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CIGNA Corporation 10-Q 2009 Table of Contents
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the quarterly period ended September 30, 2009
OR
For the transition period from to
Commission file number 1-08323
CIGNA Corporation
(Exact name of registrant as specified in its charter)
Two Liberty Place, 1601 Chestnut Street
Philadelphia, Pennsylvania 19192 (Address of principal executive offices) (Zip Code) Registrant’s telephone number, including area code (215) 761-1000
Not Applicable
(Former name, former address and former fiscal year, if changed since last report) 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 such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark 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). Yes
þ No o
Indicate by check mark 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.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of
the Exchange Act).
Yes o No þ
As of October 16, 2009, 273,436,995 shares of the issuer’s common stock were
outstanding.
CIGNA CORPORATION
INDEX
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
The accompanying Notes to the Consolidated Financial Statements are an integral part of these statements.
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CIGNA Corporation
Consolidated Balance Sheets
The accompanying Notes to the Consolidated Financial Statements are an integral part of these statements.
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CIGNA Corporation
Consolidated Statements of Comprehensive Income and Changes in Total Equity (In millions, except per share amounts)
The accompanying Notes to the Consolidated Financial Statements are an integral part of these statements.
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CIGNA Corporation
Consolidated Statements of Comprehensive Income and Changes in Total Equity (In millions, except per share amounts)
The accompanying Notes to the Consolidated Financial Statements are an integral part of these statements.
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CIGNA Corporation
Consolidated Statements of Cash Flows
The accompanying Notes to the Consolidated Financial Statements are an integral part of these statements.
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CIGNA CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) Note 1 — Basis of Presentation
The Consolidated Financial Statements include the accounts of CIGNA Corporation, its significant
subsidiaries, and variable interest entities of which CIGNA Corporation is the primary beneficiary
(referred to collectively as “the Company”). 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).
The 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 in the Company’s Form 10-K for the year ended December 31, 2008.
The preparation of interim consolidated financial statements necessarily relies heavily on
estimates. This and certain other factors, such as 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.
In preparing these interim consolidated financial statements, the Company has evaluated events that
occurred between the balance sheet date and November 5, 2009.
Certain reclassifications and restatements have been made to prior period amounts to conform to the
current presentation. In addition, certain restatements have been made in connection with
the adoption of new accounting pronouncements. See Note 2 for further information.
Discontinued operations for the nine months ended September 30, 2009 primarily represented a tax
benefit associated with a past divestiture, resolved at the completion of the 2005 and 2006 IRS
examinations.
Discontinued operations for the third quarter of 2008 included a gain of $1 million after-tax from
the settlement of certain issues related to a past divestiture. Discontinued operations for the
nine months ended September 30, 2008 included a gain of $3 million after-tax from the settlement of
certain issues related to a past divestiture.
Unless otherwise indicated, amounts in these Notes exclude the effects of discontinued operations.
Note 2 — Recent Accounting Pronouncements
Accounting Standards Codification. The Financial Accounting Standards Board (FASB) has established
the Accounting Standards Codification (Codification or ASC) as the single source of authoritative
accounting guidance effective for reporting in the third quarter of 2009. Therefore, the Company
will use the Codification section or description when referring to GAAP except for very recent
guidance that has not yet been incorporated into the Codification.
Other-than-temporary impairments. On April 1, 2009, the Company adopted the FASB’s updated
guidance for evaluating whether an impairment is other than temporary for fixed maturities with
declines in fair value below amortized cost (ASC 320). It requires assessing the Company’s intent
to sell or whether it is more likely than not that the Company will be required to sell such fixed
maturities before their fair values recover. If so, an impairment loss is recognized in net
income for the excess of the amortized cost over fair value. The Company must also determine if it
does not expect to recover the amortized cost of fixed maturities with declines in fair value (even
if it does not intend to sell or will not be required to sell these fixed maturities). In this
case, the credit portion of the impairment loss is recognized in net income and the non-credit
portion of an impairment loss is recognized in a separate component of shareholders’ equity. A
reclassification adjustment from retained earnings to accumulated other comprehensive income was
required for previously impaired fixed maturities that have a non-credit loss as of the date of
adoption, less related tax effects.
The cumulative effect of adoption increased the Company’s retained earnings with an offsetting
decrease to accumulated other comprehensive income of $18 million, with no overall change to
shareholders’ equity. See Note 9 for information on the Company’s other-than-temporary impairments
including additional required disclosures.
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Noncontrolling interests in subsidiaries. Effective January 1, 2009, the Company adopted the
FASB’s updated guidance on accounting for noncontrolling interests (ASC 810) through retroactive
restatement of prior financial statements and reclassified $6 million of noncontrolling interest as
of January 1, 2009 and 2008 from Accounts payable, accrued expenses and other liabilities to
Noncontrolling interest in total equity. In addition, for the nine months ended September 30,
2008, net income of $2 million attributable to the noncontrolling interest has been reclassified to
be included in net income, with a reduction to net income to determine net income attributable to
the Company’s shareholders (“shareholders’ net income”).
Earnings per share. Effective January 1, 2009, the Company adopted the FASB’s updated earnings per
share guidance (ASC 260) for determining participating securities which requires unvested
restricted stock awards that contain rights to nonforfeitable dividends to be included in the
denominator of both basic and diluted earnings per share (“EPS”) calculations. Prior period EPS
data have been restated to reflect the adoption of this guidance. See Note 4 for the effects of
this guidance on previously reported EPS amounts.
Business combinations. Effective January 1, 2009, the Company adopted the FASB’s guidance on
accounting for business combinations (ASC 805) that requires fair value measurements for all future
acquisitions, including contingent purchase price and certain contingent assets or liabilities of
the entity to be acquired, requires acquisition related and restructuring costs to be expensed as
incurred and requires changes in tax items after the acquisition date to be reported in income tax
expense. There were no effects to the Company’s Consolidated Financial Statements at adoption.
Derivatives disclosures. Effective January 1, 2009, the Company expanded its disclosures on
derivatives and hedging activities to comply with the FASB’s updated guidance (ASC 815) that
requires the Company to disclose the purpose for using derivative instruments, their accounting
treatment and related effects on financial condition, results of operations and liquidity. See
Note 10 for information on the Company’s derivative financial instruments including these
additional required disclosures.
Fair value measurements. Effective January 1, 2008, the Company adopted the FASB’s fair value
disclosure and measurement guidance (ASC 820) that expands disclosures about fair value
measurements and clarifies how to measure fair value by focusing on the price that would be
received when selling an asset or paid to transfer a liability (exit price). In addition, the FASB
amended the fair value guidance in 2008 to provide additional guidance for determining the fair
value of a financial asset when the market for that instrument is not active. See Note 8 for
information on the Company’s fair value measurements.
The Company carries certain financial instruments at fair value in the financial statements
including approximately $13.8 billion in invested assets at September 30, 2009. The Company also
carries derivative instruments at fair value, including assets and liabilities for reinsurance
contracts covering guaranteed minimum income benefits (GMIB assets and liabilities) under certain
variable annuity contracts issued by other insurance companies and related retrocessional
contracts. The Company also reports separate account assets at fair value; however, changes in the
fair values of these assets accrue directly to policyholders and are not included in the Company’s
revenues and expenses. At the adoption of this fair value guidance, there were no effects to the
Company’s measurements of fair values for financial instruments other than for GMIB assets and
liabilities discussed below. In addition, there were no effects to the Company’s measurements of
financial assets of adopting the FASB’s 2008 amendment to this fair value guidance.
At adoption, the Company was required to change certain assumptions used to estimate the fair
values of GMIB assets and liabilities. Because there is no market for these contracts, the
assumptions used to estimate their fair values at adoption were determined using a hypothetical
market participant’s view of exit price, rather than using historical market data and actual
experience to establish the Company’s future expectations. Certain of these assumptions have
limited or no observable market data so determining an exit price requires the Company to exercise
significant judgment and make critical accounting estimates. On adoption, the Company recorded a
charge of $131 million after-tax, net of reinsurance ($202 million pre-tax), in Run-off
Reinsurance.
The Company’s results of operations related to this business are expected to continue to be
volatile in future periods because several underlying assumptions will be based on current
market-observable inputs which will likely change each period. See Note 8 for additional
information.
During the first nine months of 2009, the Company adopted FASB guidance that clarifies how to
determine fair value for various assets and liabilities with no material effects to the Company’s
Consolidated Financial Statements.
