Table of Contents

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

R QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2014

 

OR

 

o 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 1-08323

 

Cigna Corporation

(Exact name of registrant as specified in its charter)

 

Delaware

 

06-1059331

(State or other jurisdiction of incorporation or organization)

 

(I.R.S. Employer Identification No.)

900 Cottage Grove Road Bloomfield, Connecticut

 

06002

(Address of principal executive offices)

 

(Zip Code)

(860) 226-6000

Registrant’s telephone number, including area code

(860) 226-6741

Registrant’s facsimile number, including area code

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark

 

YES

 

NO

 

· whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

R

 

o

 

· whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

 

R

 

o

 

· whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer R

Accelerated filer o

Non-accelerated filer o

Smaller Reporting Company o

 

· whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

 

o

 

 

R

 

As of April 15, 2014,  268,650,946 shares of the issuer’s common stock were outstanding.

 



Table of Contents

 

Cigna Corporation

 

INDEX

 

 

 

 

PART I

FINANCIAL INFORMATION

Page

 

 

 

Item 1.

Financial Statements (Unaudited)

1

 

Consolidated Statements of Income

1

 

Consolidated Statements of Comprehensive Income

2

 

Consolidated Balance Sheets

3

 

Consolidated Statements of Changes in Total Equity

4

 

Consolidated Statements of Cash Flows

5

 

Notes to the Consolidated Financial Statements

6

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

37

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

59

Item 4.

Controls and Procedures

60

 

 

 

 

 

 

PART II

OTHER INFORMATION

 

 

 

 

Item 1.

Legal Proceedings

61

Item 1.A.

Risk Factors

62

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

63

Item 4.

Mine Safety Disclosures

63

Item 6.

Exhibits

64

SIGNATURE

65

INDEX TO EXHIBITS

E-1

 

 

As used herein, “Cigna” or the “Company” refers to one or more of Cigna Corporation and its consolidated subsidiaries.

 



Table of Contents

 

 

 

 

 

Part I.   FINANCIAL INFORMATION

 

 

 

 

 

 

Item 1.   FINANCIAL STATEMENTS

 

 

Cigna Corporation

Consolidated Statements of Income

 

 

 

 

Unaudited

 

 

 

Three Months Ended

 

 

 

March 31,

 

(In millions, except per share amounts)

 

2014

 

2013

 

Revenues

 

 

 

 

 

Premiums and fees

 

$

7,616

 

$

7,314

 

Net investment income

 

277

 

287

 

Mail order pharmacy revenues

 

495

 

425

 

Other revenues

 

66

 

18

 

Realized investment gains (losses):

 

 

 

 

 

Other-than-temporary impairments on fixed maturities

 

-

 

-

 

Other realized investment gains, net

 

42

 

139

 

Total realized investment gains, net

 

42

 

139

 

Total revenues

 

8,496

 

8,183

 

Benefits and Expenses

 

 

 

 

 

Global Health Care medical claims expense

 

4,031

 

4,047

 

Other benefit expenses

 

1,166

 

1,862

 

Mail order pharmacy costs

 

414

 

344

 

Other operating expenses

 

2,032

 

1,856

 

Total benefits and expenses

 

7,643

 

8,109

 

Income before Income Taxes

 

853

 

74

 

Income taxes:

 

 

 

 

 

Current

 

310

 

(101)

 

Deferred

 

14

 

116

 

Total income taxes

 

324

 

15

 

Net Income

 

529

 

59

 

Less: Net Income Attributable to Noncontrolling Interests

 

1

 

2

 

Shareholders’ Net Income

 

$

528

 

$

57

 

Shareholders’ Net Income Per Share:

 

 

 

 

 

 

 

Basic

 

$

1.96

 

$

0.20

 

Diluted

 

$

1.92

 

$

0.20

 

Dividends Declared Per Share

 

$

0.04

 

$

0.04

 

The accompanying Notes to the Consolidated Financial Statements (unaudited) are an integral part of these statements.

 

1



Table of Contents

 

Cigna Corporation

Consolidated Statements of Comprehensive Income

 

 

 

 

Unaudited

 

 

 

Three Months Ended
March 31,

 

(In millions)

 

2014

 

 

2013

 

Shareholders’ net income

 

$

528

 

 

$

57

 

Shareholders’ other comprehensive income (loss):

 

 

 

 

 

 

Net unrealized appreciation (depreciation) on securities:

 

 

 

 

 

 

Fixed maturities

 

87

 

 

(72)

 

Equity securities

 

(1)

 

 

2

 

Net unrealized appreciation (depreciation), on securities

 

86

 

 

(70)

 

Net unrealized appreciation, derivatives

 

-

 

 

3

 

Net translation of foreign currencies

 

(11)

 

 

(58)

 

Postretirement benefits liability adjustment

 

12

 

 

40

 

Shareholders’ other comprehensive income (loss)

 

87

 

 

(85)

 

Shareholders’ comprehensive income (loss)

 

615

 

 

(28)

 

Comprehensive income (loss) attributable to noncontrolling interests:

 

 

 

 

 

 

Net income attributable to redeemable noncontrolling interests

 

3

 

 

2

 

Net (loss) attributable to other noncontrolling interest

 

(2)

 

 

-

 

Other comprehensive (loss) attributable to redeemable noncontrolling interests

 

(3)

 

 

(3)

 

Other comprehensive income attributable to other noncontrolling interest

 

1

 

 

-

 

Total comprehensive income (loss)

 

$

614

 

 

$

(29)

 

The accompanying Notes to the Consolidated Financial Statements (unaudited) are an integral part of these statements.

 

2



Table of Contents

 

Cigna Corporation

Consolidated Balance Sheets

 

 

 

 

Unaudited

 

 

 

As of

 

As of

 

(In millions, except per share amounts)

 

March 31, 2014

 

December 31, 2013

 

Assets

 

 

 

 

 

 

 

 

 

Investments:

 

 

 

 

 

 

 

 

 

Fixed maturities, at fair value (amortized cost, $16,156; $15,273)

 

 

 

$

 17,650

 

 

 

$

16,486

 

Equity securities, at fair value (cost, $133; $146)

 

 

 

127

 

 

 

141

 

Commercial mortgage loans

 

 

 

2,125

 

 

 

2,252

 

Policy loans

 

 

 

1,460

 

 

 

1,485

 

Real estate

 

 

 

57

 

 

 

97

 

Other long-term investments

 

 

 

1,292

 

 

 

1,273

 

Short-term investments

 

 

 

394

 

 

 

631

 

Total investments

 

 

 

23,105

 

 

 

22,365

 

Cash and cash equivalents

 

 

 

2,276

 

 

 

2,795

 

Accrued investment income

 

 

 

284

 

 

 

247

 

Premiums, accounts and notes receivable, net

 

 

 

2,432

 

 

 

1,991

 

Reinsurance recoverables

 

 

 

7,213

 

 

 

7,299

 

Deferred policy acquisition costs

 

 

 

1,438

 

 

 

1,395

 

Property and equipment

 

 

 

