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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2004
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________ to __________
Commission File Number 001-11462
DELPHI FINANCIAL GROUP, INC.
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(Exact name of registrant as specified in its charter)
Delaware (302) 478-5142 13-3427277
- ------------------------------- ------------------------------- -------------------------------
(State or other jurisdiction of (Registrant's telephone number, (I.R.S. Employer Identification
incorporation or organization) including area code) Number)
1105 North Market Street, Suite 1230, P. O. Box 8985, Wilmington, Delaware 19899
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(Address of principal executive offices) (Zip Code)
Securities registered pursuant to Section 12(b) of the Act:
Class A Common Stock, $.01 par value New York Stock Exchange
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(Title of each class) (Name of each exchange
on which registered)
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports) and (2) has been subject to filing requirements
for the past 90 days.
Yes X No ____
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes X No ____
The aggregate market value of the voting stock held by nonaffiliates of the
Registrant as of June 30, 2004 was $1,213,648,990.
As of March 1, 2005, the Registrant had 27,949,539 shares of Class A Common
Stock and 3,904,481 shares of Class B Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the Registrant's 2005 Annual Meeting of
Stockholders are incorporated by reference into Part III of this Form 10-K.
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This document contains certain forward-looking statements as defined in the
Securities Exchange Act of 1934, some of which may be identified by the use of
terms such as "expects," "believes," "anticipates," "intends," "judgment" or
other similar expressions. These statements are subject to various uncertainties
and contingencies, which could cause actual results to differ materially from
those expressed in such statements. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Forward-Looking Statements and
Cautionary Statements Regarding Certain Factors That May Affect Future Results."
PART I
ITEM 1. BUSINESS
Delphi Financial Group, Inc. (the "Company," which term includes the Company and
its consolidated subsidiaries unless the context indicates otherwise), is a
holding company whose subsidiaries provide integrated employee benefit services.
The Company was organized as a Delaware corporation in 1987 and completed the
initial public offering of its Class A common stock in 1990. The Company manages
all aspects of employee absence to enhance the productivity of its clients and
provides the related insurance coverages: long-term and short-term disability,
excess and primary workers' compensation, group life, travel accident and
dental. The Company's asset accumulation business emphasizes individual fixed
annuity products. The Company offers its products and services in all fifty
states and the District of Columbia. The Company's two reportable segments are
group employee benefit products and asset accumulation products. See Notes A and
R to the Consolidated Financial Statements included in this Form 10-K for
additional information regarding the Company's segments.
The Company makes available free of charge on its website at www.delphifin.com
its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports
on Form 8-K and all amendments to these reports as soon as reasonably possible
after such material has been filed with or furnished to the Securities and
Exchange Commission.
OPERATING STRATEGY
The Company's operating strategy is to offer financial products and services
which have the potential for significant growth, which require specialized
expertise to meet the individual needs of its customers and which provide the
Company the opportunity to achieve superior operating earnings growth and
returns on capital.
The Company has concentrated its efforts within certain niche insurance markets,
primarily group employee benefits for small to mid-sized employers, where nearly
all of the employment growth in the American economy has occurred in recent
years. The Company also markets its group employee benefit products and services
to large employers, emphasizing unique programs that integrate both employee
benefit insurance coverages and absence management services. The Company also
operates an asset accumulation business that focuses primarily on offering fixed
annuities to individuals planning for retirement.
The Company's primary operating subsidiaries are as follows:
Reliance Standard Life Insurance Company ("RSLIC"), founded in 1907 and having
administrative offices in Philadelphia, Pennsylvania, and its subsidiary, First
Reliance Standard Life Insurance Company ("FRSLIC"), underwrite a diverse
portfolio of group life, disability and accident insurance products targeted
principally to the employee benefits market. RSLIC also markets asset
accumulation products, primarily fixed annuities, to individuals and groups. The
financial strength rating of RSLIC as of February 2005 as rated by A.M. Best was
A- (Excellent). The Company, through Reliance Standard Life Insurance Company of
Texas ("RSLIC-Texas"), acquired RSLIC and FRSLIC in November 1987.
Safety National Casualty Corporation ("SNCC") focuses primarily on providing
excess workers' compensation insurance to the self-insured market. Founded in
1942 and located in St. Louis, Missouri, SNCC is one of the oldest continuous
writers of excess workers' compensation insurance in the United States. The
financial strength rating of SNCC as of February 2005 as rated by A.M. Best was
A (Excellent). The Company, through SIG Holdings, Inc. ("SIG"), acquired SNCC in
March 1996. In 2001, SNCC formed an insurance subsidiary, Safety First Insurance
Company, which also focuses on selling excess workers' compensation products to
the self-insured market.
Matrix Absence Management, Inc. ("Matrix"), founded in 1987, provides integrated
disability and absence management services to the employee benefits market
across the United States. Headquartered in San Jose, California, Matrix was
acquired by the Company in June 1998. See "Other Transactions."
-1-
GROUP EMPLOYEE BENEFIT PRODUCTS
The Company is a leading provider of group life, disability and excess workers'
compensation insurance products to small and mid-sized employers, with more than
20,000 policies in force. The Company also offers travel accident, voluntary
accidental death and dismemberment and group dental insurance. The Company
markets its group products to employer-employee groups and associations in a
variety of industries. The Company insures groups ranging from 2 to more than
5,000 individuals, although the size of an insured group generally ranges from
10 to 1,000 individuals. The Company markets unbundled employee benefit products
and absence management services as well as an Integrated Employee Benefit
program that combines both employee benefit insurance coverages and absence
management services. The Integrated Employee Benefit program, which the Company
believes helps to differentiate itself from competitors by offering clients
improved productivity from reduced employee absence, has enhanced the Company's
ability to market its group employee benefit products to large employers. In
2003, the Company introduced a suite of voluntary group life, disability and
accidental death and dismemberment products that are sold to employees at their
worksite. This suite of voluntary benefits allows the employees of the Company's
clients to choose the type and amount of benefit. In underwriting its group
employee benefit products, the Company attempts to avoid concentrations of
business in any industry segment or geographic area.
The Company's group employee benefit products are sold to employer groups
primarily through independent brokers and agents. The Company's products are
marketed to brokers and agents by 118 sales representatives and managers. RSLIC
had 107 sales representatives and managers located in 25 sales offices
nationwide at December 31, 2004, up 8% from 99 sales representatives and
managers at the end of 2003. At December 31, 2004, SNCC had 10 sales
representatives and managers. The Company's three administrative offices and 25
sales offices also service existing business.
The following table sets forth for the periods indicated selected financial data
concerning the Company's group employee benefit products:
Year Ended December 31,
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2004 2003 2002
-------------------- -------------------- ----------------------
(dollars in thousands)
Insurance premiums:
Core Products:
Disability income...................... $ 290,743 37.0% $ 233,437 34.7% $ 195,052 34.9%
Life................................... 261,797 33.4 241,902 35.9 210,030 37.6
Excess workers' compensation........... 190,794 24.3 151,522 22.5 104,170 18.6
Travel accident, dental and other...... 41,656 5.3 46,792 6.9 49,922 8.9
--------- ------ ---------- ------ ---------- ------
$ 784,990 100.0% $ 673,653 100.0% $ 559,174 100.0%
--------- ====== ---------- ====== ---------- ======
Non-Core Products:.......................
Loss portfolio transfers............... 5,300 - 26,830
Other.................................. 20,286 22,383 22,495
--------- ---------- ----------
25,586 22,383 49,325
--------- ---------- ----------
Total insurance premiums............. $ 810,576 $ 696,036 $ 608,499
========= ========== ==========
Sales (new annualized gross premiums):
Core Products:
Disability income...................... $ 95,799 45.8% $ 84,920 38.6% $ 75,996 37.8%
Life................................... 64,555 30.8 68,200 31.0 70,900 35.2
Excess workers' compensation........... 28,408 13.6 45,058 20.5 30,796 15.3
Travel accident, dental and other...... 20,547 9.8 21,933 9.9 23,454 11.7
--------- ------ ---------- ------- ---------- -------
$ 209,309 100.0% $ 220,111 100.0% $ 201,146 100.0%
--------- ======= ---------- ======= ---------- =======
Non-Core Products:
Loss portfolio transfers............... 5,300 - 26,830
Other.................................. 11,381 14,513 13,171
--------- ---------- ----------
16,681 14,513 40,001
--------- ---------- ----------
Total sales.......................... $ 225,990 $ 234,624 $ 241,147
========= ========== ==========
-2-
The profitability of group employee benefit products is affected by, among other
things, differences between actual and projected claims experience, the
retention of existing customers, product mix and the Company's ability to
attract new customers, change premium rates and contract terms and control
administrative expenses. The Company transfers its exposure to some group
employee benefit risks through reinsurance ceded arrangements with other
insurance and reinsurance companies. Under these arrangements, another insurer
assumes a specified portion of the Company's losses and loss adjustment expenses
in exchange for a specified portion of policy premiums. See "Reinsurance."
Accordingly, the profitability of group employee benefit products is affected by
the amount, cost and terms of reinsurance obtained by the Company. Profitability
of certain group employee benefit products is also affected by the difference
between the yield achieved on invested assets and the discount rate used to
calculate the related reserves.
The table below shows the loss and expense ratios as a percent of premium income
for the Company's group employee benefit products for the periods indicated.
Year Ended December 31,
----------------------------------------
2004 2003 2002
--------- --------- ---------
Loss ratio........................................................... 70.1% 68.2% 69.2%
Expense ratio........................................................ 24.6 26.1 25.4
------- -------- -------
Combined ratio................................................... 94.7% 94.3% 94.6%
======= ======== =======
The loss and expense ratios are affected by, among other things, claims
development related to prior years and the results with respect to the Company's
non-core group employee benefit products. Such ratios can also be affected by
changes in the Company's mix of products, such as the level of premium from loss
portfolio transfers ("LPTs"), from year to year. LPTs, which are classified as a
non-core product due to the episodic nature of sales, carry a higher loss ratio
and a significantly lower expense ratio as compared to the Company's other group
employee benefit products.