In the
third quarter of 2009, the FASB issued guidance on measuring the fair
value of liabilities and for investments
in certain entities to provide a practical alternative under certain conditions to determine the fair
value of these investments using their net asset value or its equivalent. The Company expects no
material effects on its Consolidated Financial Statements at adoption in the fourth quarter of
2009.
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Transfers of financial assets. In 2009, the FASB issued SFAS No. 166 “Accounting for Transfers of
Financial Assets, an amendment of FASB Statement No. 140,” which changes the requirements for
recognizing the transfer of financial assets and requires additional disclosures about a
transferor’s continuing involvement in transferred financial assets. The guidance also eliminates
the concept of a “qualifying special purpose entity” when assessing transfers of financial
instruments. The recognition and measurement provisions of this guidance must be applied to
transfers that occur on or after January 1, 2010. On adoption, the Company does not expect a
material effect to the results of operations or financial condition.
Variable interest entities. In 2009, the FASB issued Statement of Financial Accounting Standards
(SFAS) No. 167, “Amendments to FASB Interpretation No. 46(R),” which amended guidance requiring
periodic qualitative analyses to determine whether a variable interest entity must be consolidated
by the Company. In addition, this guidance requires the Company to disclose any significant
judgments and assumptions made in determining whether it must consolidate a variable interest
entity. Any changes in consolidated entities resulting from these requirements must be applied
through retrospective restatement of prior financial statements beginning in 2010. The Company is
presently evaluating the impact of these new requirements.
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Note 3 — Acquisitions and Dispositions
The Company may from time to time acquire or dispose of assets, subsidiaries or lines of
business. Significant transactions are described below.
Great-West Healthcare Acquisition. On April 1, 2008, the Company acquired the Healthcare division
of Great-West Life and Annuity, Inc. (“Great-West Healthcare” or the “acquired business”) through
100% indemnity reinsurance agreements and the acquisition of certain affiliates and other assets
and liabilities of Great-West Healthcare. The purchase price of approximately $1.5 billion
consisted of a payment to the seller of approximately $1.4 billion for the net assets acquired and
the assumption of net liabilities under the reinsurance agreement of approximately $0.1
billion. Great-West Healthcare primarily sells medical plans on a self-funded basis with stop loss
coverage to select and regional employer groups. Great-West Healthcare’s offerings also include
the following specialty products: stop loss, life, disability, medical, dental, vision,
prescription drug coverage, and accidental death and dismemberment insurance. The acquisition,
which was accounted for as a purchase, was financed through a combination of cash and the issuance
of both short and long-term debt.
In the first quarter of 2009, the Company completed its allocation of the total purchase price to
the tangible and intangible net assets acquired based on management’s estimates of their fair
values without material changes from December 31, 2008.
The results of Great-West Healthcare are included in the Company’s Consolidated Financial
Statements from the date of acquisition.
The following table presents selected unaudited pro forma information for the Company assuming the
acquisition had occurred as of January 1, 2008. The pro forma information does not purport to
represent what the Company’s actual results would have been if the acquisition had occurred as of
that date or what such results will be for any future periods.
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Note 4 — Earnings Per Share
Basic and diluted earnings per share were computed as follows:
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As described in Note 2, effective in 2009, the Company adopted the FASB’s new guidance for
determining participating securities which requires the Company’s unvested restricted stock awards
to be included in weighted average shares instead of being considered a common stock equivalent.
Prior period share information has been restated as follows.
The following outstanding employee stock options were not included in the computation of
diluted earnings per share because their effect would have increased diluted earnings per share
(antidilutive) as their exercise price was greater than the average share price of the Company’s
common stock for the period.
The Company held 77,475,700 shares of common stock in Treasury as of September 30, 2009, and
78,693,702 shares as of September 30, 2008.
Note 5 — Health Care Medical Claims Payable
Medical claims payable for the Health Care segment reflects estimates of the ultimate cost of
claims that have been incurred but not yet reported, those which have been reported but not yet
paid (reported claims in process) and other medical expense payable, which primarily comprises
accruals for provider incentives and other amounts payable to providers. Incurred but not yet
reported comprises the majority of the reserve balance as follows:
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Activity in medical claims payable was as follows:
Reinsurance and other amounts recoverable reflect 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 11 for additional information on reinsurance. For the nine months ended September 30, 2009,
actual experience differed from the Company’s key assumptions resulting in favorable incurred
claims related to prior years’ medical claims payable of $39 million, or 0.5% of the current year
incurred claims as reported for the year ended December 31, 2008. Actual completion factors
resulted in a reduction in medical claims payable of $18 million, or 0.2% of the current year
incurred claims as reported for the year ended December 31, 2008 for the insured book of business.
Actual medical cost trend resulted in a reduction in medical claims payable of $21 million, or 0.3%
of the current year incurred claims as reported for the year ended December 31, 2008 for the
insured book of business.
For the year ended December 31, 2008, actual experience differed from the Company’s key
assumptions, resulting in favorable incurred claims related to prior years’ medical claims payable
of $60 million, or 0.9% of the current year incurred claims as reported for the year ended December
31, 2007. Actual completion factors resulted in a reduction of the medical claims payable of $29
million, or 0.4% of the current year incurred claims as reported for the year ended December 31,
2007 for the insured book of business. Actual medical cost trend resulted in a reduction of the
medical claims payable of $31 million, or 0.5% of the current year incurred claims as reported for
the year ended December 31, 2007 for the insured book of business.
The favorable impacts in 2009 and 2008 relating to completion factors and medical cost trend
variances are primarily due to the release of the provision for moderately adverse conditions,
which is a component of the assumptions for both completion factors and medical cost trend,
established for claims incurred related to prior years. This release was substantially offset by
the provision for moderately adverse conditions established for claims incurred related to the
current year.
The corresponding impact of prior year development on shareholders’ net income was not material for
the three months and nine months ended September 30, 2009 and 2008. 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, due to the nature of the Company’s retrospectively experience-rated business, only
adjustments to medical claims payable on accounts in deficit affect shareholders’ net income. An
increase or decrease to medical claims payable on accounts in deficit, in effect, accrues to the
Company and directly impacts shareholders’ net income. An account is in deficit when the
accumulated medical costs and administrative charges, including profit charges, exceed the
accumulated premium received. Adjustments to medical claims payable on accounts in surplus accrue
directly to the policyholder with no impact on the Company’s shareholders’ net income. An account
is in surplus when the accumulated premium received exceeds the accumulated medical costs and
administrative charges, including profit charges.
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Second, the Company consistently recognizes the actuarial best estimate of the ultimate liability
within a level of confidence, as required by actuarial standards of practice, which require that
the liabilities be adequate under moderately adverse conditions. As the Company 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.
The determination of liabilities for Health Care medical claims payable required the Company to
make critical accounting estimates. See Note 2(O) to the Consolidated Financial Statements in the
Company’s 2008 Form 10-K.
Note 6 — Cost Reduction
During 2009, the Company continued its previously announced comprehensive review to reduce the
operating expenses of its ongoing businesses. As a result, the Company recognized severance
related charges in other operating expenses as follows:
Substantially all of these charges were recorded in the Health Care segment, and are expected to be
paid in cash by June 30, 2010.
Cost reduction activity for 2009 was as follows:
Note 7 — Guaranteed Minimum Death Benefit Contracts
The Company’s reinsurance operations, which were discontinued in 2000 and are now an inactive
business in run-off mode, reinsured guaranteed minimum death benefits (GMDB), also known as
variable annuity death benefits (VADBe), under certain variable annuities issued by other insurance
companies. These variable annuities are essentially investments in mutual funds combined with a
death benefit. The Company has equity and other market exposures as a result of this product. In
periods of declining equity markets and in periods of flat equity markets following a decline, the
Company’s liabilities for these guaranteed minimum death benefits increase. Conversely, in periods
of rising equity markets, the Company’s liabilities for these guaranteed minimum death benefits
decrease.