1,450

 

 

 

1,464

 

Deferred income taxes, net

 

 

 

27

 

 

 

92

 

Goodwill

 

 

 

6,030

 

 

 

6,029

 

Other assets, including other intangibles

 

 

 

2,530

 

 

 

2,407

 

Separate account assets

 

 

 

8,388

 

 

 

8,252

 

Total assets

 

 

 

$

55,173

 

 

 

$

54,336

 

Liabilities

 

 

 

 

 

 

 

 

 

Contractholder deposit funds

 

 

 

$

8,498

 

 

 

$

8,470

 

Future policy benefits

 

 

 

9,414

 

 

 

9,306

 

Unpaid claims and claim expenses

 

 

 

4,397

 

 

 

4,298

 

Global Health Care medical claims payable

 

 

 

2,151

 

 

 

2,050

 

Unearned premiums and fees

 

 

 

637

 

 

 

580

 

Total insurance and contractholder liabilities

 

 

 

25,097

 

 

 

24,704

 

Accounts payable, accrued expenses and other liabilities

 

 

 

5,791

 

 

 

5,456

 

Short-term debt

 

 

 

210

 

 

 

233

 

Long-term debt

 

 

 

5,022

 

 

 

5,014

 

Separate account liabilities

 

 

 

8,388

 

 

 

8,252

 

Total liabilities

 

 

 

44,508

 

 

 

43,659

 

Contingencies — Note 16

 

 

 

 

 

 

 

 

 

Redeemable noncontrolling interests

 

 

 

96

 

 

 

96

 

Shareholders’ Equity

 

 

 

 

 

 

 

 

 

Common stock (par value per share, $0.25; shares issued, 366; authorized, 600)

 

 

 

92

 

 

 

92

 

Additional paid-in capital

 

 

 

3,392

 

 

 

3,356

 

Net unrealized appreciation, fixed maturities

 

$

560

 

 

 

$

473

 

 

 

Net unrealized appreciation, equity securities

 

3

 

 

 

4

 

 

 

Net unrealized depreciation, derivatives

 

(19)

 

 

 

(19)

 

 

 

Net translation of foreign currencies

 

71

 

 

 

82

 

 

 

Postretirement benefits liability adjustment

 

(1,048)

 

 

 

(1,060)

 

 

 

Accumulated other comprehensive loss

 

 

 

(433)

 

 

 

(520)

 

Retained earnings

 

 

 

14,136

 

 

 

13,676

 

Less treasury stock, at cost

 

 

 

(6,631)

 

 

 

(6,037)

 

Total shareholders’ equity

 

 

 

10,556

 

 

 

10,567

 

Noncontrolling interest

 

 

 

13

 

 

 

14

 

Total equity

 

 

 

10,569

 

 

 

10,581

 

Total liabilities and equity

 

 

 

$

55,173

 

 

 

$

54,336

 

Shareholders’ Equity Per Share

 

 

 

$

39.28

 

 

 

$

38.35

 

The accompanying Notes to the Consolidated Financial Statements (unaudited) are an integral part of these statements.

 

3



Table of Contents

 

Cigna Corporation

Consolidated Statements of Changes in Total Equity

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

 

 

Redeemable

 

Unaudited

 

 

 

Additional

 

Other

 

 

 

 

 

 

 

Non-

 

 

 

Non-

 

For the three months ended March 31, 2014

 

Common

 

Paid-in

 

Comprehensive

 

Retained

 

Treasury

 

Shareholders’

 

controlling

 

Total

 

controlling

 

(In millions)

 

Stock

 

Capital

 

Loss

 

Earnings

 

Stock

 

Equity

 

Interest

 

Equity

 

Interests

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at January 1, 2014,

 

$

92

 

$

 3,356

 

$

(520)

 

$

13,676

 

$

(6,037)

 

$

 10,567

 

$

14

 

$

10,581

 

$

 96

 

Effect of issuing stock for employee benefit plans

 

 

 

36

 

 

 

(57)

 

49

 

28

 

 

 

28

 

 

 

Other comprehensive Income

 

 

 

 

 

87

 

 

 

 

 

87

 

1

 

88

 

(3)

 

Net income

 

 

 

 

 

 

 

528

 

 

 

528

 

(2)

 

526

 

3

 

Common dividends declared (per share: $0.04)

 

 

 

 

 

 

 

(11)

 

 

 

(11)

 

 

 

(11)

 

 

 

Repurchase of common stock

 

 

 

 

 

 

 

 

 

(643)

 

(643)

 

 

 

(643)

 

 

 

Balance at March 31, 2014

 

$

92

 

$

 3,392

 

$

(433)

 

$

14,136

 

$

(6,631)

 

$

 10,556

 

$

13

 

$

10,569

 

$

 96

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

 

 

 

 

 

 

Redeemable

 

 

 

 

 

Additional

 

Other

 

 

 

 

 

 

 

Non-

 

 

 

Non-

 

For the three months ended March 31, 2013

 

Common

 

Paid-in

 

Comprehensive

 

Retained

 

Treasury

 

Shareholders’

 

controlling

 

Total

 

controlling

 

(In millions)

 

Stock

 

Capital

 

Loss

 

Earnings

 

Stock

 

Equity

 

Interest

 

Equity

 

Interest

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at January 1, 2013,

 

$

92

 

$

3,295

 

$

(671)

 

$

12,330

 

$

(5,277)

 

$

9,769

 

$

-

 

$

9,769

 

$

114

 

Effect of issuing stock for employee benefit plans

 

 

 

10

 

 

 

(48)

 

65

 

27

 

 

 

27

 

 

 

Other comprehensive loss

 

 

 

 

 

(85)

 

 

 

 

 

(85)

 

 

 

(85)

 

(3)

 

Net income

 

 

 

 

 

 

 

57

 

 

 

57

 

 

 

57

 

2

 

Common dividends declared (per share: $0.04)

 

 

 

 

 

 

 

(11)

 

 

 

(11)

 

 

 

(11)

 

 

 

Repurchase of common stock

 

 

 

 

 

 

 

 

 

(97)

 

(97)

 

 

 

(97)

 

 

 

Balance at March 31, 2013

 

$

92

 

$

 3,305

 

$

(756)

 

$

12,328

 

$

(5,309)

 

$

9,660

 

$

-

 

$

9,660

 

$

113

 

 

The accompanying Notes to the Consolidated Financial Statements (unaudited) are an integral part of these statements.