Group disability products offered by the Company, principally long-term
disability insurance, generally provide a specified level of periodic benefits
for a specified period to persons who, because of sickness or injury, are unable
to work. The Company's group long-term disability coverages are spread across
many industries. Long-term disability benefits generally are paid monthly and
typically are limited for any one employee to two-thirds of the employee's
earned income up to a specified maximum benefit. Long-term disability benefits
are usually offset by income the claimant receives from other sources, primarily
Social Security disability benefits. The Company actively manages its disability
claims, working with claimants to help them return to work as quickly as
possible. When claimants' disabilities prevent them from returning to their
original occupations, the Company, in appropriate cases, may provide assistance
in developing new productive skills for an alternative career. Premiums are
generally determined annually for disability insurance and are based upon
expected morbidity and the insured group's emerging experience, as well as
assumptions regarding operating expenses and future interest rates. Effective
October 1, 2003 for new policies and, for existing policies, the earlier of the
next policy anniversary date or October 1, 2004, the Company reinsures risks in
excess of $7,500 (compared to $2,500 previously) in long-term disability
benefits per individual per month. See "Reinsurance" and "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources - Reinsurance."
The Company's group life insurance products provide for the payment of a stated
amount upon the death of a member of the insured group. Policy terms are
generally one year. Accidental death and dismemberment insurance, which provides
for the payment of a stated amount upon the accidental death or dismemberment of
a member of the insured group, is frequently sold in conjunction with group life
policies and is included in premiums charged for group life insurance. The
Company reinsures risks in excess of $150,000 per individual and type of
coverage for employer-provided group life insurance policies and $100,000 per
individual for voluntary group term life policies. See "Reinsurance."
Excess workers' compensation insurance products provide coverage to employers
and groups who self-insure their workers' compensation risks. The coverage
applies to losses in excess of the applicable self-insured retentions ("SIRs" or
deductibles) of employers and groups, whose workers' compensation claims are
generally handled by third-party administrators ("TPAs"). These products are
principally targeted to mid-sized companies and other groups, particularly small
municipalities, hospitals and schools. These employers and groups are believed
to be less prone to catastrophic workers' compensation exposures and less price
sensitive than larger account business. Because excess workers' compensation
claim payments do not begin until after the self-insured's total loss payments
equal the SIR, the period from when the claim is incurred to the time the
Company's claim payments begin averages 15 years. At that point, the payments
are primarily for wage replacement, similar to the benefit provided under
long-term disability coverage, and any medical payments tend to be stable and
predictable. This family of products also includes large deductible workers'
compensation insurance, which provides coverage similar to excess workers'
compensation insurance, and a complementary product, workers' compensation
self-insurance bonds.
-3-
The pricing environment and demand for excess workers' compensation insurance
has improved substantially since 2000 due to higher primary workers'
compensation rates and disruption in the excess workers' compensation
marketplace resulting from difficulties experienced by some competitors,
particularly during 2000. These trends accelerated during the second half of
2001 as sharply higher primary workers' compensation rates and rising
reinsurance costs due to the terrorist attacks on the World Trade Center in
September of that year increased the demand for alternatives to primary workers'
compensation. As a result, the demand for excess workers' compensation products
and the rates for such products continued to increase. SNCC was able to obtain
significant price increases in connection with its renewals of insurance
coverage during 2002, 2003 and 2004, with average increases of 25%, 15% and 9%,
respectively, on a substantial portion of such renewals. SNCC has also been
obtaining significant improvements in contract terms, in particular higher SIR
levels, in these renewals. On average, SIRs increased 10% in 2002, 13% in 2003
and 8% in 2004. SNCC has continued to obtain moderate price increases on its
2005 renewals and SIR levels on average are up 8%. New business production,
which represents the amount of new annualized premium sold, for excess workers'
compensation products was $30.8 million in 2002, $45.1 million in 2003 and $28.4
million in 2004 and the retention of existing customers was higher in 2004 than
in 2003. Excess workers' compensation new business production for the important
January renewal season increased 53% to $8.9 million in 2005 from $5.8 million
in 2004. During 2003, the Company replaced certain of its existing reinsurance
arrangements for its excess workers' compensation products. Under the
replacement arrangements, the Company reinsures excess workers' compensation
risks between $5.0 million (compared to $3.0 million previously) and $50.0
million, and a majority in proportionate amount of the risks between $50.0
million and $100.0 million, per occurrence. See "Reinsurance" and "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources - Reinsurance."
As a result of the terrorist attacks on the World Trade Center, a number of the
Company's reinsurers have excluded coverage for losses resulting from terrorism.
In November 2002, the Terrorism Risk Insurance Act of 2002 (the "Terrorism Act")
was enacted. The Terrorism Act established a program under which the federal
government will share with the insurance industry the risk of loss from covered
acts of international terrorism. The program terminates on December 31, 2005.
While efforts have been pending in Congress to pass a bill extending the
Terrorism Act for an additional two-year term, no assurance can be given that
such an extension will occur, or as to the duration of any such extension. The
Terrorism Act applies to all direct lines of property and casualty insurance
written by SNCC, including excess workers' compensation. The federal government
would pay 90% of each covered loss and the insurer would pay the remaining 10%.
Each insurer has a separate deductible before federal assistance becomes
available in the event of an act of terrorism. The deductible is based on a
percentage of the insurer's direct earned premiums from the previous calendar
year. The deductible is 7%, 10% and 15% of direct earned premiums in 2003, 2004
and 2005, respectively. The maximum after-tax loss to the Company for 2005
within the Terrorism Act deductible from property and casualty products is
approximately 2.3% of the Company's shareholders' equity as of December 31,
2004. Any payments made by the government under the Terrorism Act would be
subject to recoupment via surcharges to policyholders when future premiums are
billed. The Terrorism Act does not apply to the lines of insurance written by
the Company's life insurance subsidiaries.
Business travel accident as well as voluntary accidental death and dismemberment
insurance policies pay a stated amount based on a predetermined schedule in the
event of the accidental death or dismemberment of a member of the insured group.
The Company reinsures risks in excess of $150,000 per individual and type of
coverage. Group dental insurance provides coverage for preventive, restorative
and specialized dentistry up to a stated maximum benefit per individual per
year. Under a reinsurance arrangement, the Company ceded 50% of its risk under
dental policies with effective dates prior to 2003, ceded 100% of its risk under
dental policies with effective dates in 2003 through June 30, 2004 and cedes 75%
of its risk under dental policies with effective dates after June 30, 2004. See
"Reinsurance."
Non-core group employee benefit products include products that have been
discontinued, such as reinsurance facilities and excess casualty insurance,
newer products which have not demonstrated their financial potential, products
which are not expected to comprise a significant percentage of earned premiums
and products for which sales are episodic in nature, such as LPTs. Pursuant to
an LPT, the Company, in exchange for a specified one-time payment, assumes
responsibility for an existing block of disability or self-insured workers'
compensation claims. These products are typically marketed to the same types of
clients who have historically purchased the Company's disability and excess
workers' compensation products. Non-core group employee benefit products also
include primary workers' compensation for which the Company primarily receives
fee income since a significant portion of the risk is reinsured. Excess casualty
insurance consists of a discontinued excess umbrella liability program. This
program entails exposure to excess of loss liability claims from past years,
including environmental and asbestos-related claims. Net incurred losses and
loss adjustment expenses relating to this program totaled $8.0 million in 2004.
In addition, non-core group employee benefit products include bail bond
insurance, workers' compensation reinsurance and property catastrophe
reinsurance. See "Reinsurance."
-4-
ASSET ACCUMULATION PRODUCTS
The Company's asset accumulation products consist of fixed annuities, primarily
single premium deferred annuities ("SPDAs") and flexible premium annuities
("FPAs"). An SPDA provides for a single payment by an annuity holder to the
Company and the crediting of interest by the Company on the annuity contract at
the applicable crediting rate. An FPA provides for periodic payments by an
annuity holder to the Company, the timing and amount of which are at the
discretion of the annuity holder, and the crediting of interest by the Company
on the annuity contract at the applicable crediting rate. Interest credited on
SPDAs and FPAs is not paid currently to the annuity holder but instead
accumulates and is added to the annuity contract's account value. This
accumulation is tax deferred. The crediting rate may be increased or decreased
by the Company subject to specified guaranteed minimum crediting rates, which
currently range from 3.0% to 5.5%. For most of the Company's annuity products,
the crediting rate may be reset by the Company annually, typically on the policy
anniversary. The Company's annuity products also include multi-year interest
guarantee products, in which the crediting rate is fixed at a stated rate for a
specified period of years, such periods ranging from three to eight years. At
December 31, 2004, the weighted average crediting rate on the Company's annuity
products as a group was 4.67%, which includes the effects of the first year
crediting rate bonus on certain newly issued products. Withdrawals may be made
by the annuity holder at any time, but some withdrawals may result in the
assessment of surrender charges, taxes, and/or tax penalties on the withdrawn
amount. In addition, the accumulated value of the annuity may be increased or
decreased under a market value adjustment ("MVA") provision if it is surrendered
during the surrender charge period. The Company does not market variable annuity
products.
These fixed annuity products are sold predominantly to individuals through
networks of independent agents. In 2004, the Company's SPDA products accounted
for $118.5 million of asset accumulation product deposits, of which $94.0
million was attributable to the MVA annuity product, and $10.5 million was
attributable to FPA products, of which $10.1 million had an MVA feature. Three
networks of independent agents accounted for approximately 42% of the deposits
from these SPDA and FPA products during 2004, with no other network of
independent agents accounting for more than 10% of these deposits. The Company
believes that it has a good relationship with these networks.
The following table sets forth for the periods indicated selected financial data
concerning the Company's asset accumulation products:
Year Ended December 31,
-----------------------------------------
2004 2003 2002
---------- ---------- ----------
(dollars in thousands)
Asset accumulation product deposits (sales)........................... $ 133,096 $ 100,636 $ 135,046
Funds under management (at period end)................................ 993,346 929,922 878,820
Product spread (1)..................................................... 1.62% 1.22% 1.22%
(1) The product spread for each period is computed by subtracting the
weighted average crediting rate on the Company's annuity products as
a group from the sum of net investment income earned on the assets
supporting the liability balances divided by the average liability
balance for the period.
At December 31, 2004, funds under management consisted of $860.8 million of SPDA
liabilities and $132.5 million of FPA liabilities. Of these liabilities, $678.0
million were subject to surrender charges averaging 6.51% at December 31, 2004.
Annuity liabilities not subject to surrender charges have been in force, on
average, for 20 years.
The Company prices its annuity products based on assumptions concerning
prevailing and expected interest rates and other factors to achieve a positive
spread between its expected return on investments and the crediting rate. The
Company achieves this spread by active portfolio management focusing on matching
invested assets and related liabilities to minimize the exposure to fluctuations
in market interest rates and by the adjustment of the crediting rate on its
annuity products. In response to changes in interest rates, the Company
increases or decreases the crediting rates on its annuity products.
