently repaid this balance in full on April 21, 2006, utilizing a portion of the proceeds from the issuance of the Senior Notes due 2016, described below. On May 31, 2005, the Company borrowed $25,000 and subsequently repaid this balance in full on June 13, 2005, utilizing a portion of the proceeds from the issuance of the Senior Notes due 2015, described below.
On May 29, 2002, HMEC entered into a Bank Credit Agreement that was amended effective June 1, 2004, increasing the commitment amount to $35,000, and May 3, 2005, extending the commitment termination date to June 30, 2005 from the previous termination date of May 31, 2005 (the “Previous Bank Credit Agreement”). The Previous Bank Credit Agreement was terminated on May 31, 2005, when the Company entered into the Current Bank Credit Facility. The $25,000 balance outstanding under the Previous Bank Credit Agreement was repaid in full on May 31, 2005, utilizing the borrowing under the Current Bank Credit Facility, described above.
NOTE 4 - Debt-(Continued)
1.425% Senior Convertible Notes (“Senior Convertible Notes”)
On May 14, 2002, the Company issued $353,500 aggregate principal amount of 1.425% senior convertible notes due in 2032 at a discount of 52.5% resulting in an effective yield of 3.0%. In 2002, the Company repurchased $53,000 aggregate principal amount, $25,175 carrying value, of the outstanding Senior Convertible Notes at an aggregate cost of $22,770. In addition to these cash transactions, in December 2002 the Company repurchased an additional $56,000 aggregate principal amount, $26,600 carrying value, of the outstanding Senior Convertible Notes at an aggregate cost of $25,984 in a non-cash transaction. As consideration for this repurchase, 1,837,925 shares of HMEC’s common stock were issued. In March, April and July 2006, the Company repurchased $175,947 aggregate principal amount, $83,575 carrying value, of the outstanding Senior Convertible Notes at an aggregate cost of $82,846. The March and April 2006 repurchases were initially funded utilizing the Company’s Bank Credit Facility and the July 2006 repurchase was funded with a portion of the cash proceeds from the issuance of the Senior Notes due 2016. As of December 31, 2006 and 2005, HMEC held $231,947 and $56,000, respectively, aggregate principal amount of its Senior Convertible Notes in brokerage accounts which could be reissued by the Company.
Interest on the Senior Convertible Notes is payable semi-annually at a rate of 1.425% beginning November 14, 2002 until May 14, 2007. After that date, cash interest will not be paid on the Senior Convertible Notes prior to maturity unless contingent cash interest becomes payable. From May 15, 2007 through maturity of the Senior Convertible Notes, interest will be recognized at the effective rate of 3.0% and will represent the accrual of discount, excluding any contingent cash interest that may become payable. Contingent cash interest becomes payable if the average market price of a Senior Convertible Note for a five trading day measurement period preceding the applicable six-month period equals 120% or more of the sum of the Senior Convertible Note’s issue price, accrued original issue discount and accrued cash interest, if any, for such Senior Convertible Note. The contingent cash interest payable per Senior Convertible Note with respect to any quarterly period within any six-month period will equal the then applicable conversion rate multiplied by the greater of (i) $0.105 or (ii) any regular cash dividends paid by the Company per share on HMEC’s common stock during that quarterly period.
The Senior Convertible Notes will be convertible at the option of the holders into shares of HMEC’s common stock at a conversion price of $26.74 if the conditions for conversion are satisfied. The Senior Convertible Notes outstanding at December 31, 2006 are potentially convertible into 1,217,707 shares (17.763 shares per $1 thousand face amount) and with the implementation of EITF Consensus No. 04-8 these shares are included in the calculation of diluted earnings per share to the extent dilutive. The Company may elect to pay holders surrendering notes cash or a combination of cash and shares of HMEC’s common stock for the notes surrendered. Holders may also surrender Senior Convertible Notes for conversion during any period in which the credit rating assigned to the Senior Convertible Notes is Ba2 or lower by Moody’s or BB+ or lower by S&P, the Senior Convertible Notes are no longer rated by either Moody’s or S&P, or the credit rating assigned to the Senior Convertible Notes has been suspended or withdrawn by either Moody’s or S&P. The Senior Convertible Notes will cease to be convertible pursuant to this credit rating criteria during any period or periods in which all of the credit ratings are increased above such levels. The Senior Convertible Notes are redeemable by HMEC in whole or in part, at any time on or after May 14, 2007, at redemption prices equal to the sum of the issue price plus accrued original issue discount and accrued cash interest, if any, on
NOTE 4 - Debt-(Continued)
the applicable redemption date. The holders of the Senior Convertible Notes may require HMEC to purchase all or a portion of their Senior Convertible Notes on either May 14, 2007, 2012, 2017, 2022, or 2027 at stated prices plus accrued cash interest, if any, to the purchase date. HMEC may pay the purchase price in cash or shares of HMEC common stock or in a combination of cash and shares of HMEC common stock.
As of the date of this Annual Report on Form 10-K, management intends to redeem all of its outstanding Senior Convertible Notes on May 14, 2007 utilizing available excess proceeds from the 2006 issuance of the Senior Notes due 2016.
6.05% Senior Notes due 2015 (“Senior Notes due 2015”)
On June 9, 2005, the Company issued $75,000 aggregate principal amount of senior notes at an effective yield of 6.1%, which will mature on June 15, 2015. Interest on the Senior Notes due 2015 is payable semi-annually at a rate of 6.05%. The Senior Notes due 2015 are redeemable in whole or in part, at any time, at the Company’s option, at a redemption price equal to the greater of (1) 100% of their principal amount or (2) the sum of the present values of the remaining scheduled payments of principal and interest thereon discounted, on a semi-annual basis, at the Treasury yield (as defined in the indenture) plus 30 basis points, plus, in either of the above cases, accrued interest to the date of redemption.