In order to substantially reduce the equity market exposures relating to guaranteed minimum death
benefit contracts, the Company operates a dynamic hedge program (GMDB equity hedge program), using
exchange-traded futures contracts. The hedge program is designed to substantially offset both
positive and negative impacts of changes in equity markets on the GMDB liability. The hedge
program involves detailed, daily monitoring of equity market movements and rebalancing the futures
contracts within established parameters. While the hedge program is actively managed, it may not
exactly offset changes in the GMDB liability due to, among other things, divergence between the
performance of the underlying mutual funds and the hedge instruments, high levels of volatility in
the equity markets, and differences between actual contractholder behavior and what is assumed. In
addition, underlying mutual fund data is not reported and incorporated into the required hedge
position on a real time basis, which also impacts the performance of the hedge program. Although
this hedge program does not qualify for GAAP hedge accounting, it is an economic hedge because it
is designed and operated to substantially reduce equity market exposures resulting from this
product. The results of these futures contracts are included in other revenue and amounts
reflecting corresponding changes in liabilities for these GMDB contracts are included in benefits
and expenses, consistent with GAAP when a premium deficiency exists.
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The GMDB reinsurance business is considered premium deficient because the expected present value of
future claims and expenses exceeds the expected present value of future premiums and investment
income using revised assumptions based on actual and expected experience. The Company performs a
reserve review on a quarterly basis using current market conditions and assumptions. Under premium
deficiency accounting if the recorded reserve is determined insufficient, an increase to the
reserve is reflected as a charge to current period income. Consistent with GAAP, the Company does
not recognize gains on premium deficient long duration products.
The Company had future policy benefit reserves for GMDB contracts of $1.4 billion as of September
30, 2009, and $1.6 billion as of December 31, 2008. The determination of liabilities for GMDB
requires the Company to make critical accounting estimates. The Company estimates its liabilities
for GMDB exposures using a complex internal model run using many scenarios and based on assumptions
regarding lapse, future partial surrenders, mortality, interest rates (mean investment performance
and discount rate) and volatility. Lapse refers to the full surrender of an annuity prior to a
contractholder’s death. Future partial surrender refers to the fact that most contractholders have
the ability to withdraw substantially all of their mutual fund investments while retaining the
death benefit coverage in effect at the time of the withdrawal. Mean investment performance refers
to market rates to be earned over the life of the GMDB equity hedge program, and market volatility
refers to market fluctuation. These assumptions are based on the Company’s experience and future
expectations over the long-term period, consistent with the long-term nature of this product. The
Company regularly evaluates these assumptions and changes its estimates if actual experience or
other evidence suggests that assumptions should be revised. If actual experience differs from the
assumptions (including lapse, future partial surrenders, mortality, interest rates and volatility)
used in estimating these liabilities, the result could have a material adverse effect on the
Company’s consolidated results of operations, and in certain situations, could have a material
adverse effect on the Company’s financial condition.
The following provides information about the Company’s reserving methodology and assumptions for
GMDB as of September 30, 2009:
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Although the year to date results include a first quarter charge of $73 million pre-tax ($47
million after-tax) to strengthen GMDB reserves, no additional reserve strengthening has been
required for GMDB since the first quarter of 2009, primarily due to the stabilization and recovery
of equity markets. The components of the first quarter charge were:
Benefits paid and incurred are net of ceded amounts. Incurred benefits reflect the favorable
or unfavorable impact of a rising or falling equity market on the liability, and include the
charges discussed above. As discussed below, losses or gains have been recorded in other revenues
as a result of the GMDB equity hedge program to reduce equity market exposures.
As of September 30, 2009, the aggregate value of the underlying mutual fund investments was $17.1
billion. The death benefit coverage in force as of that date (representing the estimated amount of
death claims that the Company would have to pay if all of the approximately 600,000 contractholders
had submitted death claims as of that date) was $7.7 billion. As of December 31, 2008, the
aggregate value of the underlying mutual fund investments was $16.3 billion. The death benefit
coverage in force as of that date (representing the estimated amount of death claims that the
Company would have to pay if all of the approximately 650,000 contractholders had submitted death
claims as of that date) was $11.1 billion. The death benefit coverage in force represents the
excess of the guaranteed benefit amount over the value of the underlying mutual fund investments.
As discussed above, the Company operates a GMDB equity hedge program to substantially reduce the
equity market exposures of this business by selling exchange-traded futures contracts, which are
expected to rise in value as the equity market declines and decline in value as the equity market
rises. In addition, the Company uses foreign currency futures contracts to reduce the
international equity market and foreign currency risks associated with this business. The notional
amount of futures contract positions held by the Company at September 30, 2009 was $1.2
billion. The Company recorded in other revenues pre-tax losses of $161 million for the three
months ended September 30, 2009 and $232 million for the nine months ended September 30, 2009, and
pre-tax gains of $70 million for the three months ended September 30, 2008 and $118 million for the
nine months ended September 30, 2008.
The Company has also written reinsurance contracts with issuers of variable annuity contracts that
provide annuitants with certain guarantees related to minimum income benefits (GMIB). All reinsured
GMIB policies also have a GMDB benefit reinsured by the Company. See Note 8 for further
information.
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Note 8 — 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
or, for commercial mortgage loans, when classified as “held for sale.”
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.
Fair values are based on quoted market prices when available. When market prices are not
available, fair value is generally estimated using discounted cash flow analyses, incorporating
current market inputs for similar financial instruments with comparable terms and credit
quality. In instances where there is little or no market activity for the same or similar
instruments, the Company estimates fair value 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 by the Company
which becomes significant with increasingly complex instruments or pricing models. Where
appropriate, adjustments are included to reflect the risk inherent in a particular methodology,
model or input used.
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 input that is significant to its measurement. For example, a Level 3 fair value measurement
may include inputs that are both observable (Levels 1 and 2) and unobservable (Level 3). The
levels of the fair value hierarchy are as follows:
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Financial Assets and Financial Liabilities Carried at Fair Value
The following tables provide information as of September 30, 2009 and December 31, 2008 about the
Company’s financial assets and liabilities carried at fair value. Similar disclosures for separate
account assets, which are also recorded at fair value on the Company’s Consolidated Balance Sheets,
are provided separately as gains and losses related to these assets generally accrue directly to
policyholders.
September 30, 2009
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December 31, 2008
Level 1 Financial Assets
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
Fixed maturities and equity securities. Approximately 92% 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 and preferred
stocks do not trade daily, fair values are often derived using 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, benchmark yields,
reported trades, broker-dealer quotes, issuer spreads, liquidity, benchmark securities, bids,
offers, reference data, and industry and economic events. For mortgage-backed securities, inputs
and assumptions may also include characteristics of the issuer, collateral attributes, prepayment
speeds and credit rating.
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Short-term investments. 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. Amounts 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 September 30, 2009 or December 31, 2008. The nature
and use of these other derivatives are described in Note 10.
Level 3 Financial Assets and Financial Liabilities
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:
Fair values of mortgage and asset-backed securities and corporate bonds are 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 mortgage and asset-backed securities, inputs and assumptions to 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. Subordinated loans and private
equity investments are valued at transaction price in the absence of market data indicating a
change in the estimated fair values.
Guaranteed minimum income benefit contracts. Because cash flows of the GMIB 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, the Company reports these liabilities and assets as
derivatives at fair value. The Company estimates the fair value of the assets and liabilities for
GMIB contracts using assumptions regarding capital markets (including market returns, interest
rates and market volatilities of the underlying equity and bond mutual fund investments), future
annuitant and retrocessionaire behavior (including mortality, lapse, annuity election rates and
retrocessional credit), as well as risk and profit charges. At adoption of the FASB’s new guidance
for fair value measurements in 2008, the Company updated assumptions to reflect those that the
Company believes a hypothetical market participant would use to determine a current exit price for
these contracts, and recorded a charge to shareholders’ net income as described in Note 2. As
certain assumptions used to estimate fair values for these contracts are largely unobservable, the
Company classifies GMIB assets and liabilities in Level 3. The Company considered the following in
determining the view of a hypothetical market participant:
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These GMIB assets and liabilities are estimated with a complex internal model using many scenarios
to determine the present value of net amounts expected to be paid, less the present value of net
future premiums expected to be received adjusted for risk and profit charges that the Company
estimates a hypothetical market participant would require to assume this business. Net amounts
expected to be paid include the excess of the expected value of the income benefits over the values
of the annuitants’ accounts at the time of annuitization. Generally, market return, interest rate
and volatility assumptions are based on market observable information. Assumptions related to
annuitant behavior reflect the Company’s belief that a hypothetical market participant would
consider the actual and expected experience of the Company as well as other relevant and available
industry resources in setting policyholder behavior assumptions. The significant assumptions used
to value the GMIB assets and liabilities as of September 30, 2009 were as follows:
In addition, the Company has considered other assumptions related to model, expense and
nonperformance risk in calculating the GMIB liability.