 

4



Table of Contents

 

Cigna Corporation

Consolidated Statements of Cash Flows

 

 

 

 

Unaudited

 

 

 

Three Months Ended
March 31,

 

(In millions)

 

2014

 

 

2013

 

Cash Flows from Operating Activities

 

 

 

 

 

 

Net income

 

$

529

 

 

$

59

 

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

 

 

 

 

 

 

Depreciation and amortization

 

150

 

 

150

 

Realized investment gains

 

(42)

 

 

(139)

 

Deferred income taxes

 

14

 

 

116

 

Gains on sale of businesses

 

(4)

 

 

(4)

 

Net changes in assets and liabilities, net of non-operating effects:

 

 

 

 

 

 

Premiums, accounts and notes receivable

 

(431)

 

 

(158)

 

Reinsurance recoverables

 

42

 

 

328

 

Deferred policy acquisition costs

 

(67)

 

 

(82)

 

Other assets

 

(63)

 

 

103

 

Insurance liabilities

 

262

 

 

750

 

Accounts payable, accrued expenses and other liabilities

 

(107)

 

 

(328)

 

Current income taxes

 

250

 

 

(110)

 

Cash used to effectively exit run-off reinsurance business

 

-

 

 

(1,475)

 

Other, net

 

(43)

 

 

(15)

 

Net cash provided by / (used in) operating activities

 

490

 

 

(805)

 

Cash Flows from Investing Activities

 

 

 

 

 

 

Proceeds from investments sold:

 

 

 

 

 

 

Fixed maturities

 

160

 

 

958

 

Equity securities

 

34

 

 

3

 

Other (primarily short-term and other long-term investments)

 

879

 

 

221

 

Investment maturities and repayments:

 

 

 

 

 

 

Fixed maturities

 

396

 

 

386

 

Equity securities

 

-

 

 

9

 

Commercial mortgage loans

 

127

 

 

55

 

Investments purchased or originated:

 

 

 

 

 

 

Fixed maturities

 

(1,439)

 

 

(383)

 

Equity securities

 

(6)

 

 

(27)

 

Commercial mortgage loans

 

-

 

 

(15)

 

Other (primarily short-term and other long-term investments)

 

(572)

 

 

(121)

 

Property and equipment sales

 

12

 

 

-

 

Property and equipment purchases

 

(97)

 

 

(84)

 

Acquisitions and dispositions, net of cash acquired

 

-

 

 

(40)

 

Net cash (used in) / provided by investing activities

 

(506)

 

 

962

 

Cash Flows from Financing Activities

 

 

 

 

 

 

Deposits and interest credited to contractholder deposit funds

 

411

 

 

363

 

Withdrawals and benefit payments from contractholder deposit funds

 

(351)

 

 

(332)

 

Change in cash overdraft position

 

19

 

 

(3)

 

Net change in short-term debt

 

(6)

 

 

198

 

Repurchase of common stock

 

(615)

 

 

(77)

 

Issuance of common stock

 

43

 

 

36

 

Net cash (used in) / provided by financing activities

 

(499)

 

 

185

 

Effect of foreign currency rate changes on cash and cash equivalents

 

(4)

 

 

(14)

 

Net (decrease) / increase in cash and cash equivalents

 

(519)

 

 

328

 

Cash and cash equivalents, January 1,

 

2,795

 

 

2,978

 

Cash and cash equivalents, March 31,

 

$

2,276

 

 

$

3,306

 

Supplemental Disclosure of Cash Information:

 

 

 

 

 

 

Income taxes paid, net of refunds

 

$

43

 

 

$

12

 

Interest paid

 

$

70

 

 

$

70

 

 

The accompanying Notes to the Consolidated Financial Statements (unaudited) are an integral part of these statements.

 

5



Table of Contents

 

CIGNA CORPORATION

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

 

Note 1 — Basis of Presentation

 

 

Cigna Corporation and its subsidiaries (either individually or collectively referred to as “Cigna”, “the Company”, “we”, or “our”) is a global health services organization with a mission to help its customers improve their health, well-being and sense of security.  Its insurance subsidiaries are major providers of medical, dental, disability, life and accident insurance and related products and services, the majority of which are offered through employers and other groups (e.g. governmental and non-governmental organizations, unions and associations). Cigna also offers Medicare and Medicaid products and health, life and accident insurance coverages primarily to individuals in the U.S. and selected international markets.  In addition to its ongoing operations described above, Cigna also has certain run-off operations.

 

The Consolidated Financial Statements include the accounts of Cigna Corporation and its subsidiaries. Intercompany transactions and accounts have been eliminated in consolidation.  These Consolidated Financial Statements were prepared in conformity with accounting principles generally accepted in the United States of America (“GAAP”).  Amounts recorded in the Consolidated Financial Statements necessarily reflect management’s estimates and assumptions about medical costs, investment valuation, interest rates and other factors.  Significant estimates are discussed throughout these Notes; however, actual results could differ from those estimates.  The impact of a change in estimate is generally included in earnings in the period of adjustment.  Certain reclassifications have been made to prior year amounts to conform to the current presentation.

 

These interim Consolidated Financial Statements are unaudited but include all adjustments (including normal recurring adjustments) necessary, in the opinion of management, for a fair statement of financial position and results of operations for the periods reported.  The interim Consolidated Financial Statements and notes should be read in conjunction with the Consolidated Financial Statements and Notes included in the Company’s 2013 Form 10-K.  The preparation of interim Consolidated Financial Statements necessarily relies heavily on estimates.  This and certain other factors, including the seasonal nature of portions of the health care and related benefits business as well as competitive and other market conditions, call for caution in estimating full year results based on interim results of operations.

 

Beginning in the first quarter of 2014, the Company combined the results of its run-off reinsurance business with Other Operations for segment reporting purposes.  Prior year information has been conformed to the current year presentation. See Note 15 for additional information.

 

Note 2 — Recent Accounting Pronouncements

 

 

Fees Paid to the Federal Government by Health Insurers (Accounting Standards Update (“ASU”) 2011-06).  Effective January 1, 2014, the Company adopted the Financial Accounting Standards Board’s (“FASB”) accounting guidance for the health insurance industry assessment (the “fee”) mandated by the Patient Protection and Affordable Care Act of 2010 (“Health Care Reform”).  The fee will be levied based on a ratio of an insurer’s net health insurance premiums written for the previous calendar year compared to the U.S. health insurance industry total.  Based on industry studies, the Company recorded a liability in accounts payable, accrued expenses and other liabilities in the first quarter of 2014 of approximately $240 million representing an estimate of the fee for 2014.  A corresponding deferred cost was recorded in other assets, including other intangibles.  The Company will update this estimate for any adjustment in subsequent quarters.  During the first quarter of 2014, $60 million of the deferred cost was recognized in other operating expenses; the remainder will be recognized on a straight-line basis over the balance of 2014.  This fee is not tax deductible.

 

Investment Company Accounting (ASU 2013-08).  Effective January 1, 2014, the Company adopted FASB’s amended accounting guidance to change the criteria for reporting as an investment company, clarify the fair value measurement used by an investment company and require additional disclosures.  This guidance also confirms that parent company accounting for an investment company should reflect fair value accounting.  While this guidance applies to certain of the Company’s security and real estate partnership investments, its adoption did not have a material impact on the Company’s financial statements.

 

Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income (“AOCI”) (ASU 2013-02).  Effective January 1, 2013, the Company adopted new requirements to disclose the effect of items reclassified out of AOCI into net income for each individual line item impacted in the statement of income.  See Note 13 for the Company’s disclosures.