The net proceeds from the sale of the Senior Notes due 2015 were used to (1) repay the Current Bank Credit Facility, (2) redeem the Senior Notes due 2006, described below, and (3) make a capital contribution to HMEC’s primary life insurance subsidiary to substantially offset the early recapture of the Company’s life reinsurance agreement with the United States branch of Sun Life Assurance Company of Canada.
6.85% Senior Notes due 2016 (“Senior Notes due 2016”)
On April 21, 2006, the Company issued $125,000 aggregate principal amount of 6.85% Senior Notes, which will mature on April 15, 2016, issued at a discount of 0.305% resulting in an effective yield of 6.893%. Interest on the Senior Notes due 2016 is payable semi-annually at a rate of 6.85%. The Senior Notes due 2016 are redeemable in whole or in part, at any time, at the Company’s option, at a redemption price equal to the greater of (1) 100% of the principal amount of the notes being redeemed or (2) the sum of the present values of the remaining scheduled payments of principal and interest thereon discounted, on a semi-annual basis, at the Treasury yield (as defined in the indenture) plus 30 basis points, plus, in either of the above cases, accrued interest to the date of redemption.
A portion of the net proceeds from the issuance of the Senior Notes due 2016 was used to repay in full the $74,000 balance then outstanding on the Bank Credit Facility. As described above, an additional $9,419 of the net proceeds was used in July 2006 for additional repurchases of Senior Convertible Notes. Remaining net proceeds are anticipated by management to be used to redeem the outstanding Senior Convertible Notes on May 14, 2007 and for general corporate purposes.
NOTE 4 - Debt-(Continued)
6 5/8% Senior Notes due 2006 (“Senior Notes due 2006”)
On June 30, 2005, the Company redeemed all of its outstanding Senior Notes due 2006, $28,600 aggregate principal amount, utilizing a portion of the proceeds from the issuance of the Senior Notes due 2015, described above. The aggregate cost of the repurchase was $29,107.
Universal Shelf Registration
To provide additional capital management flexibility, the Company filed a “universal shelf” registration on Form S-3 with the SEC in December 2003. The registration statement, which registers the offer and sale by the Company from time to time of up to $300,000 of various securities, which may include debt securities, preferred stock, common stock and/or depositary shares, was declared effective on December 30, 2003. The $75,000 aggregate principal amount of Senior Notes due 2015 and $125,000 aggregate principal amount of Senior Notes due 2016 were issued utilizing this registration statement. No other securities associated with the registration statement have been issued as of the date of this Annual Report on Form 10-K.
Debt Retirement Gain/Charges
The repurchases of the Senior Convertible Notes during the year ended December 31, 2006 resulted in a pretax gain for the period of $159, which was reported as a component of interest expense for this period.
The repurchase of the Senior Notes due 2006 resulted in a pretax charge to income for the year December 31, 2005 of $507, which was reported as a component of interest expense for this period.
Covenants
The Company is in compliance with all of the financial covenants contained in the Senior Convertible Notes indenture, the Senior Notes due 2015 indenture, the Senior Notes due 2016 indenture and the Bank Credit Facility Agreement, consisting primarily of relationships of (1) debt to capital, (2) insurance subsidiaries’ insurance financial strength ratings issued by A.M. Best Company, Inc. and (3) net worth, as defined in the financial covenants.
NOTE 5 - Shareholders’ Equity and Stock Options
Share Repurchase Program and Treasury Shares Held (Common Stock)
At December 31, 2006, the Company held 17,503,371 shares in treasury. As of December 31, 2006, $96,343 remained authorized for future share repurchases.
Authorization of Preferred Stock
In 1996, the shareholders of HMEC approved authorization of 1,000,000 shares of $0.001 par value preferred stock. The Board of Directors is authorized to (1) direct the issuance of the preferred stock in one or more series, (2) fix the dividend rate, conversion or exchange rights, redemption price and liquidation preference, of any series of the preferred stock, (3) fix the number of shares for any series and (4) increase or decrease the number of shares of any series. No shares of preferred stock were outstanding at December 31, 2006, 2005 and 2004.
Through May 7, 2005, the Company’s catastrophe reinsurance program was augmented by a $75,000 equity put and reinsurance agreement. The equity put provided an option to sell shares of the Company’s convertible preferred stock with a floating rate dividend at a pre-negotiated price in the event losses from catastrophes exceeded the catastrophe reinsurance program coverage limit. Before tax benefits, the equity put provided a source of capital for up to $115,000 of catastrophe losses above the reinsurance coverage limit. The agreement contained certain conditions to Horace Mann’s exercise of the equity put option. Fees related to this equity put option were charged directly to additional paid-in capital.