The Company regularly evaluates each of the assumptions used in establishing these assets and
liabilities by considering how a hypothetical market participant would set assumptions at each
valuation date. Capital markets assumptions are expected to change at each valuation date
reflecting current observable market conditions. Other assumptions may also change based on a
hypothetical market participant’s view of actual experience as it emerges over time or other
factors that impact the net liability. If the emergence of future experience or future assumptions
differs from the assumptions used in estimating these assets and liabilities, the resulting impact
could be material to the Company’s consolidated results of operations, and in certain situations,
could be material to the Company’s financial condition.
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 two external
reinsurers and are reported in the Company’s Consolidated Balance Sheets in Other assets, including
other intangibles. As of September 30, 2009, Standard & Poor’s (S&P) has given a financial
strength rating of AA to one reinsurer and a financial strength rating of A- to the parent company
that guarantees the receivable from the other reinsurer.
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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 and nine months ended September 30, 2009 and 2008. These tables
exclude separate account assets as changes in fair values of these assets accrue directly to
policyholders. Gains and losses reported in these tables may include changes in fair value that
are attributable to both observable and unobservable inputs.
For the Three Months Ended September 30, 2009
For the Three Months Ended September 30, 2008
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For the Nine Months Ended September 30, 2009
For the Nine Months Ended September 30, 2008
As noted in the tables above, total gains and losses included in shareholders’ net income are
reflected in the following captions in the Consolidated Statements of Income:
Reclassifications impacting Level 3 financial instruments are reported as transfers in or out of
the Level 3 category as of the beginning of the quarter in which the transfer occurs. Therefore
gains and losses in income only reflect activity for the period the instrument was
classified in Level 3. Typically, investments that transfer out of Level 3 are classified in Level
2 as market data on the securities becomes more readily available.
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The company provided reinsurance for insurance companies that offer a guaranteed minimum income
benefit, and then retroceded a portion of the risk to other insurance companies. Because these
GMIB reinsurance arrangements remain in effect at the reporting date, the Company has reflected the
total gain or loss for the period as the total gain or loss included in income attributable to
instruments still held at the reporting date. However, the Company reduces the GMIB assets and
liabilities resulting from these reinsurance arrangements when annuitants lapse, die, elect their
benefit, or reach the age after which the right to elect their benefit expires.
Under FASB’s guidance for fair value measurements, the Company’s GMIB assets and liabilities are
expected to be volatile in future periods because the underlying assumptions will be based largely
on market-observable inputs at the close of each reporting period including interest rates and
market-implied volatilities.
The net pre-tax gain for GMIB was $19 million for the three months ended September 30, 2009, and
was primarily due to the following factors:
These favorable effects were partially offset by:
For the nine months ended September 30, 2009, the net pre-tax gain for GMIB was $215 million, and
was primarily due to the following factors:
These favorable effects were partially offset by:
For the three months ended September 30, 2008, the increase in the net GMIB liability was primarily
driven by the decline in underlying account values in the period, driven by declines in equity
markets and bond fund returns and decreases in interest rates since June 30, 2008. Excluding the
charge for the effect of adoption of FASB’s guidance for fair value measurement, the increase in
the net GMIB liability for the nine months ended September 30, 2008 was primarily driven by the
impact of declines in underlying account values in the period, driven by declines in equity markets
and bond fund returns, resulting in increased exposure and decreases in interest rates since
December 31, 2007.
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Separate account assets
Fair values and changes in the fair values of separate account assets generally accrue directly to
the policyholders and are excluded from the Company’s revenues and expenses. As of September 30,
2009 and December 31, 2008 separate account assets were as follows:
September 30, 2009
December 31, 2008
Separate account assets in Level 1 include exchange-listed equity securities. Level 2 assets
primarily include:
Separate account assets classified in Level 3 include investments primarily in securities
partnerships and real estate generally valued based on the separate account’s ownership share of
the equity of the investee including changes in the fair values of its underlying investments.
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The following tables summarize the changes in separate account assets reported in Level 3 for the
three months and nine months ended September 30, 2009 and 2008.
Assets and Liabilities Measured at Fair Value under Certain Conditions
Some financial assets and liabilities are not carried at fair value each reporting period, but may
be measured using fair value only under certain conditions, such as investments in real estate
entities when they become impaired. During the nine months ended September 30, 2009, impaired real
estate entities carried at cost of $41 million were written down to their fair values of $8
million, resulting in realized investment losses of $33 million. These fair value measurements
were based on discounted cash flow analyses using significant unobservable inputs, and were
classified in Level 3. For the three months ended September 30, 2009 and the twelve months ended
December 31, 2008, the amounts required to adjust these assets and liabilities to their fair values
were not significant.
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Fair Value Disclosures for Financial Instruments Not Carried at Fair Value
Most financial instruments that are subject to fair value disclosure requirements are carried in
the Company’s consolidated financial statements at amounts that approximate fair value. The following table
provides the fair values and carrying values of the Company’s financial instruments not recorded at
fair value that are subject to fair value disclosure requirements at September 30, 2009 and
December 31, 2008:
The fair values presented in the table above have been estimated using market information when
available. The following is a description of the valuation methodologies and inputs used by the
Company to determine fair value.
Commercial mortgage loans. The Company estimates the fair value of commercial mortgage loans
generally by discounting the contractual cash flows at estimated market interest rates that reflect
the Company’s assessment of the credit quality of the loans. Market interest rates are derived by
calculating the appropriate spread over comparable U.S. Treasury rates, based on the property type,
quality rating and average life of the loan. The quality ratings reflect the relative risk of the
loan, considering debt service coverage, the loan to value ratio and other factors. Fair values of
impaired mortgage loans are based on the estimated fair value of the underlying collateral
generally determined using an internal discounted cash flow model.
Contractholder deposit funds, excluding universal life products. Generally, these
funds do not have stated maturities. Approximately 45% of these balances can be withdrawn by the
customer at any time without prior notice or penalty. The fair value for these contracts is the
amount estimated to be payable to the customer as of the reporting date, which is generally the
carrying value. Most of the remaining contractholder deposit funds are reinsured by the buyers of
the individual life and annuity and retirement benefits businesses. The fair value for these
contracts is determined using the fair value of these buyers’ assets supporting these reinsured
contracts. The Company had a reinsurance recoverable equal to the carrying value of these
reinsured contracts.
Long-term debt, excluding capital leases. The fair value of long-term debt is based on quoted
market prices for recent trades. When quoted market prices are not available, fair value is
estimated using a discounted cash flow analysis and the Company’s estimated current borrowing rate
for debt of similar terms and remaining maturities.
Fair values of off-balance-sheet financial instruments were not material.
Note 9 — Investments
Total Realized Investment Gains and Losses
The following total realized gains and losses on investments include other-than-temporary
impairments on debt securities but exclude amounts required to adjust future policy benefits for
the run-off settlement annuity business:
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Included in pre-tax realized investment gains (losses) above were other-than-temporary
impairments on debt securities, asset write-downs and changes in valuation reserves as follows:
Fixed Maturities and Equity Securities
Securities in the following table are included in fixed maturities and equity securities on the
Company’s Consolidated Balance Sheets. These securities are carried at fair value with changes in
fair value reported in other realized investment gains and interest and dividends reported in net
investment income. The Company’s hybrid investments include preferred stock or debt securities
with call or conversion features. The Company elected fair value accounting for certain hybrid
securities to simplify accounting and mitigate volatility in results of operations and financial
condition.
Fixed maturities and equity securities included $239 million at September 30, 2009, which were
pledged as collateral to brokers as required under certain futures contracts. These fixed
maturities and equity securities were primarily corporate securities.
The following information about fixed maturities excludes trading and hybrid securities. The
amortized cost and fair value by contractual maturity periods for fixed maturities were as follows
at September 30, 2009:
Actual maturities could differ from contractual maturities because issuers may have the right
to call or prepay obligations, with or without penalties. Also, in some cases the Company may
extend maturity dates.
Mortgage-backed assets consist principally of commercial mortgage-backed securities and
collateralized mortgage obligations of which $38 million were residential mortgages and home equity
lines of credit, all of which were originated using standard underwriting practices and are not
considered sub-prime loans.
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Gross unrealized appreciation (depreciation) on fixed maturities (excluding trading securities and
hybrid securities) by type of issuer is shown below.