In light of the annuity holder's ability to withdraw funds and the volatility of
market interest rates, it is difficult to predict the timing of the Company's
payment obligations under its SPDAs and FPAs. Consequently, the Company
maintains a portfolio of investments which are readily marketable and expected
to be sufficient to satisfy liquidity requirements. See "Investments."
-5-
OTHER PRODUCTS AND SERVICES
The Company provides integrated disability and absence management services on a
nationwide basis through Matrix, which was acquired in June 1998. See "Other
Transactions." The Company's comprehensive disability and absence management
services are designed to assist clients in identifying and minimizing lost
productivity and benefit payment costs resulting from employee absence due to
illness, injury or personal leave. The Company offers services including event
reporting, leave of absence management, claims and case management and return to
work management. These services' goal is to enhance employee productivity and
provide more efficient benefit delivery and enhanced cost containment. The
Company provides these services on an unbundled basis or in a unique Integrated
Employee Benefit program that combines these services with various group
employee benefit insurance coverages. The Company believes that these integrated
disability and absence management services complement the Company's core group
employee benefit products, enhancing the Company's ability to market these core
products and providing the Company with a competitive advantage in the market
for these products.
In 1991, the Company introduced a variable flexible premium universal life
insurance policy under which the related assets are segregated in a separate
account not subject to claims of general creditors of the Company. Policyholders
may elect to deposit amounts in the account from time to time, subject to
underwriting limits and a minimum initial deposit of $1.0 million. Both the cash
values and death benefits of these policies fluctuate according to the
investment experience of the assets in the separate account; accordingly, the
investment risk with respect to these assets is borne by the policyholders. The
Company earns fee income from the separate account in the form of charges for
management and other administrative fees. The Company is not presently actively
marketing this product. The Company reinsures risks in excess of $200,000 per
individual under indemnity reinsurance arrangements with various reinsurance
companies. See "Reinsurance."
UNDERWRITING PROCEDURES
Premiums charged on insurance products are based in part on assumptions about
the incidence, severity and timing of insurance claims. The Company has adopted
and follows detailed underwriting procedures designed to assess and qualify
insurance risks before issuing its policies. To implement these procedures, the
Company employs a professional underwriting staff.
In underwriting group coverage, the Company focuses on the overall risk
characteristics of the group to be insured and the geographic concentration of
its new and renewal business. A prospective group client is evaluated with
particular attention paid to the claims experience of the group with prior
carriers, the occupations of the insureds, the nature of the business of the
client, the current economic outlook of the client in relation to others in its
industry and of the industry as a whole, the appropriateness of the benefits or
SIR applied for and income from other sources during disability. The Company's
products generally afford it the flexibility to adjust premiums charged annually
to its policyholders in order to reflect emerging mortality or morbidity
experience.
INVESTMENTS
The Company's management of its investment portfolio is an important component
of its profitability since a substantial portion of its operating income is
generated from the difference between the yield achieved on invested assets and,
in the case of asset accumulation products, the interest credited on
policyholder funds and, in the case of certain of the Company's other products,
the discount rate used to calculate the related reserves. The Company's overall
investment strategy to achieve its objectives of safety and liquidity, while
seeking the best available return, focuses on, among other things, matching of
the Company's interest-sensitive assets and liabilities and seeking to minimize
the Company's exposure to fluctuations in interest rates.
For information regarding the composition and diversification of the Company's
investment portfolio and asset/liability management, see "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources" and Notes A, B and I to the Consolidated
Financial Statements.
-6-
The following table sets forth for the periods indicated the Company's pretax
investment results:
Year Ended December 31,
-------------------------------------------------
2004 2003 2002
-------------- ------------- -------------
(dollars in thousands)
Average invested assets (1)................................... $ 3,272,813 $ 2,948,135 $ 2,556,076
Net investment income (2)..................................... 202,774 186,366 162,036
Tax equivalent weighted average annual yield (3).............. 6.4% 6.5% 6.6%
(1) Average invested assets are computed by dividing the total of
invested assets as reported on the balance sheet at the beginning of
each year plus the individual quarter-end balances by five and
deducting one-half of net investment income.
(2) Consists principally of interest and dividend income less investment
expenses.
(3) The tax equivalent weighted average annual yield on the Company's
investment portfolio for each period is computed by dividing net
investment income, increased to reflect tax exempt interest income
and similar tax savings, by average invested assets for the period.
See "Management's Discussion and Analysis of Financial Condition and
Results of Operations - Results of Operations."
REINSURANCE
The Company participates in various reinsurance arrangements both as the ceding
insurer and as the assuming insurer. Arrangements in which the Company is the
ceding insurer afford various levels of protection against excessive loss by
assisting the Company in diversifying its risks and by limiting its maximum loss
on risks that exceed retention limits. Under indemnity reinsurance transactions
in which the Company is the ceding insurer, the Company remains liable for
policy claims if the assuming company fails to meet its obligations. To limit
this risk, the Company monitors the financial position of its reinsurers,
including, among other things, the companies' financial ratings, and in certain
cases receives collateral security from the reinsurer. Also, certain of the
Company's reinsurance agreements require the reinsurer to set up security
arrangements for the Company's benefit in the event of certain ratings
downgrades. In addition, the U.S. federal government presently provides certain
protections for insurers who issue certain property and casualty insurance
coverages. See "Business - Group Employee Benefit Products."
The Company cedes portions of the risks relating to its group employee benefit
and variable life insurance products under indemnity reinsurance agreements with
various unaffiliated reinsurers. The terms of these agreements, which are
typical for agreements of this type, provide, among other things, for the
automatic acceptance by the reinsurer of ceded risks in excess of the Company's
retention limits stated in the agreements. The Company pays reinsurance premiums
to these reinsurers which are, in general, based upon percentages of premiums
received by the Company on the business reinsured less, in certain cases, ceding
commissions and experience refunds paid by the reinsurer to the Company. These
agreements are generally terminable as to new risks by either the Company or the
reinsurer on appropriate notice; however, termination does not affect risks
ceded during the term of the agreement, for which the reinsurer generally
remains liable. See "Business - Group Employee Benefit Products" and Note P to
the Consolidated Financial Statements.
The Company assumes certain workers' compensation and property risks through
reinsurance. In these arrangements, the Company provides coverage for losses in
excess of specified amounts, subject to specified maximums. Coverage for losses
as a result of terrorism is generally excluded from these reinsurance treaties.
The attachment points for workers' compensation reinsurance range from $250,000
to $1.6 billion, with an average attachment point of $96 million. Aggregate
exposures assumed under individual workers' compensation treaties generally
range from $1 million to $4 million, with the highest net exposure pursuant to
any such treaty equal to $5 million. The Company underwrites workers'
compensation reinsurance assumed pursuant to procedures similar to those
utilized in connection with its excess workers' compensation product. The
majority of the Company's property reinsurance provides coverage in the event of
a catastrophe, generally excluding losses resulting from terrorism. The Company
underwrites its property reinsurance to mitigate its risk by diversifying
geographically and limiting its exposure on any one treaty. On property
reinsurance, the Company's risk attachment points range from $1 million to $27.5
billion, with an average attachment point of $2.1 billion. The Company's
aggregate exposure under a single property treaty generally ranges from $200,000
to $2 million. The highest net exposure under a single property treaty is $3
million. The probable maximum loss on property reinsurance is estimated to be
approximately $9.7 million, net of reinstatement premium and taxes, or
approximately 1% of the Company's shareholders' equity. Premium income from
property reinsurance was $9.5 million, $7.5 million and $4.4 million in 2004,
2003 and 2002, respectively, and incurred losses from property reinsurance were
$4.7 million, $0.3 million and $0.9 million, respectively. In the fourth quarter
of 2004, the Company entered into an indemnity reinsurance arrangement under
which it will assume certain newly issued group disability insurance policies on
an ongoing basis.
-7-
Under this arrangement, the Company is responsible for underwriting and claims
management with respect to the reinsured business. The Company provides coverage
primarily on a quota share basis up to a maximum Company share of $7,500 in
benefits per individual per month. The Company did not recognize any premium
income in 2004 from this arrangement.
The Company had in the past participated as an assuming insurer in a number of
reinsurance facilities. These reinsurance facilities generally are administered
by TPAs or managing underwriters who underwrite risks, coordinate premiums
charged and process claims. During 1999 and 2000, the Company terminated, on a
prospective basis, its participations in all of the reinsurance facilities in
which the Company had participated. However, the terms of such facilities
provide for the continued assumption of risks by, and payments of premiums to,
facility participants with respect to business written in the periods during
which they formerly participated in such facilities. The Company has been and is
currently a party to certain arbitration proceedings arising out of such
facilities. See "Legal Proceedings." Premium income from all reinsurance
facilities was $0.1 million, $0.3 million and $0.8 million in 2004, 2003 and
2002, respectively, and incurred losses from these facilities were $5.5 million,
$5.1 million and $4.7 million in 2004, 2003 and 2002, respectively. The
reinsurance facilities did not constitute a significant part of the Company's
operations; accordingly, the Company's withdrawals from these facilities have
not had a material impact on its consolidated financial position, liquidity or
results of operations.
LIFE, ANNUITY, DISABILITY AND ACCIDENT RESERVES
The Company carries as liabilities actuarially determined reserves for its life,
annuity, disability and accident policy and contract obligations. These
reserves, together with premiums to be received on policies in force and
interest thereon at certain assumed rates, are calculated and established at
levels believed to be sufficient to satisfy policy and contract obligations. The
Company performs periodic studies to compare current experience for mortality,
morbidity, interest and lapse rates with the experience reflected in the reserve
assumptions to determine future policy benefit reserves for these products.
Reserves for future policy benefits and unpaid claims and claim expenses are
estimated based on individual loss data, historical loss data and industry
averages and indices and include amounts determined on the basis of individual
and actuarially determined estimates of future losses. Therefore, the ultimate
liability could deviate from the amounts currently reflected in the Consolidated
Financial Statements. Under accounting principles generally accepted in the
United States ("GAAP") these policy and claim reserves are permitted to be
discounted to reflect the time value of money. Such reserve discounting, which
is common industry practice, is based on interest rate assumptions reflecting
projected portfolio yield rates for the assets supporting the liabilities. The
assets selected to support these liabilities produce cash flows that are
intended to match the timing and amount of anticipated claim and claim expense
payments. Differences between actual and expected claims experience are
reflected currently in earnings for each period. The Company has not experienced
significant adverse deviations from its assumptions.