In connection with the equity put described in the preceding paragraph, the Board of Directors has designated a series of preferred stock. The Series so designated is Series A Cumulative Convertible Preferred Stock (the “Series A Stock”) and 100,000 shares have been assigned to this series. None of these shares are currently issued or outstanding. The Series A Stock is dividend paying, at a floating rate which varies with movements in the London Interbank Offered Rate and with changes in the risk rating of the Series A Stock as determined by Standard & Poor’s Corporation. The Series A Stock does not require any sinking fund or similar mechanism regarding payment of such dividends. Beginning on the fourth anniversary of the issuance of Series A Stock, the holders thereof have the right to demand conversion of the Series A Stock into common stock of the Company at a conversion rate based on then prevailing market prices for the common stock; however, upon receipt of a conversion demand, the Company has the right to redeem the Series A Stock prior to such conversion. The Series A Stock has liquidation rights which place the Series A Stock ahead of the common stock in priority. The Series A Stock has no voting rights other than the requirement that the Series A Stock approve any changes in the Series A Stock, the creation of any other class of stock on a par with or superior to the Series A Stock and certain extraordinary transactions such as certain mergers involving the Company.
NOTE 5 - Shareholders’ Equity and Stock Options-(Continued)
Director Stock Plan
In 1996, the shareholders of HMEC approved the Deferred Equity Compensation Plan (“Director Stock Plan”) for directors of the Company and reserved 600,000 shares for issuance pursuant to the Director Stock Plan. Shares of the Company’s common stock issued under the Director Stock Plan may be either authorized and unissued shares or shares that have been reacquired by the Company. As of December 31, 2006, 2005 and 2004, 214,238, 191,521 and 159,005 units, respectively, were outstanding under this plan representing an equal number of common shares to be issued in the future. The outstanding units accrue dividends at the same rate as dividends paid to HMEC’s shareholders. These dividends are reinvested into additional stock units.
Employee Stock Plan
In 1997, the Board of Directors of HMEC approved the Deferred Compensation Plan for Employees (“Employee Stock Plan”). Shares of the Company’s common stock issued under the Employee Stock Plan may be either authorized and unissued shares or shares that have been reacquired by the Company. As of December 31, 2006, 2005 and 2004, 149,396, 146,218 and 25,310 units, respectively, were outstanding under this plan representing an equal number of common shares to be issued in the future. The Employee Stock Plan allows distributions to be either in common shares or cash. Through December 31, 2006, all distributions under the Employee Stock Plan have been in cash. The outstanding units accrue dividends at the same rate as dividends paid to HMEC’s shareholders. These dividends are reinvested into additional stock units.
Stock Options and Restricted Common Stock Units
The shareholders of HMEC approved the 1991 Stock Incentive Plan (the “1991 Plan”), the 2001 Stock Incentive Plan (the “2001 Plan”), and the 2002 Incentive Compensation Plan and the Amended and Restated 2002 Incentive Compensation Plan (together, the “2002 Plan”) and reserved a total of 9,000,000 shares of common stock for issuance under these plans. Under the 1991 Plan, the 2001 Plan and the 2002 Plan, options to purchase shares of HMEC common stock may be granted to executive officers, other employees and directors. The options become exercisable in installments based on service generally beginning in the first year from the date of grant and generally become fully vested 4 to 5 years from the date of grant. The options generally expire 7 to 10 years from the date of grant. The exercise price of the option is equal to the market price of HMEC’s common stock on the date of grant resulting in a grant date intrinsic value of $0. Shares issued upon exercise of options may be either new shares or treasury shares; however, the Company has historically issued new shares.
Beginning in 2005, restricted common stock units also were issued under the 2002 Plan. As of December 31, 2006 and 2005, 252,867 and 190,157 units, respectively, were outstanding representing an equal number of common shares to be issued in the future. The outstanding units accrue dividends at the same rate as dividends paid to HMEC’s shareholders. These dividends are reinvested into additional stock units.
NOTE 5 - Shareholders’ Equity and Stock Options-(Continued)
Changes in outstanding options and shares available for grant under the 1991 Plan, the 2001 Plan and the 2002 Plan were as follows:
* Common stock shares issuable for the 252,867 restricted common stock units outstanding at December 31, 2006 would also draw on this available for grant balance. The Company’s stock options and restricted common stock units are subject to a common pool of authorized shares.
The weighted average grant date fair values were $5.16, $3.75 and $4.35 for options granted in 2006, 2005 and 2004, respectively. The weighted average prices of vested and exercisable options as of December 31, 2005 and 2004 were $19.05 and $19.01, respectively.
For options outstanding at December 31, 2006, information segregated by ranges of exercise prices was as follows:
As of December 31, 2006, based on a closing stock price of $20.20 per share, the aggregate intrinsic (in-the-money) values of vested options and all options outstanding were $6,987 and $7,590, respectively.
NOTE 6 - Income Taxes
The federal income tax assets and liabilities included in Other Assets and Other Liabilities, respectively, in the Consolidated Balance Sheets as of December 31, 2006 and 2005 were as follows:
Deferred tax assets and liabilities are recognized for all future tax consequences attributable to “temporary differences” between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. There are no deferred tax liabilities that have not been recognized. The “temporary differences” that give rise to the deferred tax balances at December 31, 2006 and 2005 were as follows:
Based on the Company’s historical earnings, future expectations of adjusted taxable income, as well as reversing gross deferred tax liabilities, the Company believes it is more likely than not that gross deferred tax assets will be fully realized and that a valuation allowance with respect to the realization of the total gross deferred tax assets is not necessary.
At December 31, 2006, the Company had available the following loss carryforwards and credits:
NOTE 6 - Income Taxes-(Continued)
The components of federal income tax expense (benefit) were as follows:
Income tax expense for the following periods differed from the expected tax computed by applying the federal corporate tax rate of 35% to income before income taxes as follows:
The Company records contingent tax liabilities for exposures from uncertain tax filing positions based upon management’s assessment of the amounts that are probable of being sustained upon Internal Revenue Service audit. These liabilities are reevaluated routinely and are adjusted appropriately, based upon changes in facts or law. The Company has no unrecorded contingent tax exposures.