 

Disclosures about Offsetting Assets and Liabilities (ASU 2011-11).  The FASB’s new requirements to disclose information related to certain investments on both a gross and net basis became effective January 1, 2013.  The Company had no transactions or arrangements subject to these new disclosure requirements.

 

6



Table of Contents

 

Note 3Earnings Per Share (“EPS”)

 

 

Basic and diluted earnings per share were computed as follows:

 

 

 

 

 

Effect of

 

 

 

(Dollars in millions, except per share amounts)

 

Basic

 

Dilution

 

Diluted

 

Three Months Ended March 31,

 

 

 

 

 

 

 

2014

 

 

 

 

 

 

 

Shareholders’ net income

 

$

528

 

 

 

$

528

 

Shares (in thousands):

 

 

 

 

 

 

 

Weighted average

 

269,979

 

 

 

269,979

 

Common stock equivalents

 

 

 

4,488

 

4,488

 

Total shares

 

269,979

 

4,488

 

274,467

 

EPS

 

$

1.96

 

$

(0.04)

 

$

1.92

 

2013 

 

 

 

 

 

 

 

Shareholders’ net income

 

$

57

 

 

 

$

57

 

Shares (in thousands):

 

 

 

 

 

 

 

Weighted average

 

283,804

 

 

 

283,804

 

Common stock equivalents

 

 

 

5,454

 

5,454

 

Total shares

 

283,804

 

5,454

 

289,258

 

EPS

 

$

0.20

 

$

-

 

$

0.20

 

 

All outstanding employee stock options were included in the computation of diluted earnings per share for the three months ended March 31, 2014 and 2013.

 

The Company held 97,428,469 shares of common stock in Treasury as of March 31, 2014, and 80,302,892 shares as of March 31, 2013.

 

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Note 4 — Global Health Care Medical Claims Payable

 

 

Medical claims payable for the Global Health Care segment reflects estimates of the ultimate cost of claims that have been incurred but not yet reported, those that have been reported but not yet paid (reported claims in process), and other medical expenses payable that is primarily comprised of accruals for incentives and other amounts payable to health care professionals and facilities, as follows:

 

 

 

March 31,

 

December 31,

 

(In millions)

 

2014

 

2013

 

Incurred but not yet reported

 

$

1,754

 

$

1,615

 

Reported claims in process

 

302

 

355

 

Physician incentives and other medical expense payable

 

95

 

80

 

Medical claims payable

 

$

2,151

 

$

2,050

 

 

Activity in medical claims payable was as follows:

 

 

 

For the period ended

 

 

 

March 31,

 

December 31,

 

(In millions)

 

2014

 

2013

 

Balance at January 1,

 

$

2,050

 

$

1,856

 

Less: Reinsurance and other amounts recoverable

 

194

 

242

 

Balance at January 1, net

 

1,856

 

1,614

 

 

 

 

 

 

 

Incurred claims related to:

 

 

 

 

 

Current year

 

4,149

 

16,049

 

Prior years

 

(118)

 

(182)

 

Total incurred

 

4,031

 

15,867

 

Paid claims related to:

 

 

 

 

 

Current year

 

2,625

 

14,267

 

Prior years

 

1,322

 

1,358

 

Total paid

 

3,947

 

15,625

 

Ending Balance, net

 

1,940

 

1,856

 

Add: Reinsurance and other amounts recoverable

 

211

 

194

 

Ending Balance

 

$

2,151

 

$

2,050

 

 

Reinsurance and other amounts recoverable includes amounts due from reinsurers and policyholders to cover incurred but not reported and pending claims for minimum premium products and certain administrative services only business where the right of offset does not exist.  See Note 5 for additional information on reinsurance.  For the three months ended March 31, 2014, actual experience differed from the Company’s key assumptions resulting in favorable incurred claims related to prior years’ medical claims payable of $118 million, or 0.7% of the current year incurred claims as reported for the year ended December 31, 2013. Actual completion factors accounted for $39 million, or 0.2% of the favorability while actual medical cost trend resulted in the remaining $79 million, or 0.5%.

 

For the year ended December 31, 2013, actual experience differed from the Company’s key assumptions, resulting in favorable incurred claims related to prior years’ medical claims payable of $182 million, or 1.3% of the current year incurred claims as reported for the year ended December 31, 2012. Actual completion factors accounted for $74 million, or 0.5% of favorability while actual medical cost trend resulted in the remaining $108 million, or 0.7%.

 

The impact of prior year development on shareholders’ net income was $30 million for the three months ended March 31, 2014 compared with $48 million for the three months ended March 31, 2013.  The favorable effect of prior year development for both years primarily reflects low utilization of medical services, and to a lesser extent, the impact of the medical loss ratio (“MLR”) rebate accrual.  The change in the amount of the incurred claims related to prior years in the medical claims payable liability does not directly correspond to an increase or decrease in the Company’s shareholders’ net income recognized for the following reasons:

 

First, the Company consistently recognizes the actuarial best estimate of the ultimate liability within a level of confidence, as required by actuarial standards of practice that require the liabilities be adequate under moderately adverse conditions. As the Company

 

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establishes the liability for each incurral year, the Company ensures that its assumptions appropriately consider moderately adverse conditions. When a portion of the development related to the prior year incurred claims is offset by an increase determined appropriate to address moderately adverse conditions for the current year incurred claims, the Company does not consider that offset amount as having any impact on shareholders’ net income.

 

Second, as a result of the MLR provisions of Health Care Reform, changes in medical claim estimates due to prior year development may be offset by a change in the MLR rebate accrual.

 

Third, changes in reserves for the Company’s retrospectively experience-rated business for accounts in surplus do not usually impact shareholders’ net income because such amounts are generally offset by a change in the liability to the policyholder.  An account is in surplus when the accumulated premium received exceeds the accumulated medical costs and administrative charges, including profit charges. For additional information regarding the Company’s retrospectively experience-rated business, see page 3 of the Company’s 2013 Form 10-K.

 

The determination of liabilities for the Global Health Care medical claims payable requires the Company to make critical accounting estimates. See Note 2(N) to the Consolidated Financial Statements in the Company’s 2013 Form 10-K.

 

Note 5 — Reinsurance

 

 

The Company’s insurance subsidiaries enter into agreements with other insurance companies to assume and cede reinsurance. Reinsurance is ceded primarily to limit losses from large exposures and to permit recovery of a portion of direct or assumed losses.  Reinsurance is also used in acquisition and disposition transactions when the underwriting company is not being acquired. Reinsurance does not relieve the originating insurer of liability.  The Company regularly evaluates the financial condition of its reinsurers and monitors its concentrations of credit risk.

 

Effective Exit of GMDB and GMIB Business

 

On February 4, 2013, the Company entered into an agreement with Berkshire Hathaway Life Insurance Company of Nebraska (“Berkshire”) to effectively exit the GMDB and GMIB business via a reinsurance transaction.  Berkshire reinsured 100% of the Company’s future claim payments in these businesses, net of retrocessional arrangements existing at that time.  The reinsurance agreement is subject to an overall limit of approximately $3.8 billion.