The above table includes investments with a fair value of $2.4 billion supporting the
Company’s run-off settlement annuity business, with gross unrealized appreciation of $439 million
and gross unrealized depreciation of $47 million at September 30, 2009. Such unrealized amounts
are required to support future policy benefit liabilities of this business and, as such, are not
included in accumulated other comprehensive income.
Sales information for available-for-sale fixed maturities and equity securities were as follows:
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Review of declines in fair value. Management reviews fixed maturities and equity securities
with a decline in fair value from cost for impairment based on criteria that include:
When the Company determines it does not expect to recover the amortized cost basis of fixed
maturities with declines in fair value (even if it does not intend to sell or will not be required
to sell these fixed maturities), the credit portion of the impairment loss is recognized in net
income and the non-credit portion, if any, is recognized in a separate component of shareholders’
equity. The credit portion is the difference between the amortized cost basis of the fixed
maturity and the net present value of its projected future cash flows. Projected future cash flows
are based on qualitative and quantitative factors, including probability of default, and the
estimated timing and amount of recovery. For mortgage and asset-backed securities, estimated
future cash flows are based on assumptions about the collateral attributes including prepayment
speeds, default rates and changes in value.
Excluding trading and hybrid securities, as of September 30, 2009, fixed maturities with a decline
in fair value from amortized cost (which were primarily investment grade corporate bonds) were as
follows, including the length of time of such decline:
The unrealized depreciation of investment grade fixed maturities is primarily due to increases
in market yields since purchase. Approximately $52 million of the unrealized depreciation is due
to securities with a decline in value of greater than 20%. The remaining $95 million of the
unrealized depreciation is due to securities with declines in value of less than 20%. There were
no equity securities with a fair value significantly lower than cost as of September 30, 2009.
Note 10 — Derivative Financial Instruments
The Company’s investment strategy is to manage the characteristics and risks of investment assets
(such as duration, yield, currency and liquidity) to meet the varying demands of the related
insurance and contractholder liabilities (such as paying claims, investment returns and
withdrawals). As part of this investment strategy, the Company typically uses
derivatives to minimize interest rate, foreign currency and equity price risks of chosen investment
assets to conform to the characteristics and risks of the related insurance and contractholder
liabilities. The Company routinely monitors exposure to credit risk associated with derivatives
and diversifies the portfolio among approved dealers of high credit quality to minimize credit
risk. In addition, the Company has written or sold contracts to guarantee minimum income benefits
and to enhance investment returns. See Note 7 for a discussion of derivatives associated with GMDB
contracts and Note 8 for a discussion of derivatives arising from GMIB contracts.
The Company uses hedge accounting when derivatives are designated, qualify and are highly effective
as hedges. Effectiveness is formally assessed and documented at inception and each period
throughout the life of a hedge using various qualitative and quantitative methods appropriate for
each hedge, including regression analysis and dollar offset. Under hedge accounting, the changes
in fair value of the derivative and the hedged risk are generally recognized together and offset
each other when reported in shareholders’ net income.
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The Company accounts for derivative instruments as follows:
Certain subsidiaries of the Company are parties to over-the-counter derivative instruments that
contain provisions requiring both parties to such instruments to post collateral depending on net
liability thresholds and the party’s financial strength or credit rating. The collateral posting
requirements vary by counterparty. The aggregate fair value of derivative instruments with such
credit-risk-related contingent features where a subsidiary of the Company was in a net liability
position as of September 30, 2009 was $28 million for which the Company was not required to post
collateral with its counterparties. If the various contingent features underlying the agreements
were triggered as of September 30, 2009, the Company would be required to post collateral equal to
the total net liability. Such subsidiaries are parties to certain other derivative instruments
that contain termination provisions for which the counterparties could demand immediate payment of
the total net liability position if the financial strength rating of the subsidiary were to decline
below specified levels. As of September 30, 2009, there was no net liability position under such
derivative instruments.
The tables below present information about the nature and accounting treatment of the Company’s
primary derivative financial instruments including the Company’s purpose for entering into specific
derivative transactions, and their locations in and effect on the financial statements as of and
for the three and nine month periods ended September 30, 2009. Derivatives in the Company’s
separate accounts are excluded from the tables because associated gains and losses generally accrue
directly to policyholders.
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The amount of gains (losses) reclassified from accumulated other comprehensive income into
income was not significant. No gains (losses) were recognized due to ineffectiveness and no
amounts were excluded from the assessment of hedge ineffectiveness.
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Note 11 — 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 losses. Reinsurance is also used in acquisition and
disposition transactions where 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.
Retirement benefits business. The Company had a reinsurance recoverable of $1.8 billion as of
September 30, 2009, and $1.9 billion as of December 31, 2008 from Prudential Retirement Insurance
and Annuity Company resulting from the sale of the retirement benefits business, which was
primarily in the form of a reinsurance arrangement. The reinsurance recoverable, which is reduced
as the Company’s reinsured liabilities are paid or directly assumed by the reinsurer, is secured
primarily by fixed maturities and mortgage loans equal to or greater than 100% of the reinsured
liabilities. These fixed maturities and mortgage loans are held in a trust established for the
benefit of the Company. As of September 30, 2009, the trust was adequately funded and S&P had
assigned this reinsurer a rating of AA-.
Individual life and annuity reinsurance. The Company had reinsurance recoverables totaling $4.5
billion as of September 30, 2009 and $4.6 billion as of December 31, 2008 from The Lincoln National
Life Insurance Company and Lincoln Life & Annuity of New York resulting from the 1998 sale of the
Company’s individual life insurance and annuity business through indemnity reinsurance
arrangements. Effective December 31, 2007, a substantial portion of the reinsurance recoverables
are secured by investments held in a trust established for the benefit of the Company. At
September 30, 2009, the trust assets secured approximately 90% of the reinsurance recoverables.
S&P has assigned The Lincoln National Life Insurance Company a rating of AA- and Lincoln Life &
Annuity of New York a rating of AA.
Other Ceded and Assumed Reinsurance
Ceded Reinsurance: Ongoing operations. The Company’s insurance subsidiaries have reinsurance
recoverables from various reinsurance arrangements in the ordinary course of business for its
Health Care, Disability and Life, and International segments as well as the non-leveraged and
leveraged corporate-owned life insurance business. Reinsurance recoverables of $324 million as of
September 30, 2009 are expected to be collected from more than 90 reinsurers which have been
assigned the following financial strength ratings from S&P:
The collateral protecting the recoverables includes assets held in trust and letters of
credit. The Company reviews its reinsurance arrangements and establishes reserves against the
recoverables in the event that recovery is not considered probable. As of September 30, 2009, the
Company’s recoverables related to these segments were net of a reserve of $11 million.
Assumed and Ceded reinsurance: Run-off Reinsurance segment. The Company’s Run-off Reinsurance
operations assumed risks related to GMDB contracts, GMIB contracts, workers’ compensation, and
personal accident business. The Company’s Run-off Reinsurance operations also purchased
retrocessional coverage to reduce the risk of loss on these contracts.
Liabilities related to GMDB, workers’ compensation and personal accident are included in future
policy benefits and unpaid claims. Because the GMIB contracts are treated as derivatives under
GAAP, the asset related to GMIB is recorded in the caption Other assets, including other
intangibles and the liability related to GMIB is recorded in the caption Accounts payable, accrued
expenses, and other liabilities on the Company’s Consolidated Balance Sheets (see Notes 8 and 17
for additional discussion of the GMIB assets and liabilities).
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The reinsurance recoverables for GMDB, workers’ compensation, and personal accident of $122 million
as of September 30, 2009 are expected to be collected from more than 100 retrocessionaires which
have been assigned the following financial strength ratings from S&P:
The collateral protecting the recoverables is primarily in the form of letters of credit. The
Company reviews its reinsurance arrangements and establishes reserves against the recoverables in
the event that recovery is not considered probable. As of September 30, 2009, the Company’s
recoverables related to this segment were net of a reserve of $11 million.
The Company’s payment obligations for underlying reinsurance exposures assumed by the Company under
these contracts are based on the ceding companies’ claim payments. For GMDB, claim payments vary
because of changes in equity markets and interest rates, as well as mortality and contractholder
behavior. For workers’ compensation and personal accident, the payments relate to accidents and
injuries. Any of these claim payments can extend many years into the future, and the amount of the
ceding companies’ ultimate claims, and therefore the amount of the Company’s ultimate payment
obligations and corresponding ultimate collection from retrocessionaires, may not be known with
certainty for some time.