At December 31, 2006, the Company had federal income tax returns for the 2002 through 2005 tax years still open and subject to adjustment upon IRS examination. The Company has recorded $4,236 of contingent tax liabilities related to those open tax years.
In 2005, the Company recorded reductions in federal income tax expense of $9,176 due to favorable resolution of contingent tax liabilities related to reinsurance premiums and separate account dividends received deductions ($5,567 in the corporate and other segment and $3,609 in the annuity segment) and recorded $1,394 of pretax income representing interest on federal income tax refunds received ($937 in the annuity segment and $457 in the other segments). In April 2005, the Company received refunds for tax years 1996 through 2001 from the IRS totaling $8,087, an amount consistent with the Company’s tax refund accruals related to those years. As a result of the receipt of IRS refunds for tax years 1996 and 1997, which were then deemed to be closed, the contingent tax liability related to those two years was eliminated, which resulted in a decrease in federal income tax expense of $2,734 in the second quarter of 2005. The remaining refunds received related to tax years 1998 through 2001, which were deemed to be closed on September 15, 2005 due to the expiration of the statute of limitations, resulting in an additional reduction in the contingent tax liability related to those four years of $6,442 that was recorded in the third quarter of 2005.
NOTE 7 - Fair Value of Financial Instruments
The Company is required under GAAP to disclose estimated fair values for certain financial instruments. Fair values of the Company’s insurance contracts other than annuity contracts are not required to be disclosed. However, the fair values of liabilities under all insurance contracts are taken into consideration in the Company’s overall management of interest rate risk through the matching of investment maturities with amounts due under insurance contracts. The following methods and assumptions were used to estimate the fair value of financial instruments.
Investments - For fixed maturities and short-term and other investments, fair value equals quoted market price, if available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities, adjusted for differences between the quoted securities and the securities being valued. The fair value of policy loans is based on estimates using discounted cash flow analysis and current interest rates being offered for new loans. The fair value of mortgage loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and the same remaining maturities.
Annuity Contract Liabilities and Policyholder Account Balances on Interest-sensitive Life Contracts - The fair values of annuity contract liabilities and policyholder account balances on interest-sensitive life contracts are equal to the discounted estimated future cash flows (using the Company’s current interest rates for similar products including consideration of minimum guaranteed interest rates) including an adjustment for risk that the timing or amount of cash flows will vary from management’s estimate.
Other Policyholder Funds - Other policyholder funds are liabilities related to supplementary contracts without life contingencies and dividend accumulations which represent deposits that do not have defined maturities. The carrying value of these funds is used as a reasonable estimate of fair value.
Long-term Debt - The fair value of long-term debt is estimated based on quoted market prices of publicly traded issues.
The carrying amounts and fair values of financial instruments at December 31, 2006 and 2005 consisted of the following:
NOTE 7 - Fair Value of Financial Instruments-(Continued)
Fair value assumptions are based upon subjective estimates of market conditions and perceived risks of financial instruments at a certain point in time. The disclosed fair values do not reflect any premium or discount that could result from offering for sale at one time an entire holding of a particular financial instrument. In addition, potential taxes and other expenses that would be incurred in an actual sale or settlement are not reflected in amounts disclosed.
NOTE 8 - Statutory Surplus and Subsidiary Dividend Restrictions
The insurance departments of various states in which the insurance subsidiaries of HMEC are domiciled recognize as net income and surplus those amounts determined in conformity with statutory accounting principles prescribed or permitted by the insurance departments, which differ in certain respects from GAAP.
Reconciliations of statutory capital and surplus and net income, as determined using statutory accounting principles, to the amounts included in the accompanying consolidated financial statements are as follows:
NOTE 8 - Statutory Surplus and Subsidiary Dividend Restrictions-(Continued)
The Company has principal insurance subsidiaries domiciled in Illinois, California and Texas. The statutory financial statements of these subsidiaries are prepared in accordance with accounting principles prescribed or permitted by the Illinois Department of Financial and Professional Regulation (Division of Insurance), the California Department of Insurance and the Texas Department of Insurance, as applicable. Prescribed statutory accounting principles include a variety of publications of the National Association of Insurance Commissioners (“NAIC”), as well as state laws, regulations and general administrative rules.
The Company’s insurance subsidiaries are subject to various regulatory restrictions which limit the amount of annual dividends or other distributions, including loans or cash advances, available to HMEC without prior approval of the insurance regulatory authorities. The aggregate amount of dividends that may be paid by the insurance subsidiaries to HMEC during 2007 without prior approval is approximately $106,000.
The NAIC has adopted risk-based capital guidelines to evaluate the adequacy of statutory capital and surplus in relation to risks assumed in investments, reserving policies, and volume and types of insurance business written. State insurance regulations prohibit insurance companies from making any public statements or representations with regard to their risk-based capital levels. Based on current guidelines, the risk-based capital statutory requirements are not expected to have a negative regulatory impact on the Company’s insurance subsidiaries. At December 31, 2006 and 2005, statutory capital and surplus of each of the Company’s insurance subsidiaries was above required levels.
In the third quarter of 2005, a portion of the proceeds from the issuance of the Senior Notes due 2015 was utilized to make a capital contribution to HMEC’s primary life insurance subsidiary, Horace Mann Life Insurance Company, (“HMLIC”), to substantially offset the early recapture of the reinsurance agreement with the United States branch of Sun Life Assurance Company of Canada, described below. This agreement was terminated effective July 1, 2005 for a minimal recapture fee. At the time of this Annual Report on Form 10-K, the Company has no financial reinsurance agreements in effect.