 

This transaction resulted in an after-tax charge to shareholders’ net income in the first quarter of 2013 of $507 million ($781 million pre-tax reported as follows:  $727 million in other benefits expense; $45 million in GMIB fair value loss; and $9 million in other operating expenses). The payment to Berkshire under the agreement was $2.2 billion and was funded from the sale of investment assets, tax benefits related to the transaction and available parent cash.

 

Because this effective exit was accomplished via a reinsurance contract, the amounts related to the reinsured GMDB and GMIB contracts cannot be netted, so the gross assets and liabilities must continue to be measured and reported.  The following disclosures provide further context to the methods and assumptions used to determine these assets and liabilities.

 

GMDB

 

The Company estimates this liability with an internal model based on the Company’s experience and future expectations over an extended period, consistent with the long-term nature of this product.  Because the product is premium deficient, the Company records increases to the reserve if it is inadequate based on the model.  Prior to the reinsurance transaction with Berkshire, any such reserve increases were recorded as a charge to shareholders’ net income.  Reserve increases after the reinsurance transaction are expected to have a corresponding increase in the recorded reinsurance recoverable, provided the increased recoverable remains within the overall Berkshire limit (including the GMIB assets).

 

The Company’s dynamic hedge programs were discontinued during the first quarter of 2013 due to the Berkshire reinsurance transaction.  These hedge programs generated losses (included in other revenues) of $32 million for the three months ended March 31, 2013.

 

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Activity in the future policy benefit reserve for the GMDB business was as follows:

 

 

 

For the period ended

 

 

 

March 31,

 

December 31,

 

(In millions)

 

2014

 

2013

 

Balance at January 1

 

$

1,396

 

$

1,090

 

Add: Unpaid claims

 

18

 

24

 

Less: Reinsurance and other amounts recoverable

 

1,317

 

42

 

Balance at January 1, net

 

97

 

1,072

 

Add: Incurred benefits

 

1

 

699

 

Less: Paid benefits (including the $1,647 payment in 2013 for the Berkshire reinsurance transaction)

 

-

 

1,674

 

Ending balance, net

 

98

 

97

 

Less: Unpaid claims

 

19

 

18

 

Add: Reinsurance and other amounts recoverable

 

1,292

 

1,317

 

Ending balance

 

$

1,371

 

$

1,396

 

 

Benefits paid and incurred are net of ceded amounts.  The ending net retained reserve is to cover ongoing administrative expenses, as well as claims retained by the Company.

 

The death benefit coverage in force for GMDB contracts assumed by the Company was $2.9 billion as of March 31, 2014 and $3.0 billion as of December 31, 2013 assuming no reinsurance.  The death benefit coverage in force is the amount the Company would have to pay if all contractholders (approximately 382,000 as of March 31, 2014 and 390,000 as of December 31, 2013) died as of the specified date.  Unless the Berkshire reinsurance limit is exceeded, the Company would be reimbursed in full for these payments.  The aggregate value of the underlying mutual fund investments for these GMDB contracts was $13.8 billion as of March 31, 2014 and $14.1 billion as of December 31, 2013.

 

GMIB

 

As discussed further in Note 7, because GMIB contracts are without significant life insurance risk, they are not accounted for as insurance products. Instead, the Company reports GMIB liabilities and assets as derivatives at fair value. The GMIB assets are classified in other assets, including other intangibles, and the GMIB liabilities are classified in accounts payable, accrued expenses and other liabilities in the Consolidated Balance Sheet.  Disclosures related to fair value are included in Note 7 and derivatives are further described in Note 9.

 

GMIB assets included $384 million as of March 31, 2014 and $352 million as of December 31, 2013 from Berkshire, and were 100% secured by assets in a trust.  GMIB assets also included $431 million as of March 31, 2014 and $399 million as of December 31, 2013 from two other retrocessionaires, and 40% were secured by assets in a trust.

 

Effects of reinsurance

 

In the Company’s Consolidated Statements of Income, Premiums and fees were net of ceded premiums, and Total benefits and expenses were net of reinsurance recoveries, in the following amounts:

 

 

 

Three Months Ended

 

 

 

March 31,

 

(In millions)

 

2014

 

2013

 

Ceded premiums and fees

 

 

 

 

 

Individual life insurance and annuity business sold

 

$

45

 

$

46

 

Other

 

96

 

79

 

Total

 

$

141

 

$

125

 

Reinsurance recoveries

 

 

 

 

 

Individual life insurance and annuity business sold

 

$

99

 

$

88

 

Other

 

82

 

(262)

 

Total

 

$

181

 

$

(174)

 

 

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As noted in the GMDB section above, recoveries for the three months ended March 31, 2013 are net of a decrease in reinsurance recoverables from a change in the growth rate assumption, due to discontinuing the hedge programs after the reinsurance transaction with Berkshire.

 

Reinsurance Recoverables

 

Components of the Company’s reinsurance recoverables are presented below:

 

(In millions)

 

 

Line of Business

 

Reinsurer(s)

 

March 31,
2014

 

December 31,
2013

 

Collateral and Other Terms
at March 31, 2014

 

 

 

 

 

 

 

 

 

 

 

GMDB

 

Berkshire

 

$

1,251

 

 $

1,276

 

100% secured by assets in a trust.

 

 

 

 

 

 

 

 

 

 

 

 

 

Other

 

41

 

41

 

98% secured by assets in a trust or letter of credit.

 

 

 

 

 

 

 

 

 

 

 

Individual Life and Annuity (sold)

 

Lincoln National Life and Lincoln Life & Annuity of New York

 

3,881

 

3,905

 

Both companies’ ratings are sufficient to avoid triggering a contractual obligation to fully secure the outstanding balance.

 

 

 

 

 

 

 

 

 

 

 

Retirement Benefits business (sold)

 

Prudential Retirement Insurance and Annuity

 

1,179

 

1,200

 

100% secured by assets in a trust.

 

 

 

 

 

 

 

 

 

 

 

Supplemental Benefits business (resulting from the acquisition)

 

Great American Life

 

352

 

363

 

98% secured by assets in a trust.

 

 

 

 

 

 

 

 

 

 

 

Ongoing operations (Global Health Care, Global Supplemental Benefits, Group Disability and Life)

 

Various

 

403

 

407

 

Recoverables from more than 80 reinsurers used in the ordinary course of business. Balances range from less than $1 million up to $68 million, with 14% secured by assets in trusts or letters of credit.

 

 

 

 

 

 

 

 

 

 

 

Other run-off reinsurance

 

Various

 

106

 

107

 

90% secured by assets in a trust.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total reinsurance recoverables

 

 

 

$

7,213

 

$

7,299

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reserves for underlying reinsurance exposures assumed by the Company, as well as those for amounts recoverable from reinsurers and retrocessionaires for both ongoing operations and the run-off reinsurance operation, are considered appropriate as of March 31, 2014, based on current information.  The Company bears the risk of loss if its reinsurers and retrocessionaires do not meet or are unable to meet their reinsurance obligations to the Company.