The life, annuity, disability and accident reserves carried in the Consolidated
Financial Statements are calculated based on GAAP and differ from those reported
by the Company for statutory financial statement purposes. These differences
arise from the use of different mortality and morbidity tables and interest
assumptions, the introduction of lapse assumptions into the reserve calculation
and the use of the net level method on all insurance business. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Critical Accounting Policies" and Note A to the Consolidated Financial
Statements for certain additional information regarding reserve assumptions
under GAAP.
PROPERTY AND CASUALTY INSURANCE RESERVES
The Company carries as liabilities actuarially determined reserves for
anticipated claims and claim expenses for its excess workers' compensation
insurance and other casualty and property insurance products. Reserves for claim
expenses represent the estimated probable costs of investigating those claims
and, when necessary, defending lawsuits in connection with those claims.
Reserves for claims and claim expenses are estimated based on individual loss
data, historical loss data and industry averages and indices and include amounts
determined on the basis of individual and actuarially determined estimates of
future losses. Therefore, the ultimate liability could deviate from the amounts
currently reflected in the Consolidated Financial Statements.
Reserving practices under GAAP allow discounting of claim reserves related to
excess workers' compensation losses to reflect the time value of money. Reserve
discounting for these types of claims is common industry practice, and the
discount factors used are less than the annual tax-equivalent investment yield
earned by the Company on its invested
-8-
assets. The discount factors are based on the expected duration and payment
pattern of the claims at the time the claims are settled and the risk-free rate
of return for U.S. government securities with a comparable duration. Reserves
for claim expenses are not discounted.
The following table provides a reconciliation of beginning and ending unpaid
claims and claim expenses for the periods indicated:
Year Ended December 31,
------------------------------------------
2004 2003 2002
----------- ----------- -----------
(dollars in thousands)
Unpaid claims and claim expenses, net of reinsurance,
beginning of period.............................................. $ 479,660 $ 439,147 $ 413,950
Add provision for claims and claim expenses incurred, net of
reinsurance, occurring during:
Current year.................................................... 103,444 82,372 82,197
Prior years (1)................................................. 30,868 20,541 15,869
----------- ----------- -----------
Incurred claims and claim expenses, net of reinsurance,
during the current year................................ 134,312 102,913 98,066
----------- ----------- -----------
Deduct claims and claim expenses paid, net of reinsurance, occurring
during:
Current year.................................................... 8,120 5,165 10,915
Prior years .................................................... 64,170 57,235 61,954
----------- ----------- -----------
Total paid................................................... 72,290 62,400 72,869
----------- ----------- -----------
Unpaid claims and claim expenses, net of reinsurance, end of period... 541,682 479,660 439,147
Reinsurance receivables, end of period................................ 104,266 93,030 95,709
----------- ----------- -----------
Unpaid claims and claim expenses, gross of reinsurance,
end of period................................................ $ 645,948 $ 572,690 $ 534,856
=========== =========== ===========
(1) In 2004, the change in the provision for claims and claim
expenses incurred in prior years reflects the accretion of
discounted reserves and unfavorable claims development. In
2003 and 2002, the change in the provision for claims and
claim expenses incurred in prior years reflects the accretion
of discounted reserves offset by favorable claims development.
-9-
The effects of the discount to reflect the time value of money have been removed
from the amounts set forth in the loss development table which follows in order
to present the gross loss development, net of reinsurance. During 2004, 2003 and
2002, $18.1 million, $21.5 million and $17.2 million, respectively, of discount
was amortized, and $64.9 million, $44.9 million and $34.6 million, respectively,
was accrued.
The loss development table below illustrates the development of reserves from
March 5, 1996 to December 31, 2004 and is net of reinsurance.
December 31,
----------------------------------------------------------------------------------
March 5,
1996(1) 1996 1997 1998 1999
------------ ------------ ------------ ------------ ------------
(dollars in thousands)
Reserve for unpaid
claims and claim
expenses, net of
reinsurance................ $ 520,370 $ 532,923 $ 541,280 $ 422,159 $ 434,513
Cumulative amount of
liability paid:
One year later............ 23,467 28,162 98,365 40,815 40,660
Two years later........... 50,713 125,020 127,481 74,571 4,020(2)
Three years later......... 140,943 152,842 156,119 33,429(2) 54,846
Four years later.......... 167,811 179,705 111,253(2) 78,981 94,899
Five years later.......... 193,363 133,228(2) 150,772 114,295 139,949
Six years later........... 153,504(2) 170,405 182,281 154,101
Seven years later......... 188,719 197,318 217,649
Eight years later......... 214,715 230,278
Nine years later.......... 246,714
Liability reestimated as of:
One year later............ 507,375 513,402 523,430 410,875 424,187
Two years later........... 487,830 500,964 511,602 404,559 420,420
Three years later......... 476,854 488,432 503,906 401,475 417,869
Four years later.......... 476,600 487,195 500,514 396,403 423,426
Five years later.......... 476,890 478,206 492,280 399,311 466,975
Six years later........... 470,283 468,142 493,586 437,913
Seven years later......... 460,670 472,492 531,603
Eight years later......... 463,015 507,670
Nine years later.......... 501,208
Cumulative redundancy
(deficiency)............... $ 19,162 $ 25,253 $ 9,677 $ (15,754) $ (32,462)
December 31,
--------------------------------------------------------------------
2000 2001 2002 2003 2004
------------- ---------- ---------- ---------- ---------
(dollars in thousands)
Reserve for unpaid
claims and claim
expenses, net of
reinsurance................ $ 444,061 $ 638,191 $ 680,835 $ 744,760 $ 853,515
Cumulative amount of
liability paid:
One year later............ (29,990)(2) 61,954 57,235 64,170
Two years later........... 26,398 112,639 118,685
Three years later......... 71,938 169,890
Four years later.......... 123,330
Five years later..........
Six years later...........
Seven years later.........
Eight years later.........
Nine years later..........
Liability reestimated as of:
One year later............ 442,624 636,125 678,535 766,886
Two years later........... 442,807 634,578 714,303
Three years later......... 446,948 678,009
Four years later.......... 502,140
Five years later..........
Six years later...........
Seven years later.........
Eight years later.........
Nine years later..........
Cumulative redundancy
(deficiency)............... $ (58,079) $ (39,818) $ (33,468) $ (22,126)
(1) Amounts are as of or for the periods subsequent to March 5,
1996, the date the Company acquired its workers' compensation
business.
(2) The cumulative amount of liability paid through December 31,
2001 reflects the Company's receipt of $74.3 million related
to the commutation of the reinsurance agreements with Oracle
Reinsurance Company Ltd. in 2001. See "Other Transactions."
The "Reserve for unpaid claims and claim expenses, net of reinsurance" line in
the table above shows the estimated reserve for unpaid claims and claim expenses
recorded at the end of each of the periods indicated. These net liabilities
represent the estimated amount of losses and expenses for claims arising in the
current year and all prior years that are unpaid at the end of each period. The
"Cumulative amount of liability paid" lines of the table represent the
cumulative amounts paid with respect to the liability previously recorded as of
the end of each succeeding period. The "Liability reestimated" lines of the
table show the reestimated amount relating to the previously recorded liability
and is based upon experience as of the end of each succeeding period. This
estimate is either increased or decreased as additional information about the
frequency and severity of claims for each period becomes available and is
reviewed. The Company periodically reviews the estimated reserves for claims and
claim expenses and any changes are reflected currently in earnings for each
period. The "Cumulative redundancy (deficiency)" line in the table represents
the aggregate change in the net estimated claim reserve liabilities from the
dates indicated through December 31, 2004.
-10-
The table below is gross of reinsurance and illustrates the effects of the
discount to reflect the time value of money that was removed from the amounts
set forth in the loss development table above.
December 31,
----------------------------------------------------------------------
March 5,
1996(1) 1996 1997 1998 1999
--------- --------- --------- --------- ---------
(dollars in thousands)
Reserve for unpaid claims and
claim expenses before
discount:
Net of reinsurance......... $ 520,370 $ 532,923 $ 541,280 $ 422,159 $ 434,513
Add reinsurance
recoverable.............. 13,501 16,730 23,454 164,825 179,180
Deduct discount for time
value of money........... 164,000 168,827 176,683 180,770 192,220
--------- --------- --------- --------- ---------
Unpaid claims and claim
expenses as reported
on balance sheets............ 369,871 380,826 388,051 406,214 421,473
--------- --------- --------- --------- ---------
Reestimated unpaid claims
and claim expenses, gross
of reinsurance, net of
discount, as of December
31, 2004..................... 472,869 471,041 486,013 510,138 550,755
--------- --------- --------- --------- ---------
Discounted cumulative
deficiency, gross of
reinsurance.................. (102,998) (90,215) (97,962) (103,924) (129,282)
Add accretion of discount
and change in reinsurance
recoverable.................. 122,160 115,468 107,639 88,170 96,820
--------- --------- --------- --------- ---------
Cumulative redundancy
(deficiency) before
discount, net of
reinsurance.................. $ 19,162 $ 25,253 $ 9,677 $ (15,754) $ (32,462)
========= ========= ========= ========= =========
December 31,
------------------------------------------------------------------
2000 2001 2002 2003 2004
--------- --------- --------- --------- ---------
(dollars in thousands)
Reserve for unpaid claims and
claim expenses before
discount:
Net of reinsurance......... $ 444,061 $ 638,191 $ 680,835 $ 744,760 $ 853,515
Add reinsurance
recoverable.............. 206,704 92,828 95,709 93,030 104,266
Deduct discount for time
value of money........... 203,710 224,241 241,688 265,100 311,833
--------- --------- --------- --------- ---------
Unpaid claims and claim
expenses as reported
on balance sheets............ 447,055 506,778 534,856 572,690 $645,948
--------- --------- --------- --------- =========
Reestimated unpaid claims
and claim expenses, gross
of reinsurance, net of
discount, as of December
31, 2004..................... 599,411 644,161 638,425 628,557
--------- --------- --------- ---------
Discounted cumulative
deficiency, gross of
reinsurance.................. (152,356) (137,383) (103,569) (55,867)
Add accretion of discount
and change in reinsurance
recoverable.................. 94,277 97,565 70,101 33,741
--------- --------- --------- ---------
Cumulative redundancy
(deficiency) before
discount, net of
reinsurance.................. $ (58,079) $ (39,818) $ (33,468) $ (22,126)
========= ========= ========= =========
(1) Amounts are as of or for the periods subsequent to March 5,
1996, the date the Company acquired its workers' compensation
business.