On December 31, 2003, HMLIC entered into a reinsurance agreement with the United States branch of Sun Life Assurance Company of Canada (“SLACC”) which replaced the 2002 agreement with Sun Life Reinsurance Company Limited, a member of the Sun Life Financial Group. Under the terms of the December 31, 2003 agreement, which was written to be in place for a five year period, HMLIC ceded to SLACC, on a combination coinsurance and modified coinsurance basis, a 75% quota share of HMLIC’s in force interest-sensitive life block of business issued prior to January 1, 2002. SLACC assumed its proportional share of all risks attendant to the business reinsured such as mortality, persistency and investment risk, reducing HMLIC’s liabilities under statutory accounting principles to the extent of the ceded commission. The initial ceded commission received by HMLIC was $50,000 and resulted in a $32,500 after-tax increase in HMLIC’s statutory surplus. These transactions improved the statutory operating leverage and risk-based capital ratio of HMLIC in 2004, 2003 and 2002, but did not impact reported GAAP capitalization. The agreement provided that HMLIC could recapture the agreement without penalty after giving 30 days written notice.
NOTE 9 - Pension Plans and Other Postretirement Benefits
The Company has the following retirement plans: a defined contribution plan; a 401(k) plan; a defined benefit plan for employees hired on or before December 31, 1998; and certain employees participate in a supplemental defined contribution plan or a supplemental defined benefit plan or both.
After completing the first year of employment, all employees participate in the defined contribution plan. Under this plan, the Company makes contributions to each participant’s account based on eligible compensation and years of service. Contribution percentages are currently as follows: (1) employees hired on or after April 1, 1997, 5% of eligible compensation; (2) employees hired prior to April 1, 1997 with less than 15 years of service, 6% of eligible compensation; and (3) employees hired prior to April 1, 1997 with 15 or more years of service, 7% of eligible compensation. Through December 31, 2006, participants were 100% vested in this plan after 5 years of service. Effective January 1, 2007, participants will be 100% vested in this plan after 3 years of service.
All employees of the Company participate in a 401(k) plan. Beginning January 1, 2002, the Company automatically contributes 3% of eligible compensation to each employee’s account, which is 100% vested at the time of the contribution. In addition, employees may voluntarily contribute up to 20% of their eligible compensation into their account.
Effective April 1, 2002, participants stopped accruing benefits under the defined benefit and supplemental defined benefit plans but continue to retain the benefits they had accrued to date. Amounts earned under the defined benefit and supplemental defined benefit plans are based on years of service and the highest 36 consecutive months of earnings while under the plan (through March 31, 2002). Participants will be 100% vested in these defined benefit plans on April 1, 2007.
The Company’s policy with respect to funding the defined benefit plan is to contribute to the plan trust amounts which are actuarially determined to provide the plan with sufficient assets to meet future benefit payments consistent with the funding requirements of federal laws and regulations. For the defined contribution, 401(k) and defined benefit plans, investments have been set aside in separate trust funds. The supplemental retirement plans are unfunded, non-qualified plans.
Employees whose compensation exceeds the limits covered under the qualified plans participate in an unfunded, non-qualified defined contribution plan. The Company accrues an amount for each participant based on their compensation, years of service and account balance. Participants are 100% vested in this plan after 5 years of service.
Total expense recorded for the qualified and non-qualified defined contribution, 401(k), defined benefit and supplemental plans was $14,823, $14,647 and $13,862 for the years ended December 31, 2006, 2005 and 2004, respectively.
NOTE 9 - Pension Plans and Other Postretirement Benefits-(Continued)
Qualified Defined Contribution Plan, 401(k) Plan and Non-qualified Defined Contribution Plan
Pension benefits under the qualified defined contribution plan were fully funded. Contributions to employees’ accounts under this plan were expensed in the Company’s Consolidated Statements of Operations. Investments for this plan were set aside in a trust fund and none of the trust fund assets for the plan have been invested in shares of HMEC’s common stock.
The 401(k) plan is fully funded. Contributions to employees’ accounts under this plan were expensed in the Company’s Consolidated Statements of Operations. Investments for this plan were set aside through an annuity contract underwritten by the Company’s principal life insurance subsidiary. The annuity contract includes a fixed return account option and several variable return account options, with the account options selected by the individual plan participants for both the Company and participant portions contributed. One of the variable return account options invests in shares of HMEC common stock.
The non-qualified defined contribution plan is an unfunded plan. Contributions to employees’ accounts under the non-qualified defined contribution plan are equal to cash payments to retirees for the period.
Contributions to employees’ accounts under the qualified defined contribution plan, the 401(k) plan and the non-qualified defined contribution plan, as well as total assets of the plans, were as follows:
Defined Benefit Plan and Supplemental Retirement Plans
In September 2006, the FASB issued SFAS No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Postretirement Plans”, effective for years ending after December 15, 2006. As a result of adopting this standard, December 31, 2006, shareholders’ equity and book value per share increased by approximately $7,000 and 16 cents, respectively, related to the Company’s defined benefit pension plan and postretirement benefit plan, and also incorporating the previously disclosed changes to its retiree health care benefit plan. The changes to the retiree health care benefit plan decreased the Company’s postretirement benefit obligation, which is included in Other Liabilities in the Consolidated Balance Sheets, by approximately $10,000 at December 31, 2006. SFAS No. 158 requires recognition in the balance sheet of the funded status of defined benefit pension plans and other postretirement benefit plans, including all previously unrecognized actuarial gains and losses and unamortized prior service cost, as a component of accumulated other comprehensive income, net of tax. There was no impact on results of operations or cash flow.