 

Note 6 — Organizational Efficiency Plans

 

 

The Company is regularly evaluating ways to deliver its products and services more efficiently and at a lower cost.  During 2013 and 2012, the Company adopted specific plans to increase its organizational efficiency as follows.

 

2013 Plan.  During the fourth quarter of 2013, the Company committed to a plan to increase its organizational efficiency and reduce costs through a series of actions that includes employee headcount reductions.  As a result, the Company recognized charges in other operating expenses of $60 million pre-tax ($40 million after-tax) in the fourth quarter of 2013, primarily for severance costs.  We expect most of the severance to be paid by the end of 2015.

 

2012 Plan.  During the third quarter of 2012, in connection with the execution of its strategy, the Company committed to a series of actions to further improve its organizational alignment, operational effectiveness, and efficiency.  As a result, the Company recognized charges in other operating expenses of $77 million pre-tax ($50 million after-tax) in the third quarter of 2012 consisting primarily of severance costs.  As of March 31, 2014, the costs associated with this plan have been substantially paid.

 

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Summarized below is activity for these plans for 2013 and the first quarter of 2014.

 

(In millions)

 

Severance

 

Real estate

 

Total

Balance, January 1, 2013

$

67 

$

$

71 

Fourth quarter 2013 charge

 

47 

 

 13 

 

 60 

Less: 2013 payments

 

46 

 

 4 

 

 50 

Balance, December 31, 2013

 

68 

 

 13 

 

 81 

Less: First quarter 2014 payments

 

11 

 

 1 

 

 12 

Balance, March 31, 2014

$

57 

$

12 

$

69 

 

Note 7 — Fair Value Measurements

 

 

The Company carries certain financial instruments at fair value in the financial statements including fixed maturities, equity securities, short-term investments and derivatives.  Other financial instruments are measured at fair value under certain conditions, such as when impaired.

 

Fair value is defined as the price at which an asset could be exchanged in an orderly transaction between market participants at the balance sheet date.  A liability’s fair value is defined as the amount that would be paid to transfer the liability to a market participant, not the amount that would be paid to settle the liability with the creditor.

 

The Company’s financial assets and liabilities carried at fair value have been classified based upon a hierarchy defined by GAAP.  The hierarchy gives the highest ranking to fair values determined using unadjusted quoted prices in active markets for identical assets and liabilities (Level 1) and the lowest ranking to fair values determined using methodologies and models with unobservable inputs (Level 3). An asset’s or a liability’s classification is based on the lowest level of input that is significant to its measurement.  For example, a financial asset or liability carried at fair value would be classified in Level 3 if unobservable inputs were significant to the instrument’s fair value, even though the measurement may be derived using inputs that are both observable (Levels 1 and 2) and unobservable (Level 3).

 

The Company estimates fair values using prices from third parties or internal pricing methods.  Fair value estimates received from third-party pricing services are based on reported trade activity and quoted market prices when available, and other market information that a market participant may use to estimate fair value.  The internal pricing methods are performed by the Company’s investment professionals and generally involve using discounted cash flow analyses, incorporating current market inputs for similar financial instruments with comparable terms and credit quality, as well as other qualitative factors.  In instances where there is little or no market activity for the same or similar instruments, fair value is estimated using methods, models and assumptions that the Company believes a hypothetical market participant would use to determine a current transaction price.  These valuation techniques involve some level of estimation and judgment that becomes significant with increasingly complex instruments or pricing models.

 

The Company is responsible for determining fair value, as well as the appropriate level within the fair value hierarchy, based on the significance of unobservable inputs.  The Company reviews methodologies, processes and controls of third-party pricing services and compares prices on a test basis to those obtained from other external pricing sources or internal estimates.  The Company performs ongoing analyses of both prices received from third-party pricing services and those developed internally to determine that they represent appropriate estimates of fair value.  The controls completed by the Company and third-party pricing services include reviewing to ensure that prices do not become stale and whether changes from prior valuations are reasonable or require additional review.  The Company also performs sample testing of sales values to confirm the accuracy of prior fair value estimates.  Exceptions identified during these processes indicate that adjustments to prices are infrequent and do not significantly impact valuations.

 

Financial Assets and Financial Liabilities Carried at Fair Value

 

The following tables provide information as of March 31, 2014 and December 31, 2013 about the Company’s financial assets and liabilities carried at fair value.  Separate account assets that are also recorded at fair value on the Company’s Consolidated Balance Sheets are reported separately under the heading “Separate account assets” as gains and losses related to these assets generally accrue directly to policyholders.

 

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March 31, 2014
(In millions)

 

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

 

Significant Other
Observable Inputs

(Level 2)

 

Significant
Unobservable
Inputs
(Level 3)

 

Total

Financial assets at fair value:

 

 

 

 

 

 

 

 

Fixed maturities:

 

 

 

 

 

 

 

 

Federal government and agency

 

$

497

 

$

631

 

$

-

 

$

1,128

State and local government

 

-

 

2,096

 

-

 

2,096

Foreign government

 

-

 

1,557

 

26

 

1,583

Corporate

 

-

 

11,309

 

505

 

11,814

Federal agency mortgage-backed

 

-

 

71

 

-

 

71

Other mortgage-backed

 

-

 

79

 

1

 

80

Other asset-backed

 

-

 

260

 

618

 

878

Total fixed maturities (1)

 

497

 

16,003

 

1,150

 

17,650

Equity securities

 

1

 

78

 

48

 

127

Subtotal

 

498

 

16,081

 

1,198

 

17,777

Short-term investments

 

-

 

394

 

-

 

394

GMIB assets (2)

 

-

 

-

 

815

 

815

Other derivative assets (3)

 

-

 

2

 

-

 

2

Total financial assets at fair value, excluding separate accounts

 

$

498

 

$

16,477

 

$

2,013

 

$

18,988

Financial liabilities at fair value:

 

 

 

 

 

 

 

 

GMIB liabilities

 

$

-

 

$

-

 

$

794

 

$

794

Other derivative liabilities (3)

 

-

 

16

 

-

 

16

Total financial liabilities at fair value

 

$

-

 

$

16

 

$

794

 

$

810

 

(1)        Fixed maturities included $605 million of net appreciation required to adjust future policy benefits for the run-off settlement annuity business including $82 million of appreciation for securities classified in Level 3.

(2)        The GMIB assets represent retrocessional contracts in place from three external reinsurers that cover the exposures on these contracts.  See Note 5 for additional information.

(3)        Other derivative assets and other derivative liabilities reflected foreign currency and interest rate swaps qualifying as cash flow hedges.  See Note 9 for additional information.