The excess workers' compensation insurance reserves carried in the Consolidated
Financial Statements are calculated in accordance with GAAP and, net of
reinsurance, are approximately $134.0 million less than those reported by the
Company for statutory financial statement purposes at December 31, 2004. This
difference is primarily due to the use of different discount factors between
GAAP and statutory accounting principles and differences in the bases against
which such discount factors are applied. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Critical Accounting
Policies" and Note A to the Consolidated Financial Statements for certain
additional information regarding reserve assumptions under GAAP.
COMPETITION
The financial services industry is highly competitive. The Company competes with
numerous other insurance and financial services companies both in connection
with sales of insurance and asset accumulation products and integrated
disability and absence management services and in acquiring blocks of business
and companies. Many of these organizations have substantially greater asset
bases, higher ratings from ratings agencies, larger and more diversified
portfolios of insurance products and larger sales operations. Competition in
asset accumulation product markets is also encountered from the expanding number
of banks, securities brokerage firms and other financial intermediaries
marketing alternative savings products, such as mutual funds, traditional bank
investments and retirement funding alternatives.
The Company believes that its reputation in the marketplace, quality of service,
unique programs which integrate employee benefit products and absence management
services and investment returns have enabled it to compete effectively for new
business in its targeted markets. The Company reacts to changes in the
marketplace generally by focusing on products with adequate margins and
attempting to avoid those with low margins. The Company believes that its
smaller size, relative to some of its competitors, enables it to more easily
tailor its products to the demands of customers.
-11-
REGULATION
The Company's insurance subsidiaries are regulated by state insurance
authorities in the states in which they are domiciled and the states in which
they conduct business. These regulations, among other things, limit the amount
of dividends and other payments that can be made by the Company's insurance
subsidiaries without prior regulatory approval and impose restrictions on the
amount and type of investments these subsidiaries may have. These regulations
also affect many other aspects of the Company's insurance subsidiaries'
business, including, for example, risk-based capital ("RBC") requirements,
various reserve requirements, the terms, conditions and manner of sale and
marketing of insurance products and the form and content of required financial
statements. These regulations are intended to protect policyholders rather than
investors. The Company's insurance subsidiaries are required under these
regulations to file detailed annual financial reports with the supervisory
agencies in the various states in which they do business, and their business and
accounts are subject to examination at any time by these agencies. To date, no
examinations have produced any significant adverse findings or adjustments. The
ability of the Company's insurance subsidiaries to continue to conduct their
businesses is dependent upon the maintenance of their licenses in these various
states.
In April 2004, the New York State Attorney General ("NYAG") initiated an
investigation into certain insurance broker compensation arrangements and other
aspects of dealings between insurance brokers and insurance companies, and, in
connection therewith, filed a civil complaint in October 2004 against a major
insurance brokerage firm, Marsh & McLennan, based on certain of such firm's
compensation arrangements with insurers and alleged misconduct in connection
with the placement of insurance business. Other state regulators subsequently
announced the commencement of similar investigations and reviews. As previously
disclosed, the Company has received administrative subpoenas or similar requests
for information from the Illinois Division of Insurance, the Missouri Department
of Insurance, the NYAG's office and the North Carolina Department of Insurance
in connection with their investigations. The Company anticipates that additional
regulatory inquiries may be received by its insurance subsidiaries as the
various investigations continue. The Company will fully cooperate with inquiries
it has received to date, as well as any future inquiries of this type.
As also previously disclosed, based on an internal review relating to the
Company's insurance subsidiaries, the Company has identified certain potential
issues concerning past insurance solicitation practices involving SNCC and Marsh
& McLennan. The instances that the Company has been able to specifically
identify in this regard are limited in number and involved modest amounts of
premium. The Company has reported on these issues to the NYAG's office and to
the Missouri Department of Insurance, and will fully cooperate with these and
any other regulatory agencies relating to these issues. It is not possible to
predict the future impact of this matter on the Company or of the various
investigations, or any regulatory changes or litigation resulting from such
investigations, on the insurance industry or on the Company and its insurance
subsidiaries.
From time to time, increased scrutiny has been placed upon the insurance
regulatory framework, and a number of state legislatures have considered or
enacted legislative measures that alter, and in many cases increase, state
authority to regulate insurance companies. In addition to legislative
initiatives of this type, the National Association of Insurance Commissioners
(the "NAIC") and insurance regulators are continuously involved in a process of
reexamining existing laws and regulations and their application to insurance
companies. Furthermore, while the federal government currently does not directly
regulate the insurance business, federal legislation and administrative policies
in a number of areas, such as employee benefits regulation, age, sex and
disability-based discrimination, financial services regulation and federal
taxation, can significantly affect the insurance business. It is not possible to
predict the future impact of changing regulation on the operations of the
Company and its insurance subsidiaries.
The NAIC's RBC requirements for insurance companies take into account asset
risks, insurance risks, interest rate risks and other relevant risks with
respect to the insurer's business and specify varying degrees of regulatory
action to occur to the extent that an insurer does not meet the specified RBC
thresholds, with increasing degrees of regulatory scrutiny or intervention
provided for companies in categories of lesser RBC compliance. The Company
believes that its insurance subsidiaries are adequately capitalized under the
RBC requirements and that the thresholds will not have any significant
regulatory effect on the Company. However, were the insurance subsidiaries' RBC
position to materially decline in the future, the insurance subsidiaries'
continued ability to pay dividends and the degree of regulatory supervision or
control to which they are subjected may be affected.
The Company's insurance subsidiaries can also be required, under solvency or
guaranty laws of most states in which they do business, to pay assessments to
fund policyholder losses or liabilities of insurance companies that become
insolvent. These assessments may be deferred or forgiven under most solvency or
guaranty laws if they would threaten an insurer's
-12-
financial strength and, in most instances, may be offset against future state
premium taxes. SNCC recognized expenses of $0.8 million, $1.6 million and $1.3
million in 2004, 2003 and 2002, respectively, for these types of assessments.
None of the Company's life insurance subsidiaries has ever incurred any
significant costs of this nature.
EMPLOYEES
The Company and its subsidiaries employed approximately 1,100 persons at
December 31, 2004. The Company believes that it enjoys good relations with its
employees.
OTHER SUBSIDIARIES
The Company conducts certain of its investment management activities through its
wholly-owned subsidiary, Delphi Capital Management, Inc. ("DCM"), and makes
certain investments through other wholly-owned non-insurance subsidiaries.
OTHER TRANSACTIONS
In January 1998, an offering was completed whereby shareholders and
optionholders of the Company received, at no cost, rights to purchase shares of
Delphi International Ltd. ("Delphi International"), a newly-formed, independent
Bermuda insurance holding company. During 1998, the Company entered into various
reinsurance agreements with Oracle Reinsurance Company Ltd. ("Oracle Re"), a
wholly owned subsidiary of Delphi International. Pursuant to these agreements,
approximately $101.5 million of group employee benefit reserves ($35.0 million
of long-term disability insurance reserves and $66.5 million of net excess
workers' compensation and casualty insurance reserves) were ceded to Oracle Re.
The Company received collateral security from Oracle Re in an amount sufficient
to support the ceded reserves. During 2000 and 1999, Oracle Re and the Company
effected the partial recaptures of approximately $4.6 million and $10.0 million,
respectively, of the group long-term disability liabilities ceded to Oracle Re.
In October 2001, Oracle Re and the Company effected the commutation of their
reinsurance agreements, pursuant to which Oracle Re paid approximately $84.0
million to the Company (net of $11.5 million which had been held by the Company)
related to the reserves ceded to Oracle Re under such agreements. These
transactions did not have a material impact on the Company's consolidated
financial position, liquidity or net income. In furtherance of the commutation
of the reinsurance agreements, the Company agreed to waive a portion of the
amounts due to the Company under certain subordinated notes issued by Delphi
International. As a result of this waiver, the Company recognized a pre-tax loss
of $7.5 million in 2001 for the other than temporary decline in the value of
these notes. In March 2002, Delphi International repaid the adjusted amounts due
under the subordinated notes and the Company did not realize any significant
additional loss in connection with such repayment.
On June 30, 1998, the Company acquired Matrix, a provider of integrated
disability and absence management services to the employee benefits market. The
purchase price of $33.8 million consisted of 614,136 shares of the Company's
Class A Common Stock, $7.9 million of cash and $5.7 million of 8% subordinated
notes which matured in June 2003 (the "Subordinated Notes"). Under the terms of
the purchase agreement, additional consideration of up to $5.2 million in cash
was payable if Matrix's earnings met specified targets over the four-year period
subsequent to the acquisition. Because Matrix met all of the specified targets,
the Company paid the $5.2 million of contingent consideration in two equal
installments of $2.6 million during 2000 and 2001.
In the fourth quarter of 2000, the Company liquidated a substantial majority of
the investments of its investment subsidiaries. The proceeds from these sales
were used in 2001 to repay $150.0 million of outstanding borrowings under its
revolving credit facilities, to repurchase $64.0 million liquidation amount of
the Capital Securities of its subsidiary, Delphi Funding L.L.C. (the "Capital
Securities"), and to repurchase $8.0 million principal amount of its 8% Senior
Notes which matured in October 2003 (the "Matured Senior Notes").
In May 2003, the Company issued $143.8 million in principal amount of 8.00%
Senior Notes due 2033 (the "2033 Senior Notes") in a public offering. The
proceeds from the 2033 Senior Notes were used to repay the outstanding
borrowings under the Company's revolving credit facility and to repay in full
the principal amount of $66.5 million of the Matured Senior Notes. The 2033
Senior Notes, which were issued at par value, will mature on May 15, 2033 and
are redeemable at par at the option of the Company, in whole or in part, at any
time on or after May 15, 2008. The 2033 Senior Notes are
-13-
not redeemable at the option of any holder of the notes prior to maturity nor
are they entitled to any sinking fund redemptions. Interest on the 2033 Senior
Notes is payable quarterly on February 15, May 15, August 15 and November 15 of
each year. The 2033 Senior Notes are senior unsecured obligations of the Company
and, as such, are effectively subordinated to all claims of secured creditors of
the Company and its subsidiaries and to claims of unsecured creditors of the
Company's subsidiaries, including the insurance subsidiaries' obligations to
policyholders. As a result of the issuance of the 2033 Senior Notes, under the
terms of the Company's revolving credit facility, the maximum amount of
borrowings available to the Company thereunder was reduced from $150 million to
$100 million and the facility was converted to an unsecured facility, with
collateral being released to the Company. The 2033 Senior Notes were issued in
denominations of $25 and multiples of $25 and are listed on the New York Stock
Exchange. See Note D to the Consolidated Financial Statements.