NOTE 9 - Pension Plans and Other Postretirement Benefits-(Continued)
The following tables summarize both the funding status of the defined benefit and supplemental retirement pension plans and identify the assumptions used to determine the projected benefit obligation and the components of net pension cost for the defined benefit plan and supplemental retirement plans for the following periods:
* Not applicable.
NOTE 9 - Pension Plans and Other Postretirement Benefits-(Continued)
The decreases in the Company’s 2006 and 2005 minimum liability for the defined benefit plan of $5,167 and $786, respectively, were primarily attributable to improvements in asset performance and decreases in settlements. These changes were recorded to a separate component of shareholders’ equity.
* Not applicable.
The assumption for the long-term rate of return on plan assets was determined by considering actual investment experience during the lifetime of the plan, balanced with reasonable expectations of future growth considering the various classes of assets and percentage allocation for each asset class.
The allocation by asset category of the Company’s defined benefit pension plan assets at December 31, 2006, 2005 and 2004 (the measurement dates) were as follows:
(1) None of the trust fund assets for the defined benefit pension plan have been invested in shares of HMEC’s common stock.
NOTE 9 - Pension Plans and Other Postretirement Benefits-(Continued)
The Company has an investment policy for the defined benefit pension plan that aligns the assets within the plan’s trust to an approximate 70% equity and 30% stable value funds allocation. Management believes this allocation will produce the targeted long-term rate of return on assets necessary for payment of future benefit obligations, while providing adequate liquidity for payments to current beneficiaries. Assets are reviewed against the defined benefit pension plan’s investment policy and the trustee has been directed to adjust invested assets at least quarterly to maintain the target allocation percentages.
The Company expects to contribute $250 to the defined benefit plan and $1,140 to the supplemental retirement plans in 2007.
Postretirement Benefits Other than Pensions
In addition to providing pension benefits, the Company also provides certain health care and life insurance benefits to retired employees and their eligible dependents. Effective January 1, 2001, the eligibility requirement was age 55 and 20 years of service. Employees hired on or after January 1, 2001 are not eligible for postretirement medical benefits. Effective January 1, 2004, only employees who were at least age 50 with at least 15 years of service by December 31, 2003 are eligible to participate in this program. Postretirement benefits other than pensions of active and retired employees are accrued as expense over the employees’ service years.
In July 2006, the Company announced that effective January 1, 2007 it would eliminate the existing health care benefits for retirees 65 years of age and over and establish a Health Reimbursement Account (“HRA”) for each eligible participant. Health care benefits for eligible retirees under 65 years of age will continue to be provided as a bridge to Medicare eligibility. Eligible participants will receive a one-time credit of $10 to their HRA account to use for covered expenses incurred on or after age 65. As of December 31, 2006, HRA accounts were established for eligible participants and totaled $7,310. Also, the new plan does not provide life insurance benefits to individuals who retired in 1994 or later.
As a result of the changes in the plan for other postretirement benefits, the Company recorded a reduction in its expenses of $2,277 in 2006 and anticipates a reduction in its expenses of approximately $4,500 and $2,300 in 2007 and 2008, respectively.
NOTE 9 - Pension Plans and Other Postretirement Benefits-(Continued)
The following table presents the funded status of postretirement benefits other than pensions of active and retired employees (including employees on disability more than 2 years) as of December 31, 2006, 2005 and 2004 (the measurement dates) reconciled with amounts recognized in the Company’s Consolidated Balance Sheets:
* Not applicable.
The Company expects to contribute $1,637 to the postretirement benefit plans in 2007.
NOTE 9 - Pension Plans and Other Postretirement Benefits-(Continued)
Sensitivity Analysis for Postretirement Benefits Other than Pensions
A one percentage point change in the assumed health care cost trend rate for each year would change the accumulated postretirement benefit obligation as follows:
* Not applicable.
The discount rates at December 31, 2006 were based on the average yield for long-term, high-grade securities available during the benefit payout period. To set its discount rate, the Company looks to leading indicators, including Moody’s Aa long-term bond index.
In May 2004, the FASB issued FASB Staff Position (“FSP”) No. FAS 106-2, providing guidance on the accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“the Act”) for employers that sponsor postretirement health care plans that provide prescription drug benefits. The Company determined that the retiree prescription drug benefits provided by its plan were actuarially equivalent to the Medicare Part D benefit under the Act, and was thus eligible for the federal retiree drug subsidy in 2006. As a result of this eligibility, the Company’s accumulated postretirement benefit obligation and net periodic cost for 2005 were reduced by $5,967 and $101, respectively. Due to the Company’s changes to its retiree health care benefit plan, as described above, the Company will not be eligible for the federal retiree drug subsidy effective January 1, 2007.
NOTE 9 - Pension Plans and Other Postretirement Benefits-(Continued)
Estimated Future Benefit Payments
The Company’s defined benefit and supplemental defined benefit plans are subject to settlement accounting. Assumptions for both the number of individuals retiring in a calendar year and their elections regarding lump sum distributions are significant factors impacting the payout patterns for these plans. Therefore, actual results could vary from the estimates below. Estimated future benefit payments at December 31, 2006 are as follows:
NOTE 10 - Catastrophes and Reinsurance
In the normal course of business, the Company’s insurance subsidiaries assume and cede reinsurance with other insurers. Reinsurance is ceded primarily to limit losses from large exposures and to permit recovery of a portion of direct losses; however, such a transfer does not relieve the originating insurance company of contingent liability.