 

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December 31, 2013
(In millions)

 

Quoted Prices in
Active Markets for
Identical Assets
(Level 1)

 

Significant Other
Observable Inputs
(Level 2)

 

Significant
Unobservable
Inputs
(Level 3)

 

Total

Financial assets at fair value:

 

 

 

 

 

 

 

 

Fixed maturities:

 

 

 

 

 

 

 

 

Federal government and agency

 

$

297

 

$

583

 

$

-

 

$

880

State and local government

 

-

 

2,144

 

-

 

2,144

Foreign government

 

-

 

1,421

 

23

 

1,444

Corporate

 

-

 

10,476

 

505

 

10,981

Federal agency mortgage-backed

 

-

 

76

 

-

 

76

Other mortgage-backed

 

-

 

76

 

1

 

77

Other asset-backed

 

-

 

282

 

602

 

884

Total fixed maturities (1)

 

297

 

15,058

 

1,131

 

16,486

Equity securities

 

8

 

74

 

59

 

141

Subtotal

 

305

 

15,132

 

1,190

 

16,627

Short-term investments

 

-

 

631

 

-

 

631

GMIB assets (2)

 

-

 

-

 

751

 

751

Other derivative assets (3)

 

-

 

3

 

-

 

3

Total financial assets at fair value, excluding separate accounts

 

$

305

 

$

15,766

 

$

1,941

 

$

18,012

Financial liabilities at fair value:

 

 

 

 

 

 

 

 

GMIB liabilities

 

$

-

 

$

-

 

$

741

 

$

741

Other derivative liabilities (3)

 

-

 

16

 

-

 

16

Total financial liabilities at fair value

 

$

-

 

$

16

 

$

741

 

$

757

 

(1)        Fixed maturities included $458 million of net appreciation required to adjust future policy benefits for the run-off settlement annuity business including $60 million of appreciation for securities classified in Level 3.

(2)        The GMIB assets represented retrocessional contracts in place from three external reinsurers that cover the exposures on these contracts.  See Note 5 for additional information.

(3)        Other derivative assets reflected interest rate and foreign currency swaps qualifying as cash flow hedges.  Other derivative liabilities included $15 million of interest rate and foreign currency swaps qualifying as cash flow hedges and $1 million of interest rate and foreign currency swaps not designated as accounting hedges.  See Note 9 for additional information.

 

Level 1 Financial Assets

 

Inputs for instruments classified in Level 1 include unadjusted quoted prices for identical assets in active markets accessible at the measurement date.  Active markets provide pricing data for trades occurring at least weekly and include exchanges and dealer markets.

 

Assets in Level 1 include actively-traded U.S. government bonds and exchange-listed equity securities.  Given the narrow definition of Level 1 and the Company’s investment asset strategy to maximize investment returns, a relatively small portion of the Company’s investment assets are classified in this category.

 

Level 2 Financial Assets and Financial Liabilities

 

Inputs for instruments classified in Level 2 include quoted prices for similar assets or liabilities in active markets, quoted prices from those willing to trade in markets that are not active, or other inputs that are market observable or can be corroborated by market data for the term of the instrument.  Such other inputs include market interest rates and volatilities, spreads and yield curves. An instrument is classified in Level 2 if the Company determines that unobservable inputs are insignificant.

 

Fixed maturities and equity securities.  Approximately 90% of the Company’s investments in fixed maturities and equity securities are classified in Level 2 including most public and private corporate debt and equity securities, federal agency and municipal bonds, non-government mortgage-backed securities and preferred stocks.  Because many fixed maturities do not trade daily, third-party pricing services and internal methods often use recent trades of securities with similar features and characteristics. When recent trades are not available, pricing models are used to determine these prices.  These models calculate fair values by discounting future cash flows at estimated market interest rates.  Such market rates are derived by calculating the appropriate spreads over comparable U.S. Treasury securities, based on the credit quality, industry and structure of the asset.  Typical inputs and assumptions to pricing models include, but are not limited to, a combination of benchmark yields, reported trades, issuer spreads, liquidity, benchmark securities, bids, offers, reference data, and industry and economic events.  For mortgage-backed securities, inputs and assumptions may also

 

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include characteristics of the issuer, collateral attributes, prepayment speeds and credit rating.

 

Nearly all of these instruments are valued using recent trades or pricing models.  Less than 1% of the fair value of investments classified in Level 2 represent foreign bonds that are valued using a single unadjusted market-observable input derived by averaging multiple broker-dealer quotes, consistent with local market practice.

 

Short-term investments are carried at fair value which approximates cost. On a regular basis the Company compares market prices for these securities to recorded amounts to validate that current carrying amounts approximate exit prices. The short-term nature of the investments and corroboration of the reported amounts over the holding period support their classification in Level 2.

 

Other derivatives classified in Level 2 represent over-the-counter instruments such as interest rate and foreign currency swap contracts.  Fair values for these instruments are determined using market observable inputs including forward currency and interest rate curves and widely published market observable indices.  Credit risk related to the counterparty and the Company is considered when estimating the fair values of these derivatives.  However, the Company is largely protected by collateral arrangements with counterparties, and determined that no adjustment for credit risk was required as of March 31, 2014 or December 31, 2013.  Level 2 also includes exchange-traded interest rate swap contracts.  Credit risk related to the clearinghouse counterparty and the Company is considered minimal when estimating the fair values of these derivatives because of upfront margin deposits and daily settlement requirements.  The nature and use of these other derivatives are described in Note 9.

 

Level 3 Financial Assets and Financial Liabilities

 

Certain inputs for instruments classified in Level 3 are unobservable (supported by little or no market activity) and significant to their resulting fair value measurement.  Unobservable inputs reflect the Company’s best estimate of what hypothetical market participants would use to determine a transaction price for the asset or liability at the reporting date.

 

The Company classifies certain newly issued, privately-placed, complex or illiquid securities, as well as assets and liabilities relating to GMIB, in Level 3.

 

Fixed maturities and equity securities.  Approximately 7% of fixed maturities and equity securities are priced using significant unobservable inputs and classified in this category, including:

 

 

 

March 31,

 

December 31,

(In millions)

 

2014

 

2013

Other asset and mortgage-backed securities - valued using pricing models

 

$

619

 

$

603

Corporate and government fixed maturities - valued using pricing models

 

443

 

417

Corporate fixed maturities - valued at transaction price

 

88

 

111

Equity securities - valued at transaction price

 

48

 

59

Total

 

$

1,198

 

$

1,190

 

Fair values of other asset and mortgage-backed securities, corporate and government fixed maturities are primarily determined using pricing models that incorporate the specific characteristics of each asset and related assumptions including the investment type and structure, credit quality, industry and maturity date in comparison to current market indices, spreads and liquidity of assets with similar characteristics.  For other asset and mortgage-backed securities, inputs and assumptions for pricing may also include collateral attributes and prepayment speeds.  Recent trades in the subject security or similar securities are assessed when available, and the Company may also review published research, as well as the issuer’s financial statements, in its evaluation.  Approximately 10% of fixed maturities classified in Level 3 represent single, unadjusted, non-binding broker quotes that are not considered market observable.  Certain private equity investments and subordinated corporate fixed maturities, representing approximately 10% of securities included in Level 3, are valued at transaction price in the absence of market data indicating a change in the estimated fair values.

 

Quantitative Information about Unobservable Inputs

The following tables summarize the fair value and significant unobservable inputs used in pricing Level 3 securities that were developed directly by the Company as of March 31, 2014 and December 31, 2013.  The range and weighted average basis point amounts reflect the Company’s best estimates of the unobservable adjustments a market participant would make to the market observable spreads (adjustment to discount rates) used to calculate the fair values in a discounted cash flow analysis.