Summary. The Company’s reserves for underlying reinsurance exposures assumed by the Company, as
well as for amounts recoverable from reinsurers/retrocessionaires for both ongoing operations and
the run-off reinsurance operation, are considered appropriate as of September 30, 2009, based on
current information. However, it is possible that future developments could have a material
adverse effect on the Company’s consolidated results of operations and, in certain situations, such
as if actual experience differs from the assumptions used in estimating reserves for GMDB, could
have a material adverse effect on the Company’s financial condition. The Company bears the risk of
loss if its retrocessionaires do not meet or are unable to meet their reinsurance obligations to
the Company.
Effects of reinsurance. In the Company’s Consolidated Statements of Income, premiums and fees were
net of ceded premiums, and benefits and expenses were net of reinsurance recoveries, in the
following amounts:
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Note 12 — Pension and Other Postretirement Benefit Plans
The Company and certain of its subsidiaries provide pension, health care and life insurance defined
benefits to eligible retired employees, spouses and other eligible dependents through various
plans.
On May 8, 2009, the Company announced a freeze of its primary domestic pension plans effective July
1, 2009. A curtailment of benefits occurred as a result of this action since it eliminated the
accrual of benefits effective July 1, 2009 for active employees enrolled in the domestic pension
plans. Accordingly, the Company recognized an after-tax curtailment gain of $30 million during the
second quarter of 2009, which was the remaining unamortized negative prior service cost at May 31,
2009. As a result of the plan freeze, the Company re-measured the benefit obligations of the
affected plans effective May 31, 2009, causing a reduction in the pension obligation of $47 million
in the second quarter of 2009. The reduction primarily reflects an increase in the discount rates
used to re-measure the pension plan obligations from 6.25% at December 31, 2008 to 6.5% at May 31,
2009 reflecting the change in market interest rates. Significant changes from the Company’s
disclosures at December 31, 2008 as a result of the decision to freeze the domestic pension plans
are as follows:
Pension benefits. Components of net pension cost were as follows:
The Company funds its qualified pension plans at least at the minimum amount required by the
Pension Protection Act of 2006, which requires companies to fully fund defined benefit pension
plans over a seven-year period beginning in 2008. The Internal Revenue Service recently issued
regulations providing relief in measuring pension plan funding obligations for 2009. As a result,
only approximately $90 million of the Company’s $354 million in domestic pension plan contributions
during the nine months ended September 30, 2009 were necessary to meet minimum funding requirements
and the remaining contributions were voluntary. Although not
required, the Company may make
additional voluntary contributions of approximately $55 million during the remainder of 2009.
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Other postretirement benefits. Components of net other postretirement benefit cost were as
follows:
Note
13 — Debt
Under a universal shelf registration statement filed with the Securities and Exchange
Commission, the Company issued $350 million of 8.5% Notes on May 4, 2009 ($349 million, net of debt
discount, with an effective interest rate of 9.90% per year). The difference between the stated
and effective interest rates primarily reflects the effect of a treasury lock. See Note 10 for
further information. Interest is payable on May 1 and November 1 of each year beginning November
1, 2009. These Notes will mature on May 1, 2019.
On March 4, 2008, the Company issued $300 million of 6.35% Notes (with an effective interest rate
of 6.68% per year). Interest is payable on March 15 and September 15 of each year beginning
September 15, 2008. These Notes will mature on March 15, 2018.
The Company may redeem these Notes, at any time, in whole or in part, at a redemption price equal
to the greater of:
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On March 14, 2008, the Company entered into a new commercial paper program (“the Program”). Under
the Program, the Company is authorized to sell from time to time short-term unsecured commercial
paper notes up to a maximum of $500 million. The proceeds are used for general corporate purposes,
including working capital, capital expenditures, acquisitions and share repurchases. The Company
uses the credit facility entered into in June 2007, as back-up liquidity to support the outstanding
commercial paper. If at any time funds are not available on favorable terms under the Program, the
Company may use its credit agreement for funding. In October 2008, the Company added an additional
dealer to its Program. As of September 30, 2009, the Company had $100 million in commercial paper
outstanding at a weighted average interest rate of 0.53% and remaining maturities ranging from five
to 55 days.
Note 14 — Accumulated Other Comprehensive Loss
Accumulated other comprehensive loss excludes amounts required to adjust future policy benefits for
the run-off settlement annuity business. Changes in accumulated other comprehensive loss were as
follows:
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Note 15 — Income Taxes
The Company has historically accrued U.S. income taxes on the undistributed earnings of foreign
subsidiaries. In 2009, the Company determined that the prospective earnings of its South Korean
operation are to be permanently invested overseas. Income taxes for this operation will therefore
be accrued at the tax rate of the foreign jurisdiction. As a result, shareholders’ net income
increased for the nine months ended September 30, 2009 by $24 million, which included $22 million
representing the unrecognized deferred tax liabilities attributable to its investment in the South
Korean subsidiary that are considered permanent in nature. Management is currently assessing
whether the undistributed earnings of certain other foreign operations will be permanently invested
overseas.
During the first quarter of 2009, the IRS completed its examination of the Company’s 2005 and 2006
consolidated federal income tax returns, resulting in an increase to shareholders’ net income of
$21 million ($20 million in continuing operations and $1 million in discontinued operations). This
increase reflected a reduction in net unrecognized tax benefits of $8 million ($17 million reported
in income tax expense, partially offset by a $9 million pre-tax charge) and a reduction of interest
and penalties of $13 million (reported in income tax expense).
Gross unrecognized tax benefits declined for the nine months ended September 30, 2009 by $6
million. This decline was primarily due to completion of the IRS examination noted above which
increased shareholders’ net income by $8 million, partially offset by non-audit related changes in
net unrecognized tax benefits which decreased shareholder net income by $4 million.
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Over the next twelve months, the Company has determined it reasonably possible that the level of
unrecognized tax benefits could increase or decrease significantly, subject to developments in
certain matters in dispute with the IRS. It is also reasonably possible there could be a
significant change in the level of valuation allowances recorded against deferred tax benefits of
the reinsurance operations and certain unrealized investment losses within the next twelve months.
The Company, however, is currently unable to reasonably estimate the potential impact of such
changes.
During the first quarter of 2009, final resolution was reached in one of the two disputed issues
associated with the IRS examination of the Company’s 2003 and 2004 consolidated federal income tax
returns. The second of these disputed matters remains unresolved and on June 4, 2009 the Company
initiated litigation of this matter by filing a petition in the United States Tax Court. Due to
the nature of the litigation process, the timing of the resolution of this matter is uncertain.
Though the Company expects to prevail, unfavorable resolution of this litigation would result in a
charge to shareholder’s net income of up to $15 million, representing net interest expense on the
cumulative incremental tax for all affected years. In addition, there remain two unresolved issues
from the IRS examination of the Company’s 2005 and 2006 consolidated federal income tax returns.
The Company initiated a regulatory appeal of these matters on March 31, 2009 by filing a formal
protest of the proposed adjustments. One of these unresolved issues is the same matter which
remains in dispute from the prior IRS examination.
The Company continues to evaluate income tax specific provisions that were included in the 2010
federal budget proposal, particularly those related to the U.S. taxation of foreign operations.
Also, certain of the healthcare reform proposals under consideration by Congress include provisions
which, if enacted as currently proposed, could increase the Company’s effective tax rate.
Note
16 — Segment Information
The Company’s operating segments generally reflect groups of related products, except for the
International segment which is generally based on geography. In accordance with GAAP, operating
segments that do not require separate disclosure have been combined into Other Operations. The
Company measures the financial results of its segments using “segment earnings (loss),” which
subsequent to implementing the FASB’s guidance for noncontrolling interests, is defined as
shareholders’ income (loss) from continuing operations excluding after-tax realized investment
gains and losses.
Summarized segment financial information was as follows:
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Note
17 — Contingencies and Other Matters
The Company, through its subsidiaries, is contingently liable for various financial guarantees
provided in the ordinary course of business.
Financial Guarantees Primarily Associated with the Sold Retirement Benefits Business
Separate account assets are contractholder funds maintained in accounts with specific investment
objectives. The Company records separate account liabilities equal to separate account assets. In
certain cases, primarily associated with the sold retirement benefits business (which was sold in
April 2004), the Company guarantees a minimum level of benefits for retirement and insurance
contracts, written in separate accounts. The Company establishes an additional liability if
management believes that the Company will be required to make a payment under these guarantees.