In May 2003, Delphi Financial Statutory Trust I (the "Trust"), a subsidiary of
the Company, issued $20.0 million liquidation amount of Floating Rate Capital
Securities (the "2003 Capital Securities") in a private placement. In connection
with the issuance of the 2003 Capital Securities and the related purchase by the
Company of all of the common securities of the Trust (the "2003 Common
Securities" and, collectively with the 2003 Capital Securities, the "Trust
Securities"), the Company issued $20.6 million principal amount of floating rate
junior subordinated deferrable interest debentures, due 2033 (the "2003 Junior
Debentures"). Interest on the 2003 Junior Debentures is payable quarterly on
February 15, May 15, August 15 and November 15 of each year. The interest rate
on the 2003 Junior Debentures resets quarterly to a rate equal to the London
interbank offered interest rate for three-month U.S. dollar deposits, plus 4.10%
(not to exceed 12.50%). The weighted average interest rate on the outstanding
advances was 5.56% and 5.31% for the years ended December 31, 2004 and 2003,
respectively. The distribution and other payment dates on the Trust Securities
correspond to the interest and other payment dates on the 2003 Junior
Debentures. The 2003 Junior Debentures are unsecured and subordinated in right
of payment to all of the Company's existing and future senior indebtedness.
Beginning in May 2008, the Company will have the right to redeem the 2003 Junior
Debentures, in whole or in part, at a price equal to 100% of the principal
amount of the debentures, plus accrued and unpaid interest to the date of
redemption.
ITEM 2. PROPERTIES
The Company leases its principal executive office at 1105 North Market Street,
Suite 1230, Wilmington, Delaware under an operating lease expiring in October
2009. RSLIC leases its administrative office at 2001 Market Street, Suite 1500,
Philadelphia, Pennsylvania, under an operating lease expiring in June 2009. SNCC
owns its home office building at 2043 Woodland Parkway, Suite 200, St. Louis,
Missouri, which consists of approximately 58,000 square feet. SNCC also owns a
neighboring office building located at 2029 Woodland Parkway, St. Louis,
Missouri. The building consists of approximately 17,000 square feet and is
largely occupied by SNCC with a small portion leased to third parties. DCM and
FRSLIC lease their offices at 153 East 53rd Street, 49th Floor, New York, New
York under an operating lease expiring in July 2008. In the fourth quarter of
2004, the Company entered into a lease expiring in November 2010 for
approximately 36,000 square feet in New York, New York to which space DCM and
FRSLIC will relocate their offices during 2005. DCM and FRSLIC intend to sublet
their existing office space to third parties in 2005. Matrix leases its
principal office at 5225 Hellyer Avenue, Suite 210, San Jose, California under
an operating lease expiring in December 2005. The Company also maintains sales
and administrative offices throughout the country to provide nationwide sales
support and service existing business.
ITEM 3. LEGAL PROCEEDINGS
In the course of its business, the Company is a party to litigation and other
proceedings, primarily involving its insurance operations. In some cases, these
proceedings entail claims against the Company for punitive damages and similar
types of relief. The ultimate disposition of such pending litigation and
proceedings is not expected to have a material adverse effect on the Company's
financial position. In addition, incident to its discontinued products, the
Company has been and is currently a party to various arbitrations arising out of
accident and health reinsurance arrangements in which it and other companies
formerly were participating reinsurers. During the second quarter of 2004, the
Company, along with other former participants, reached a settlement resolving
the matters in dispute in one of these arbitrations, and a hearing in another is
scheduled to be held in the second quarter of 2005. The Company increased its
reserves related to the reinsurance business in dispute in the settled
arbitration by a total of $5.5 million during the year ended December 31, 2004.
The Company believes that it has substantial defenses upon which to contest the
claims made in the remaining arbitration, although it is not possible to predict
the ultimate outcome of this arbitration. In the opinion of management, such
arbitration, when ultimately resolved, will not have an adverse effect on the
Company's financial position.
-14-
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 4A. EXECUTIVE OFFICERS OF THE COMPANY
The table below presents certain information concerning each of the executive
officers of the Company:
Name Age Position
--------------------------------------------------------------------------------------------------------------
Robert Rosenkranz 62 Director of the Company; Chairman of the Board, President and Chief
Executive Officer of the Company; Chairman of the Board of RSLIC
Robert M. Smith, Jr. 53 Director and Executive Vice President of the Company
Chad W. Coulter 42 Vice President, Secretary and General Counsel of the Company; Vice
President, General Counsel and Assistant Secretary of RSLIC
Thomas W. Burghart 46 Vice President and Treasurer of the Company and RSLIC
Lawrence E. Daurelle 53 Director of the Company and President and Chief Executive Officer of RSLIC
Harold F. Ilg 57 Director of the Company and Chairman of the Board of SNCC
Mr. Rosenkranz has served as the President and Chief Executive Officer of the
Company since May 1987 and has served as Chairman of the Board of Directors of
the Company since April 1989. He also serves as Chairman of the Board or as a
Director of the Company's principal subsidiaries. Mr. Rosenkranz, by means of
beneficial ownership of the corporate general partner of Rosenkranz & Company
and direct or beneficial ownership, has the power to vote all of the outstanding
shares of Class B Common Stock, which represent 49.9% of the voting power of the
Company's common stock as of March 1, 2005.
Mr. Smith has served as Executive Vice President of the Company and DCM since
November 1999 and as a Director of the Company since January 1995. He has also
served as the Chief Investment Officer of RSLIC and FRSLIC since April 2001.
From July 1994 to November 1999, he served as Vice President of the Company and
DCM. Mr. Smith also serves as a Director of the Company's principal
subsidiaries.
Mr. Coulter has served as Vice President and General Counsel of the Company and
as Vice President, General Counsel and Assistant Secretary of RSLIC, FRSLIC and
RSLIC-Texas since January 1998, and has served as Secretary of the Company since
May 2003. He also served for RSLIC in similar capacities from February 1994 to
August 1997, and in various capacities from January 1991 to February 1994. From
August 1997 to December 1997, Mr. Coulter was Vice President and General Counsel
of National Life of Vermont.
Mr. Burghart has served as Vice President and Treasurer of the Company since
April 2001 and as Vice President and Treasurer of RSLIC, FRSLIC and RSLIC-Texas
since October 2000. From March 1992 to September 2000, he served as the Second
Vice President, Actuarial Statements, of RSLIC.
Mr. Daurelle has served as a Director of the Company since August 2002. He also
has served as President and Chief Executive Officer of RSLIC, FRSLIC and
RSLIC-Texas since October 2000. He served as Vice President and Treasurer of the
Company from August 1998 to April 2001. He also serves on the Board of Directors
of RSLIC, FRSLIC and RSLIC-Texas. From May 1995 to October 2000, Mr. Daurelle
was Vice President and Treasurer of RSLIC, FRSLIC and RSLIC-Texas.
Mr. Ilg has served as a Director of the Company since August 2002. He also has
served as Chairman of the Board of SNCC since January 1999. He serves on the
Board of Directors of RSLIC and FRSLIC. From April 1999 until October 2000, he
served as President and Chief Executive Officer of RSLIC, FRSLIC, and
RSLIC-Texas. Prior to January 1999, he served as Vice Chairman of the Board of
SNCC, where he has been employed in various capacities since 1978.
-15-
PART II
ITEM 5. MARKET FOR THE COMPANY'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS
The closing price of the Company's Class A Common Stock was $45.25 on March 1,
2005. There were approximately 3,400 holders of record of the Company's Class A
Common Stock as of March 1, 2005.
The Company's Class A Common Stock is listed on the New York Stock Exchange
under the symbol DFG. The following table sets forth the high and low sales
prices for the Company's Class A Common Stock and the cash dividends paid per
share for the Company's Class A and Class B Common Stock.
High Low Dividends
------------ ------------ ------------
2003: First Quarter.............................. $ 26.46 $ 21.73 $ 0.05
Second Quarter............................. 31.77 25.67 0.05
Third Quarter.............................. 33.63 30.33 0.05
Fourth Quarter............................. 36.88 31.08 0.08
2004: First Quarter.............................. $ 42.30 $ 35.99 $ 0.08
Second Quarter............................. 44.53 36.29 0.08
Third Quarter.............................. 44.85 38.82 0.08
Fourth Quarter............................. 47.60 37.66 0.08
In 2001, the Company's Board of Directors approved the initiation of a quarterly
cash dividend payable on the Company's Class A Common Stock and Class B Common
Stock. The quarterly cash dividend was $0.05 per share during the first three
quarters of 2003. In the fourth quarter of 2003, the Company's Board of
Directors increased the cash dividend by 50% to $0.08 per share. In the first
quarter of 2005, the cash dividend declared by the Company's Board of Directors
was increased by 12.5% to $0.09 per share, and was paid on the Company's Class A
Common Stock and Class B Common Stock on March 9, 2005. The Company intends to
continue to pay a quarterly dividend at this level. However, the declaration and
payment of such dividends, including the amount and frequency of such dividends,
is at the discretion of the Board and depends upon many factors, including the
Company's consolidated financial position, liquidity requirements, operating
results and such other factors as the Board may deem relevant. Cash dividend
payments are permitted under the respective terms of the Company's $100.0
million revolving credit facility subject to certain restrictions and covenants
and the 2033 Senior Notes. See Note K to the Consolidated Financial Statements.
In addition, dividend payments by the Company's insurance subsidiaries to the
Company are subject to certain regulatory restrictions. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Liquidity and Capital Resources" and "Business - Regulation."
-16-
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data below should be read in conjunction with
Management's Discussion and Analysis of Financial Condition and Results of
Operations and the Consolidated Financial Statements and related notes.