The Company is a national underwriter and therefore has exposure to catastrophic losses in certain coastal states and other regions throughout the U.S. Catastrophes can be caused by various events including hurricanes, windstorms, earthquakes, hail, severe winter weather and fires, and the frequency and severity of catastrophes are inherently unpredictable. The financial impact from catastrophic losses results from both the total amount of insured exposure in the area affected by the catastrophe as well as the severity of the event. The Company seeks to reduce its exposure to catastrophe losses through the geographic diversification of its insurance coverage, deductibles, maximum coverage limits, the purchase of catastrophe reinsurance, and, prior to May 7, 2005, the purchase of a catastrophe-linked equity put option and reinsurance agreement, described below.
The Company’s net catastrophe losses incurred of approximately $19,223 for the year ended December 31, 2006 reflected wind/hail/tornado events in April and August as well as other smaller weather events. The Company’s net catastrophe losses incurred of approximately $59,293 for the year ended December 31, 2005 primarily reflected losses from Hurricane Katrina, Hurricane Rita, Minnesota storms, Hurricane Dennis and Hurricane Wilma which totaled $52,025. The Company’s net catastrophe losses incurred of approximately $70,460 for the year ended December 31, 2004 were at a record high level for the Company and primarily reflected losses from Hurricanes Charley, Frances, Ivan and Jeanne, which totaled $64,196.
The total amounts of reinsurance recoverable on unpaid insurance reserves classified as assets and reported in Other Assets in the Consolidated Balance Sheets were as follows:
NOTE 10 - Catastrophes and Reinsurance-(Continued)
The Company recognizes the cost of reinsurance premiums over the contract periods for such premiums in proportion to the insurance protection provided. Amounts recoverable from reinsurers for unpaid claims and claim settlement expenses, including estimated amounts for unsettled claims, claims incurred but not reported and policy benefits are estimated in a manner consistent with the insurance liability associated with the policy. The effect of reinsurance on premiums written and contract deposits, premiums and contract charges earned, and benefits, claims and settlement expenses were as follows:
Gross and ceded benefits, claims and settlement expenses for the year ended December 31, 2005 reflect the impact of property and casualty losses from Hurricane Katrina, Hurricane Rita, Minnesota storms, Hurricane Dennis and Hurricane Wilma. Gross and ceded benefits, claims and settlement expenses for the year ended December 31, 2004 reflect the impact of property and casualty losses from Hurricanes Charley, Frances, Ivan and Jeanne. Ceded premiums written and earned for the years ended December 31, 2006, 2005 and 2004 included approximately $600, $10,000 and $5,000, respectively, of catastrophe reinsurance reinstatement premium.
There were no losses from uncollectible reinsurance recoverables in the three years ended December 31, 2006. Past due reinsurance recoverables as of December 31, 2006 were not material.
The Company maintains a catastrophe excess of loss and catastrophe aggregate reinsurance coverage. The excess of loss coverage consists of two contracts in addition to coverage with the Florida Hurricane Catastrophe Fund (“FHCF”). Effective January 1, 2006, the Company reinsured 95% of catastrophe losses above a retention of $15,000 per occurrence up to $110,000 per occurrence. The catastrophe treaty coverage consisted of four layers, each of which provided for one mandatory reinstatement. The four layers were $10,000 excess of $15,000, $20,000 excess of $25,000, $30,000 excess of $45,000 and $35,000 excess of $75,000. The other excess of loss contract provided 95% coverage of catastrophe losses above a retention of $10,000 per occurrence up to $15,000 per occurrence after the Company retained $5,000 of losses above $10,000 per occurrence. This contract also provided for one mandatory reinstatement. In addition, the Company’s predominant insurance subsidiary for property and casualty business written in Florida reinsures 90% of hurricane losses in that state above an estimated retention of $12,500 up to $52,200 with the FHCF, based on the FHCF’s financial resources. The FHCF contract is a one-year contract, effective June 1. The catastrophe aggregate contract provided 95% coverage of the Company’s 2006 catastrophe losses, capped at $10,000 per occurrence above an annual retention of $20,000 up to an annual limit of $40,000.
NOTE 10 - Catastrophes and Reinsurance-(Continued)
For liability coverages, including the educator excess professional liability policy, in 2006 the Company reinsured each loss above a retention of $500 up to $20,000. For property coverages, in 2006 the Company reinsured each loss above a retention of $500 up to $2,500, including catastrophe losses that in the aggregate were less than the retention levels above.
The maximum individual life insurance risk retained by the Company is $200 on any individual life and a maximum of $100 or $125 is retained on each group life policy depending on the type of coverage. Excess amounts are reinsured. The Company also maintains a life catastrophe reinsurance program. The Company reinsured 100% of the catastrophe risk in excess of $1,000 up to $15,000 per occurrence effective January 1, 2004. The 2006 program covered acts of terrorism but excluded nuclear, biological and chemical explosions as well as other acts of war.
NOTE 11 - Contingencies and Commitments
Lawsuits and Legal Proceedings
Companies in the insurance industry have been subject to substantial litigation resulting from claims, disputes and other matters. Most recently, they have faced expensive claims, including class action lawsuits, alleging, among other things, improper sales practices and improper claims settlement procedures. Negotiated settlements of certain such actions have had a material adverse effect on many insurance companies.