The Company guarantees that separate account assets will be sufficient to pay certain retiree or
life benefits. The sponsoring employers are primarily responsible for ensuring that assets are
sufficient to pay these benefits and are required to maintain assets that exceed a certain
percentage of benefit obligations. This percentage varies depending on the asset class within a
sponsoring employer’s portfolio (for example, a bond fund would require a lower percentage than a
riskier equity fund) and thus will vary as the composition of the portfolio changes. If employers
do not maintain the required levels of separate account assets, the Company or an affiliate of the
buyer has the right to redirect the management of the related assets to provide for benefit
payments. As of September 30, 2009, employers maintained assets that exceeded the benefit
obligations. Benefit obligations under these arrangements were $1.8 billion as of September 30,
2009. Approximately 76% of these guarantees are reinsured by an affiliate of the buyer of the
retirement benefits business. The remaining guarantees are provided by the Company with minimal
reinsurance from third parties. There were no additional liabilities required for these guarantees
as of September 30, 2009. Separate account assets supporting these guarantees are classified in
Levels 1 and 2 of the GAAP fair value hierarchy. See Note 8 for further information on the fair
value hierarchy.
Other Financial Guarantees
Guaranteed minimum income benefit contracts. The Company’s reinsurance operations, which were
discontinued in 2000 and are now an inactive business in run-off mode, reinsured minimum income
benefits under certain variable annuity contracts issued by other insurance companies. A
contractholder can elect the guaranteed minimum income benefit (GMIB) within 30 days of any
eligible policy anniversary after a specified contractual waiting period. The Company’s exposure
arises when the guaranteed annuitization benefit exceeds the annuitization benefit based on the
policy’s current account value. At the time of annuitization, the Company pays the excess (if any)
of the guaranteed benefit over the benefit based on the current account value in a lump sum to the
direct writing insurance company.
In periods of declining equity markets or declining interest rates, the Company’s GMIB liabilities
increase. Conversely, in periods of rising equity markets and rising interest rates, the Company’s
liabilities for these benefits decrease.
The Company estimates the fair value of the GMIB assets and liabilities using assumptions for
market returns and interest rates, volatility of the underlying equity and bond mutual fund
investments, mortality, lapse, annuity election rates, nonperformance risk, and risk and profit
charges. Assumptions were updated beginning at January 1, 2008 to reflect requirements for fair
value measurements. See Note 8 for additional information on how fair values for these liabilities
and related receivables for retrocessional coverage are determined.
The Company is required to disclose the maximum potential undiscounted future payments for
guarantees related to minimum income benefits. Under these guarantees, the future payment amounts
are dependent on equity and bond fund market and interest rate levels prior to and at the date of
annuitization election, which must occur within 30 days of a policy anniversary, after the
appropriate waiting period. Therefore, the future payments are not fixed and determinable under
the terms of the contract. Accordingly, the Company has estimated the maximum potential
undiscounted future payments using hypothetical adverse assumptions, defined as follows:
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The maximum potential undiscounted payments that the Company would make under those assumptions
would aggregate $1.4 billion before reinsurance recoveries. The Company expects the amount of
actual payments to be significantly less than this hypothetical undiscounted aggregate amount. The
Company has retrocessional coverage in place from two external reinsurers which covers 55% of the
exposures on these contracts. The Company bears the risk of loss if its retrocessionaires do not
meet or are unable to meet their reinsurance obligations to the Company.
Certain other guarantees. The Company had indemnification obligations to lenders of up to $239
million as of September 30, 2009 related to borrowings by certain real estate joint ventures which
the Company either records as an investment or consolidates. These borrowings, which are
nonrecourse to the Company, are secured by the joint ventures’ real estate properties with fair
values in excess of the loan amounts and mature at various dates beginning in 2010 through
2017. The Company’s indemnification obligations would require payment to lenders for any actual
damages resulting from certain acts such as unauthorized ownership transfers, misappropriation of
rental payments by others or environmental damages. Based on initial and ongoing reviews of
property management and operations, the Company does not expect that payments will be required
under these indemnification obligations. Any payments that might be required could be recovered
through a refinancing or sale of the assets. In some cases, the Company also has recourse to
partners for their proportionate share of amounts paid. There were no liabilities required for
these indemnification obligations as of September 30, 2009.
As of September 30, 2009, the Company guaranteed that it would compensate the lessors for a
shortfall of up to $44 million in the market value of certain leased equipment at the end of the
lease. Guarantees of $28 million expire in 2012 and $16 million expire in 2016. The Company had
liabilities for these guarantees of $8 million as of September 30, 2009.
As part of the reinsurance and administrative service arrangements acquired from Great-West Life
and Annuity, Inc., the Company is responsible to pay claims for the group medical and long-term
disability business of Great-West Healthcare and collect related amounts due from their third party
reinsurers. Any such amounts not collected will represent additional assumed liabilities of the
Company and decrease shareholders’ net income if and when these amounts are determined
uncollectible. At September 30, 2009, there were no receivables recorded for paid claims due from
third party reinsurers for this business and unpaid claims related to this business were estimated
at $24 million.
The Company had indemnification obligations as of September 30, 2009 in connection with acquisition
and disposition transactions. These indemnification obligations are triggered by the breach of
representations or covenants provided by the Company, such as representations for the presentation
of financial statements, the filing of tax returns, compliance with law or the identification of
outstanding litigation. These obligations are typically subject to various time limitations,
defined by the contract or by operation of law, such as statutes of limitation. In some cases, the
maximum potential amount due is subject to contractual limitations based on a percentage of the
transaction purchase price, while in other cases limitations are not specified or applicable. The
Company does not believe that it is possible to determine the maximum potential amount due under
these obligations, since not all amounts due under these indemnification obligations are subject to
limitation. There were no liabilities required for these indemnification obligations as of
September 30, 2009.
The Company does not expect that these guarantees will have a material adverse effect on the
Company’s consolidated results of operations, liquidity or financial condition.
Regulatory and Industry Developments
Employee benefits regulation. The business of administering and insuring employee benefit
programs, particularly health care programs, is heavily regulated by federal and state laws and
administrative agencies, such as state departments of insurance and the Federal Departments of
Labor and Justice, as well as the courts. Regulation and judicial decisions have resulted in
changes to industry and the Company’s business practices and will continue to do so in the
future. In addition, the Company’s subsidiaries are routinely involved with various claims,
lawsuits and regulatory and IRS audits and investigations that could result in financial liability,
changes in business practices, or both. Health care regulation in its various forms could have an
adverse effect on the Company’s health care operations if it inhibits the Company’s ability to
respond to market demands or results in increased medical or administrative costs without improving
the quality of care or services.
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Other possible regulatory and legislative changes or judicial decisions that could have an adverse
effect on the Company’s employee benefits businesses include:
The employee benefits industry remains under scrutiny by various state and federal government
agencies and could be subject to government efforts to bring criminal actions in circumstances that
could previously have given rise only to civil or administrative proceedings.
Concentration of risk. For the Company’s International segment, South Korea is the single largest
geographic market. South Korea generated 29% of the segment’s revenues for the third quarter of
2009 and 28% of the segment’s revenues for the nine months ended September 30, 2009. South Korea
generated 37% of the segment’s earnings for the third quarter of 2009 and 43% of the segment’s
earnings for the nine months ended September 30, 2009. Due to the concentration of business in
South Korea, the International segment is exposed to potential losses resulting from economic and
geopolitical developments in that country, as well as foreign currency movements affecting the
South Korean currency, which could have a significant impact on the segment’s results and the
Company’s consolidated financial results.
Litigation and Other Legal Matters
The Company is routinely involved in numerous claims, lawsuits, regulatory and IRS audits,
investigations and other legal matters arising, for the most part, in the ordinary course of the
business of administering and insuring employee benefit programs including payments to providers
and benefit level disputes. Litigation of income tax matters is accounted for under FASB’s
accounting guidance for uncertainty in income taxes. Further information can be found in Note
15. An increasing number of claims are being made for substantial non-economic, extra-contractual
or punitive damages. The outcome of litigation and other legal matters is always uncertain, and
outcomes that are not justified by the evidence can occur. The Company believes that it has valid
defenses to the legal matters pending against it and is defending itself vigorously and has
recorded accruals in accordance with GAAP. Nevertheless, it is possible that resolution of one or
more of the legal matters currently pending or threatened could result in losses material to the
Company’s consolidated results of operations, liquidity or financial condition.