Year Ended December 31,
--------------------------------------------------------------------
2004 2003 2002 2001 2000
---------- ---------- ---------- ---------- ----------
INCOME STATEMENT DATA: (dollars and shares in thousands, except per share data)
Insurance premiums and fee income:
Core group employee benefit products........ $ 784,990 $ 673,653 $ 559,174 $ 452,158 $ 400,405
Non-core group employee benefit products(1). 25,586 22,383 49,325 35,836 47,285
Asset accumulation products................. 3,335 4,158 2,645 3,088 2,551
Other....................................... 23,686 18,893 16,713 16,122 16,116
---------- ---------- ---------- ---------- ----------
837,597 719,087 627,857 507,204 466,357
Net investment income(2)...................... 202,774 186,366 162,036 157,509 184,576
Net realized investment gains (losses)(3)..... 15,460 12,724 (28,469) (70,289) (138,047)
(Loss) gain on extinguishment of debt and
capital securities(2)....................... -- -- (332) 11,456 --
---------- ---------- ---------- ---------- ----------
Total revenue............................... 1,055,831 918,177 761,092 605,880 512,886
Income (loss) from continuing operations(4) .. 123,543 98,916 60,652 6,505 (3,293)
Net income (loss)(4).......................... 123,543 98,916 60,652 6,505 (3,293)
BASIC RESULTS PER SHARE(4)(5):
Income (loss) from continuing operations...... $ 3.87 $ 3.17 $ 1.95 $ 0.21 $ (0.11)
Net income (loss)............................. 3.87 3.17 1.95 0.21 (0.11)
Weighted average shares outstanding........... 31,952 31,208 31,139 30,848 30,582
DILUTED RESULTS PER SHARE(4)(5):
Income (loss) from continuing operations...... $ 3.75 $ 3.09 $ 1.90 $ 0.21 $ (0.11)
Net income (loss)............................. 3.75 3.09 1.90 0.21 (0.11)
Weighted average shares outstanding........... 32,941 32,023 31,887 31,629 30,582
OTHER DATA:
Cash dividends paid per share(6):............. $ 0.32 $ 0.23 $ 0.20 $ 0.20 $ --
Diluted book value per share(7)............... 29.36 25.49 21.83 19.00 17.91
December 31,
----------------------------------------------------------------------
2004 2003 2002 2001 2000
---------- ---------- ---------- ---------- ----------
BALANCE SHEET DATA: (dollars in thousands)
Total investments............................. $3,541,076 $3,202,754 $2,816,051 $2,427,214 $2,475,945
Total assets.................................. 4,829,467 4,177,532 3,734,942 3,336,146 3,440,010
Corporate debt(2)(8).......................... 157,750 143,750 118,139 125,675 267,770
Junior subordinated deferrable interest
debentures underlying company-obligated
mandatorily redeemable capital securities
issued by unconsolidated subsidiaries(9).... 59,762 -- -- -- --
Company-obligated mandatorily redeemable
capital securities of subsidiaries(2)(9).... -- 56,050 36,050 36,050 100,000
Shareholders' equity.......................... 939,848 798,440 681,655 581,994 538,193
Corporate debt to total capitalization
ratio(10)................................... 13.6% 14.4% 14.1% 16.9% 29.6%
(1) Non-core group employee benefit products include LPTs, primary workers'
compensation, bail bond insurance, workers' compensation and property
catastrophe reinsurance, and reinsurance facilities. Premiums from
non-core group employee benefit products include premiums from LPTs, which
are episodic in nature, of $13.9 million, $4.3 million, $26.8 million, $0
and $5.3 million, in 2000, 2001, 2002, 2003 and 2004, respectively. See
"Business - Group Employee Benefit Products" and "Business - Reinsurance."
(2) Net investment income declined in 2001 and 2002 primarily due to the
Company's liquidation during the fourth quarter of 2000 of a substantial
majority of the investments of its investment subsidiaries. In 2001, the
Company used the proceeds from these sales to repay $150.0 million of
outstanding borrowings under its revolving credit facilities, to
repurchase $64.0 million liquidation amount of the Capital Securities and
to
-17-
repurchase $8.0 million principal amount of the Matured Senior Notes. See
"Business - Other Transactions." The Company recognized a gain on
extinguishment of debt and capital securities of $11.5 million in
connection with these repurchases. In the second quarter of 2002, the
Company repurchased $10.5 million aggregate principal amount of the
Matured Senior Notes and recognized a loss on extinguishment of debt of
$0.3 million in connection with this repurchase.
(3) In 2004, 2003, 2002 and 2001, the Company recognized pre-tax losses of
$3.9 million, $13.0 million, $54.1 million and $79.3 million,
respectively, due to the other than temporary declines in the market
values of certain securities, which are reported as net realized
investment losses. In 2000, the Company realized losses of $72.5 million,
related to the liquidation of a substantial majority of the investments of
its investment subsidiaries, and $58.5 million, on closed U.S. Treasury
futures and option contracts.
(4) Results for 2001 include a charge of $0.91 per diluted share or $28.8
million, net of an income tax benefit of $15.5 million and reinsurance
coverages of $21.8 million, for reserve strengthening primarily related to
an unusually high number of large losses in the Company's excess workers'
compensation business. Included in this charge, on a pre-tax basis, are
additions to excess workers' compensation case reserves of $9.0 million
and incurred but not reported ("IBNR") reserves of $24.0 million. This
charge also includes reported workers' compensation losses of $6.3 million
and a $5.0 million addition to long-term disability IBNR reserves
attributable to the terrorist attacks on the World Trade Center. In the
years subsequent to 2001, the number of large losses experienced by the
Company returned to the Company's pre-2001 historical average.
During the second half of 2004, the Company's income taxes payable was
reduced by $6.6 million primarily from the favorable resolution of
Internal Revenue Service ("IRS") audits of the 1998 through 2002 tax
years. This reduction represented the release of previous accruals for
potential audit adjustments which were subsequently settled or eliminated
and the further refinement of existing tax exposures.
Income (loss) from continuing operations and net income (loss) include
realized investment gains (losses), net of federal income tax expense
(benefit) and the (loss) gain on extinguishment of debt and capital
securities, net of federal income tax (benefit) expense, as follows:
Year Ended December 31,
-------------------------------------------------------------------
2004 2003 2002 2001 2000
---------- --------- ---------- ---------- ----------
(dollars in thousands, except per share data)
Realized investment gains (losses), net of
income tax expense (benefit).................... $ 10,049 $ 8,271 $ (18,505) $ (45,688) $ (89,731)
Basic per share amount............................ 0.32 0.26 (0.59) (1.48) (2.94)
Diluted per share amount.......................... 0.30 0.26 (0.58) (1.44) (2.94)
(Loss) gain on extinguishment of debt and capital
securities, net of income tax (benefit) expense. -- -- (216) 7,446 --
Basic per share amount............................ -- -- (0.01) 0.24 --
Diluted per share amount.......................... -- -- (0.01) 0.24 --
(5) In computing the earnings per share amount for 2000, equivalent shares
attributable to in-the-money stock options, which totaled 1.0 million,
were not considered in the calculation of these per share amounts since
the inclusion of these equivalent shares would have diluted the loss from
continuing operations.
(6) In 2001, the Company's Board of Directors approved the initiation of a
quarterly cash dividend payable on the Company's outstanding Class A and
Class B Common Stock. The quarterly cash dividend was $0.05 per share
during 2001, 2002 and the first three quarters of 2003. In the fourth
quarter of 2003, the Company's Board of Directors increased the cash
dividend to $0.08 per share. During 2004, 2003, 2002 and 2001, the Company
paid cash dividends on its capital stock in the amount of $10.1 million,
$7.4 million, $6.0 million and $5.7 million, respectively. See Note K to
the Consolidated Financial Statements.
(7) Diluted book value per share is calculated by dividing shareholders'
equity (as determined in accordance with GAAP), as increased by the
proceeds and tax benefit from the assumed exercise of outstanding
in-the-money stock options, by total shares outstanding, also increased by
shares issued upon the assumed exercise of the options and deferred
shares.
(8) In May 2003, the Company issued $143.8 million of the 2033 Senior Notes.
See "Business - Other Transactions" and Note D to the Consolidated
Financial Statements.
(9) In May 2003, the Trust issued $20.0 million liquidation amount of 2003
Capital Securities in a private placement. See "Business - Other
Transactions" and Note J to the Consolidated Financial Statements.
As of March 31, 2004, the Company adopted revised Financial Accounting
Standards Board Interpretation ("FIN") No. 46, "Consolidation of Variable
Interest Entities." The revised interpretation changed the conceptual
framework for determining if an entity holds a controlling interest in a
variable interest entity and required the Company to deconsolidate its
subsidiaries that hold junior subordinated deferrable interest debentures
of the Company which underlie the Company-obligated mandatorily redeemable
capital securities of these subsidiaries. Therefore, the Company presented
in its consolidated financial statements the junior subordinated
deferrable interest debentures of $59.8 million as a liability and its
interest of $3.7 million in the subsidiaries that hold these debentures as
a component of other assets. The adoption of revised FIN No. 46 did not
have a material effect on the Company's financial position, results of
operations or ability to comply with its debt covenants.
(10) The corporate debt to total capitalization ratio is calculated by dividing
long-term corporate debt by the sum of the Company's long-term corporate
debt, junior subordinated deferrable interest debentures underlying
company-obligated mandatorily redeemable capital securities issued by
unconsolidated subsidiaries/Company-obligated mandatorily redeemable
capital securities of subsidiaries and shareholders' equity.
-18-
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
INTRODUCTION
The Company, through its subsidiaries, underwrites a diverse portfolio of group
employee benefit products, primarily group life, disability, and excess workers'
compensation insurance. Revenues from this group of products are primarily
comprised of earned premiums and investment income. The profitability of group
employee benefit products is affected by, among other things, differences
between actual and projected claims experience, the retention of existing
customers, product mix and the Company's ability to attract new customers,
change premium rates and contract terms and control administrative expenses. The
Company transfers its exposure to some group employee benefit risks through
reinsurance ceded arrangements with other insurance and reinsurance companies.
Accordingly, the profitability of group employee benefit products is affected by
the amount, cost and terms of reinsurance obtained by the Company. The
profitability of certain group employee benefit products is also affected by the
difference between the yield achieved on invested assets and the discount rate
used to calculate the related reserves. The Company is continuing to experience
favorable market conditions for its excess workers' compensation products, due
to higher primary workers' compensation rates. For its other group employee
benefit products, the Company is maintaining its underwriting discipline under
competitive market conditions, and is continuing to increase the size of its
sales force in order to enhance its focus on the small case niche (insured
groups of 10 to 500 individuals), including employers which are first-time
providers of these employee benefits, which it believes to offer opportunities
for superior profitability.