There are various lawsuits and legal proceedings against the Company. Management and legal counsel are of the opinion that the ultimate disposition of such litigation will have no material adverse effect on the Company’s financial position.
Assessments for Insolvencies of Unaffiliated Insurance Companies
The Company is also contingently liable for possible assessments under regulatory requirements pertaining to potential insolvencies of unaffiliated insurance companies. Liabilities, which are established based upon regulatory guidance, have generally been insignificant.
Leases
The Company has entered into various operating lease agreements, primarily for real estate (agency and claims offices across the country and portions of the home office complex) and also for computer equipment. Rental expenses were $7,901, $10,766 and $9,754 for the years ended December 31, 2006, 2005 and 2004, respectively. Future minimum lease payments under leases expiring subsequent to December 31, 2006 are as follows:
NOTE 12 - Supplementary Data on Cash Flows
A reconciliation of net income to net cash provided by operating activities as presented in the Consolidated Statements of Cash Flows is as follows:
The Company’s repurchases of debt in 2006 and 2005 resulted in non-cash financing (gains) charges of $(339) and $30, respectively.
NOTE 13 - Segment Information
The Company conducts and manages its business through four segments. The three operating segments, representing the major lines of insurance business, are: property and casualty insurance, principally personal lines automobile and homeowners products; annuity products, principally individual, tax-qualified fixed and variable deposits; and life insurance. The Company does not allocate the impact of corporate level transactions to the insurance segments, consistent with management’s evaluation of the results of those segments, but classifies those items in the fourth segment, corporate and other. In addition to debt service, realized investment gains and losses and certain public company expenses, such charges historically have included restructuring charges, debt retirement costs, litigation charges and the provision for prior years’ taxes.
The accounting policies of the segments are the same as those described in “Note 1 - Summary of Significant Accounting Policies”. The Company accounts for intersegment transactions, primarily the allocation of agent and overhead costs from the corporate and other segment to the property and casualty, annuity and life segments, on a direct cost basis.
NOTE 13 - Segment Information-(Continued)
Summarized financial information for these segments is as follows:
Additional significant financial information for these segments is as follows:
NOTE 14 - Unaudited Selected Quarterly Financial Data
Selected quarterly financial data is presented below.
(a) Rounded to thousands.
For 2005 and 2004, the Company’s third quarter net income was significantly affected by after tax net catastrophe costs incurred (primarily attributable to hurricanes) of $28,900 and $38,700, respectively. In addition, revenues for the third quarter were lower than all other quarters in 2005 due to property and casualty catastrophe reinsurance reinstatement premiums ceded in the third quarter of $8,900 compared to $500, $500 and $0, for the fourth, second and first quarters, respectively.
SCHEDULE I
HORACE MANN EDUCATORS CORPORATION
SUMMARY OF INVESTMENTS-OTHER THAN INVESTMENTS IN RELATED PARTIES
December 31, 2006
(Dollars in thousands)
(1) Bonds at original cost reduced by repayments and adjusted for amortization of premiums or accrual of discounts and impairment in value of specifically identified investments.
See accompanying Report of Independent Registered Public Accounting Firm.
SCHEDULE II
HORACE MANN EDUCATORS CORPORATION
(Parent Company Only)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
As of December 31, 2006 and 2005
(Dollars in thousands, except per share data)
See accompanying note to condensed financial statements.
See accompanying Report of Independent Registered Public Accounting Firm.
SCHEDULE II
HORACE MANN EDUCATORS CORPORATION
(Parent Company Only)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF OPERATIONS
(Dollars in thousands)
See accompanying note to condensed financial statements.
See accompanying Report of Independent Registered Public Accounting Firm.
SCHEDULE II
HORACE MANN EDUCATORS CORPORATION
(Parent Company Only)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF CASH FLOWS
(Dollars in thousands)
See accompanying note to condensed financial statements.
See accompanying Report of Independent Registered Public Accounting Firm.
SCHEDULE II
HORACE MANN EDUCATORS CORPORATION
(Parent Company Only)
CONDENSED FINANCIAL INFORMATION OF REGISTRANT
NOTE TO CONDENSED FINANCIAL STATEMENTS
The accompanying condensed financial statements should be read in conjunction with the Consolidated Financial Statements and the accompanying notes thereto.
See accompanying Report of Independent Registered Public Accounting Firm.
SCHEDULE III & VI (COMBINED)
HORACE MANN EDUCATORS CORPORATION
SCHEDULE III: SUPPLEMENTARY INSURANCE INFORMATION
SCHEDULE VI: SUPPLEMENTAL INFORMATION CONCERNING PROPERTY AND CASUALTY INSURANCE OPERATIONS
(Dollars in thousands)
N/A Not applicable.
See accompanying Report of Independent Registered Public Accounting Firm.
SCHEDULE IV
HORACE MANN EDUCATORS CORPORATION
REINSURANCE
(Dollars in thousands)
NOTE: Premiums above include insurance premiums earned and contract charges earned.
See accompanying Report of Independent Registered Public Accounting Firm.
HORACE MANN EDUCATORS CORPORATION
EXHIBITS
To
FORM 10-K
For the Year Ended December 31, 2006
VOLUME 1 OF 1
The following items are filed as Exhibits to Horace Mann Educators Corporation’s (“HMEC”) Annual Report on Form 10-K for the year ended December 31, 2006. Management contracts and compensatory plans are indicated by an asterisk (*).
EXHIBIT INDEX