 

Other asset and mortgage-backed securities.  The significant unobservable inputs used to value the following other asset and mortgage-backed securities are liquidity and weighting of credit spreads.  When there is limited trading activity for the security, an

 

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adjustment for liquidity is made as of the measurement date that considers current market conditions, issuer circumstances and complexity of the security structure.  An adjustment to weight credit spreads is needed to value a more complex bond structure with multiple underlying collateral and no standard market valuation technique.  The weighting of credit spreads is primarily based on the underlying collateral’s characteristics and their proportional cash flows supporting the bond obligations.  The resulting wide range of unobservable adjustments in the table below is due to the varying liquidity and quality of the underlying collateral, ranging from high credit quality to below investment grade.

 

Corporate and government fixed maturities.  The significant unobservable input used to value the following corporate and government fixed maturities is an adjustment for liquidity.  When there is limited trading activity for the security, an adjustment is needed to reflect current market conditions and issuer circumstances.

 

As of March 31, 2014
(In millions except basis points)

 

Fair Value

 

Unobservable Input

 

Unobservable Adjustment
to Discount Rates Range
(Weighted Average)
in Basis Points

 

Other asset and mortgage-backed securities

 

$

610

 

Liquidity

 

40-530 (160) 

 

 

 

 

 

Weighting of credit spreads

 

130-2,410 (300) 

 

Corporate and government fixed maturities

 

$

366

 

Liquidity

 

80-490 (190) 

 

 

As of December 31, 2013
(In millions except basis points)

 

Fair Value

 

Unobservable Input

 

Unobservable Adjustment
to Discount Rates Range
(Weighted Average)
in Basis Points

 

Other asset and mortgage-backed securities

 

$

593

 

Liquidity

 

60 - 620 (170)

 

 

 

 

 

Weighting of credit spreads

 

120 - 2,090 (290)

 

Corporate and government fixed maturities

 

$

305

 

Liquidity

 

80 - 370 (200)

 

 

Significant increases in any of these inputs would result in a lower fair value measurement while decreases in these inputs would result in a higher fair value measurement.  Generally, the unobservable inputs are not interrelated and a change in the assumption used for one unobservable input is not accompanied by a change in the other unobservable input.  The tables do not include Level 3 securities when fair value and significant unobservable inputs were not developed directly by the Company, including securities using single, unadjusted non-binding broker quotes and securities valued at transaction price.  See the preceding discussion regarding the Company’s valuation processes and controls.

 

Guaranteed minimum income benefit contracts.  As discussed in Note 5, the Company effectively exited from this business in 2013.  Although these GMIB assets and liabilities must continue to be reported as derivatives at fair value, the only assumption that is expected to impact future shareholders’ net income is the risk of non-performance.  This assumption reflects a market participant’s view of (a) the risk of the Company not fulfilling its GMIB obligations (GMIB liabilities) and (b) the credit risk that the reinsurers do not pay their obligations (GMIB assets).

 

The Company reports GMIB liabilities and assets as derivatives at fair value because cash flows of these liabilities and assets are affected by equity markets and interest rates, but are without significant life insurance risk and are settled in lump sum payments.  Under the terms of these written and purchased contracts, the Company periodically receives and pays fees based on either contractholders’ account values or deposits increased at a contractual rate.  The Company will also pay and receive cash depending on changes in account values and interest rates when contractholders first elect to receive minimum income payments.  The Company estimates the fair value of the assets and liabilities for GMIB contracts by calculating the results for many scenarios run through a model utilizing various assumptions that include non-performance risk, among other things.

 

The non-performance risk adjustment is incorporated by adding an additional spread to the discount rate in the calculation of both (a) the GMIB liabilities to reflect a market participant’s view of the risk of the Company not fulfilling its GMIB obligations, and (b) the GMIB assets to reflect a market participant’s view of the credit risk of the reinsurers, after considering collateral.  Non-performance risk adjustments had an immaterial effect on shareholders’ net income for the three months ended March 31, 2014 and 2013.

 

Other assumptions that affect GMIB assets and liabilities include capital market assumptions (including market returns, interest rates and market volatilities of the underlying equity and bond mutual fund investments) and future annuitant behavior (including mortality, lapse, and annuity election rates).  As certain assumptions used to estimate fair values for these contracts are largely unobservable (primarily related to future annuitant behavior), the Company classifies GMIB assets and liabilities in Level 3.

 

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The Company regularly evaluates each of the assumptions used in establishing these assets and liabilities.  Significant decreases in assumed lapse rates or spreads used to calculate non-performance risk, or increases in assumed annuity election rates would result in higher fair value measurements.  A change in one of these assumptions is not necessarily accompanied by a change in another assumption.

 

GMIB liabilities are reported in the Company’s Consolidated Balance Sheets in accounts payable, accrued expenses and other liabilities.  GMIB assets associated with these contracts represent net receivables in connection with reinsurance that the Company has purchased from three external reinsurers and are reported in the Company’s Consolidated Balance Sheets in other assets, including other intangibles.

 

Changes in Level 3 Financial Assets and Financial Liabilities Carried at Fair Value

 

The following tables summarize the changes in financial assets and financial liabilities classified in Level 3 for the three months ended March 31, 2014 and 2013.  Separate account asset changes are reported separately under the heading “Separate account assets” as the changes in fair values of these assets accrue directly to the policyholders.  Gains and losses reported in these tables may include net changes in fair value that are attributable to both observable and unobservable inputs.

 

For the Three Months Ended March 31, 2014
(In millions)

 

Fixed Maturities &
Equity Securities

 

GMIB Assets

 

GMIB Liabilities

 

GMIB Net

 

Balance at January 1, 2014

 

$

1,190

 

$

751

 

$

(741)

 

$

10

 

Gains (losses) included in shareholders’ net income:

 

 

 

 

 

 

 

 

 

GMIB fair value gain/(loss)

 

-

 

77

 

(77)

 

-

 

Other

 

12

 

(1)

 

12

 

11

 

Total gains (losses) included in shareholders’ net income

 

12

 

76

 

(65)

 

11

 

Gains included in other comprehensive income

 

8

 

-

 

-

 

-

 

Gains required to adjust future policy benefits for settlement annuities (1)

 

22

 

-

 

-

 

-

 

Purchases, sales and settlements:

 

 

 

 

 

 

 

 

 

Purchases

 

24

 

-

 

-

 

-

 

Sales

 

(24)

 

-

 

-

 

-

 

Settlements

 

(61)

 

(12)

 

12

 

-

 

Total purchases, sales and settlements

 

(61)

 

(12)

 

12

 

-

 

Transfers into/(out of) Level 3:

 

 

 

 

 

 

 

 

 

Transfers into Level 3

 

124

 

-

 

-

 

-

 

Transfers out of Level 3

 

(97)

 

-

 

-

 

-

 

Total transfers into/(out of) Level 3

 

27

 

-