The Company also operates an asset accumulation business that focuses primarily
on offering fixed annuities to individuals. Deposits from the Company's asset
accumulation business consist of new annuity sales, which are recorded as
liabilities rather than as premiums. Revenues from the Company's asset
accumulation business are primarily comprised of investment income earned on the
funds under management. The profitability of asset accumulation products is
primarily dependent on the spread achieved between the return on investments and
the interest credited to annuity holders. The Company is disciplined in setting
the crediting rates offered on its asset accumulation products in order to
achieve its targeted interest rate spreads on these products, and is willing to
accept lower levels of sales on these products when market conditions make these
targeted spreads more difficult to achieve.
The following discussion and analysis of the results of operations and financial
condition of the Company should be read in conjunction with the Consolidated
Financial Statements and related notes. The preparation of financial statements
in conformity with GAAP requires management, in some instances, to make
judgments about the application of these principles. The amounts of assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period could differ materially from
the amounts reported if different conditions existed or different judgments were
utilized. A discussion of how management applies certain critical accounting
policies is presented below under the caption "Critical Accounting Policies" and
should be read in conjunction with the following discussion and analysis of
results of operations and financial condition of the Company. In addition, a
discussion of uncertainties and contingencies which can affect actual results
and could cause actual results to ultimately differ materially from those
described below can be found under the caption "Forward-Looking Statements And
Cautionary Statements Regarding Certain Factors That May Affect Future Results."
RESULTS OF OPERATIONS
2004 COMPARED TO 2003
Summary of Results. Net income was $123.5 million, or $3.75 per diluted share,
in 2004 as compared to $98.9 million, or $3.09 per diluted share, in 2003. Net
income in 2004 and 2003 included realized investment gains (net of the related
income tax expense) of $10.0 million, or $0.30 per diluted share, and $8.3
million, or $0.26 per diluted share, respectively. The increase in net income in
2004 is attributable to growth in income from group employee benefit products,
net investment income and a reduction in income tax expense. Premiums from the
Company's core group employee benefit products increased 17% in 2004 and the
combined ratio (loss ratio plus expense ratio) was modestly higher than in 2003.
The weighted average annual crediting rate on the Company's asset accumulation
products, which reflects the effects of the first year bonus crediting rate on
certain newly issued products, decreased from 5.5% in 2003 to 4.7% in 2004. Net
investment income in 2004, which increased 9% from 2003, reflects an 11%
increase in average invested assets. In addition, income tax expense was reduced
by $6.6 million during 2004 primarily resulting from the favorable resolution of
IRS audits of the 1998 through 2002 tax years. This reduction represented the
release of previous accruals for potential audit adjustments which were
subsequently settled or eliminated and the further refinement of existing tax
exposures.
-19-
Premium and Fee Income. Premium and fee income in 2004 was $837.6 million as
compared to $719.1 million in 2003, an increase of 16%. Premiums from core group
employee benefit products increased 17% to $785.0 million in 2004 from $673.7
million in 2003. This increase reflects normal growth in employment and salary
levels for the Company's existing customer base, price increases, new business
production and a decrease in premiums ceded by the Company to reinsurers for
these products. Core group employee benefit products include group life,
disability, excess workers' compensation, travel accident and dental insurance.
See "Business - Group Employee Benefit Products." Premiums from excess workers'
compensation insurance for self-insured employers increased 26% to $190.8
million in 2004 from $151.5 million in 2003. This increase was primarily due to
the favorable pricing environment and demand for this product as a result of
higher primary workers' compensation rates. SNCC obtained average price
increases of 9% in connection with its renewals of insurance coverage during
2004, and has continued to obtain significant improvements in contract terms, in
particular higher SIR levels, in these renewals. On average, SIRs increased 8%
in 2004. SNCC has continued to obtain moderate price increases on its 2005
renewals and SIR levels on average are up 8%. In addition, retention of existing
customers for excess workers' compensation products in 2004 was higher than in
2003. Excess workers' compensation new business production, which represents the
amount of new annualized premium sold, was $28.4 million in 2004 as compared
with exceptionally strong production in 2003 of $45.1 million. The significantly
higher renewal ratio and rate increases offset the decline in new business
production as the Company focused on achieving rate increases on its existing
business and maintained pricing and underwriting discipline as to new sales.
Excess workers' compensation new business production for the important January
renewal season increased 53% to $8.9 million in 2005 from $5.8 million in 2004.
Premiums from the Company's other core group employee benefit products increased
14% to $594.2 million in 2004 from $522.1 million in 2003, reflecting new
business production and a decrease in premiums ceded by the Company to
reinsurers for these products. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Liquidity and Capital Resources
- - Reinsurance." New business production for the Company's other core group
employee benefit products was $180.9 million in 2004 and $175.1 million in 2003.
The 2004 production level for these products reflects the Company's focus on the
small case niche (insured groups of 10 to 500 individuals) which resulted in a
22% increase in production based on the number of cases sold as compared to
2003. The Company continues to maintain its underwriting discipline under
competitive market conditions for these products and to implement price
increases for certain existing disability and group life customers.
Non-core group employee benefit products include LPTs, primary workers'
compensation, bail bond insurance, workers' compensation and property
catastrophe reinsurance, and reinsurance facilities. See "Business - Group
Employee Benefit Products" and "Business - Reinsurance." Premiums from non-core
group employee benefit products were $25.6 million in 2004 as compared to $22.4
million in 2003.
Deposits from the Company's asset accumulation products were $133.1 million in
2004 as compared to $100.6 million in 2003. These deposits consist of new
annuity sales, which are recorded as liabilities rather than as premiums. The
Company continues to maintain its discipline in setting the crediting rates
offered on its asset accumulation products, since the interest rate spreads
available on these products remained below average throughout 2003 and 2004. The
increase in deposits from the Company's asset accumulation products in 2004 was
primarily due to an increase in the number of independent agents and marketing
companies distributing the Company's annuity products. The Company plans to
maintain its discipline in setting the crediting rates offered on its asset
accumulation products in 2005 in order to achieve its targeted interest rate
spreads on these products.
Net Investment Income. Net investment income in 2004 was $202.8 million as
compared to $186.4 million in 2003, an increase of 9%. The level of net
investment income in the 2004 period reflects an increase in average invested
assets in 2004 partially offset by a decrease in the tax equivalent weighted
average annual yield. The tax equivalent weighted average annual yield on
invested assets was 6.4% on average invested assets of $3,272.8 million in 2004
and 6.5% on average invested assets of $2,948.1 million in 2003.
Net Realized Investment Gains. Net realized investment gains were $15.5 million
in 2004 as compared to $12.7 million in 2003. The Company's investment strategy
results in periodic sales of securities and, therefore, the recognition of
realized investment gains and losses. During 2004 and 2003, the Company
recognized $19.4 million and $25.7 million, respectively, of net gains on the
sales of securities. The Company monitors its investments on an ongoing basis.
When the market value of a security declines below its cost, and management
judges the decline to be other than temporary, the security is written down to
fair value, and the decline is reported as a realized investment loss. In 2004
and 2003, the Company recognized $3.9 million and $13.0 million, respectively,
of losses due to the other than temporary declines in the market values of
certain fixed maturity securities.
The losses of this type in 2004 ($2.5 million on an after-tax basis) resulted
primarily from credit quality-related deterioration in certain municipal and
asset-backed securities and the Company may recognize additional losses of this
-20-
type in the future. The Company anticipates that if certain other existing
declines in security values are determined to be other than temporary, it may
recognize additional investment losses in the range of $2 million to $5 million,
on an after-tax basis, with respect to the relevant securities. However, the
extent of any such losses will depend on future market developments and changes
in security values, and such losses may be outside this range. The Company
continuously monitors the affected securities pursuant to its procedures for
evaluation for other than temporary impairment in valuation. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations -
Critical Accounting Policies" for a description of these procedures, which take
into account a number of factors. It is not possible to predict the extent of
any future changes in value, positive or negative, or the results of the future
application of these procedures, with respect to these securities. There can be
no assurance that the Company will realize investment gains in the future in an
amount sufficient to offset any such losses.
Benefits and Expenses. Policyholder benefits and expenses were $869.6 million as
compared to $756.6 million in 2003, an increase of 15%. This increase primarily
reflects the increase in premiums from the Company's group employee benefit
products discussed above. The combined ratio (loss ratio plus expense ratio) for
the Company's group employee benefits segment was 94.7% in 2004 and 94.3% in
2003. Benefits and expenses related to the Company's asset accumulation products
decreased $3.0 million primarily due to a decrease in the weighted average
annual crediting rate on these products, which reflects the effects of the first
year bonus crediting rate on certain newly issued products, from 5.5% in 2003 to
4.7% in 2004.
Income Tax Expense. Income tax expense was $44.2 million in 2004 as compared to
$44.6 million in 2003. The Company's effective tax rate was 26.3% in 2004 and
31.1% in 2003. The decrease in the Company's effective tax rate during 2004
reflects a $6.6 million reduction in federal income tax expense primarily
resulting from the favorable resolution of IRS audits of the 1998 through 2002
tax years. This reduction represents the release of previous accruals for
potential audit adjustments which were subsequently settled or eliminated and
further refinement of existing tax exposures.
2003 COMPARED TO 2002
Summary of Results. Net income was $98.9 million, or $3.09 per diluted share, in
2003 as compared to $60.7 million, or $1.90 per diluted share, in 2002. Net
income in 2003 and 2002 included realized investment gains (losses) (net of the
related income tax effects) of $8.3 million, or $0.26 per diluted share, and
$(18.5) million, or $(0.58) per diluted share, respectively. Net income in 2002
also included a loss on extinguishment of debt (net of an income tax benefit) of
$0.2 million, or $0.01 per diluted share. The increase in net income in 2003 is
also attributable to growth in income from group employee benefit products and
net investment income partially offset by an increase in interest expense.
Premiums from the Company's core group employee benefit products increased 20%
in 2003 and the combined ratio (loss ratio plus expense ratio) was modestly
lower than in 2002. Net investment income increased 15% in 2003 primarily due to
a 15% increase in average invested assets. The increase in interest expense
resulted from the Company's issuance of the 2033 Senior Notes and the 2003
Capital Securities.
Premium and Fee Income. Premium and fee income in 2003 was $719.1 million as
compared to $627.9 million in 2002, an increase of 15%. Premiums from core group
employee benefit products increased 20% to $673.7 million in 2003 from $559.2
million in 2002. This increase reflects normal growth in employment and salary
levels for the Company's existing customer base, price increases, and strong
production of new business. Core group employee benefit products include group
life, disability, excess workers' compensation, travel accident and dental
insurance. Premiums from excess workers' compensation insurance for self-insured
employers increased 45% to $151.5 million in 2003 from $104.2 million in 2002.
This increase was