Managed care litigation. On April 7, 2000, several pending actions were consolidated in the United
States District Court for the Southern District of Florida in a multi-district litigation
proceeding captioned In re Managed Care Litigation challenging, in general terms, the mechanisms
used by managed care companies in connection with the delivery of or payment for health care
services. The consolidated cases include Shane v. Humana, Inc., et al., Mangieri v. CIGNA
Corporation, Kaiser and Corrigan v. CIGNA Corporation, et al. and Amer. Dental Ass’n v. CIGNA Corp.
et al.
In 2004, the court approved a settlement agreement between the physician class and CIGNA. However,
a dispute over disallowed claims under the settlement submitted by a representative of certain
class member physicians is in arbitration. Separately, in 2005, the court approved a settlement
between CIGNA and a class of non-physician health care providers. Only the American Dental
Association case remains unresolved. On March 2, 2009, the Court dismissed five of the six counts
of the complaint with prejudice. On March 20, 2009, the Court declined to exercise supplemental
jurisdiction over the remaining state law claim and dismissed the case. Plaintiffs filed a notice
of appeal on April 17, 2009. CIGNA denies the allegations and will continue to vigorously defend
itself.
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CIGNA has received insurance recoveries related to this litigation. In 2008, the trial court ruled
that the Company is not entitled to insurance recoveries from one of the two insurers from which
the Company is pursuing further recoveries. CIGNA appealed that decision and on June 3, 2009, the
Superior Court of Pennsylvania reversed the trial court’s decision remanding the case to the trial
court for further proceedings.
Broker compensation. Beginning in 2004, the Company, other insurance companies and certain
insurance brokers received subpoenas and inquiries from various regulators, including the New York
and Connecticut Attorneys General, the Florida Office of Insurance Regulation, the U.S. Attorney’s
Office for the Southern District of California and the U.S. Department of Labor relating to their
investigations of insurance broker compensation. CIGNA has cooperated with the inquiries and
investigations.
On August 1, 2005, two CIGNA subsidiaries, Connecticut General Life Insurance Company and Life
Insurance Company of North America, were named as defendants in a multi-district litigation
proceeding, In re Insurance Brokerage Antitrust Litigation, consolidated in the United States
District Court for the District of New Jersey. The complaint alleges that brokers and insurers
conspired to hide commissions, increasing the cost of employee benefit plans, and seeks treble
damages and injunctive relief. Numerous insurance brokers and other insurance companies are named
as defendants. In 2008, the court ordered the clerk to enter judgment against plaintiffs and in
favor of the defendants. Plaintiffs have filed an appeal. CIGNA denies the allegations and will
continue to vigorously defend itself.
Amara cash balance pension plan litigation. On December 18, 2001, Janice Amara filed a class
action lawsuit, now captioned Janice C. Amara, Gisela R. Broderick, Annette S. Glanz, individually
and on behalf of all others similarly situated v. CIGNA Corporation and CIGNA Pension Plan, in the
United States District Court for the District of Connecticut against CIGNA Corporation and the
CIGNA Pension Plan on behalf of herself and other similarly situated participants in the CIGNA
Pension Plan affected by the 1998 conversion to a cash balance formula. The plaintiffs allege
various ERISA violations including, among other things, that the Plan’s cash balance formula
discriminates against older employees; the conversion resulted in a wear away period (during which
the pre-conversion accrued benefit exceeded the post-conversion benefit); and these conditions are
not adequately disclosed in the Plan.
In 2008, the court issued a decision finding in favor of CIGNA Corporation and the CIGNA Pension
Plan on the age discrimination and wear away claims. However, the court found in favor of the
plaintiffs on many aspects of the disclosure claims and ordered an enhanced level of benefits from
the existing cash balance formula for the majority of the class, requiring class members to receive
their frozen benefits under the pre-conversion CIGNA Pension Plan and their accrued benefits under
the post-conversion CIGNA Pension Plan. The court also ordered, among other things, pre-judgment
and post-judgment interest. The court stayed implementation of the decision until the parties’
appeals have been exhausted. Both parties appealed the court’s decisions. In the second quarter
of 2008, the Company recorded a charge of $80 million pre-tax ($52 million after-tax), which
principally reflects the Company’s best estimate of the liabilities related to the court order. On
October 6, 2009, the Second Circuit Court of Appeals issued a decision affirming the District
Court’s judgment and order on all issues. On October 26,
2009 the Company moved the Second Circuit Court of Appeals to continue
to stay the implementation of the decision citing its intention to
seek to appeal to the United States Supreme Court. The Company will continue to vigorously defend itself in
this case.
Ingenix. On February 13, 2008, State of New York Attorney General Andrew M. Cuomo announced an
industry-wide investigation into the use of data provided by Ingenix, Inc., a subsidiary of
UnitedHealthcare, used to calculate payments for services provided by out-of-network
providers. The Company received four subpoenas from the New York Attorney General’s office in
connection with this investigation and responded appropriately. On February 17, 2009, the Company
entered into an Assurance of Discontinuance resolving the investigation. In connection with the
industry-wide resolution, the Company contributed $10 million to the establishment of a new
non-profit company that will compile and provide the data currently provided by Ingenix. In
addition, on March 28, 2008, the Company received a voluntary request for production of documents
from the Connecticut Attorney General’s office seeking certain out-of-network claim payment
information. The Company has responded appropriately. Since January 2009, the Company has
received and responded to inquiries regarding the use of Ingenix data from the Texas Attorney
General and the Departments of Insurance in Illinois, Florida, Vermont, Georgia, Pennsylvania,
Connecticut and Alaska and will be responding to a letter from the Illinois Attorney General
received on October 9, 2009.
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The Company was named as a defendant in seven putative nationwide class actions
asserting that due to the use of data from Ingenix, Inc., the Company
improperly underpaid claims, an industry-wide issue. Two actions were
brought on behalf of members, (Franco v.
CIGNA Corp. et al., and Chazen v. CIGNA Corp. et al.), and
five actions were brought on behalf of providers, (American Medical
Association et al. v. CIGNA Corp. et al., Shiring et al. v. CIGNA Corp. et al., Higashi et al. v.
CGLIC et al. and Pain Management and Surgery Center of
Southeast Indiana v. CGLIC et al. and North Peninsula Surgical
Center v. Connecticut General Life Insurance Co. et al.). Six of
the seven matters have been consolidated into the Franco case
pending in the United States District Court for the District of New
Jersey. The
consolidated amended complaint, filed on August 7, 2009, asserts claims under ERISA, the RICO
statute, the Sherman Antitrust Act and New Jersey state law. CIGNA filed a motion to dismiss the
consolidated amended complaint on September 9, 2009. Discovery is ongoing and class certification
is scheduled to be litigated in March and April of 2010. The one remaining class action that has
not yet been consolidated in the Franco case is North
Peninsula Surgical Center filed on July 6, 2009, in the United States District Court for
the Central District of California, asserting claims under ERISA, the Sherman Antitrust Act and
state unfair competition law.
On June 9, 2009, CIGNA filed motions in the United States District Court for the Southern District
of Florida to enforce the Managed Care MDL settlement by enjoining the RICO and antitrust causes of
action asserted by the provider plaintiffs on the ground that they arose prior to and were released
in the April, 2004 settlement. The motions are now fully briefed and pending.
It is reasonably possible that others could initiate additional litigation or additional regulatory
action against the Company with respect to use of data provided by Ingenix, Inc. The Company
denies the allegations asserted in the investigations and litigation and will vigorously defend
itself in these matters.
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INDEX
INTRODUCTION
In this filing and in other marketplace communications, CIGNA Corporation and its subsidiaries (the
Company) make certain forward-looking statements relating to the Company’s financial condition and
results of operations, as well as to trends and assumptions that may affect the
Company. Generally, forward-looking statements can be identified through the use of predictive
words (e.g., “Outlook for 2009”). Actual results may differ from the Company’s predictions. Some
factors that could cause results to differ are discussed throughout Management’s Discussion and
Analysis (MD&A), including in the Cautionary Statement beginning on page 82. The forward-looking
statements contained in this filing represent management’s current estimate as of the date of this
filing. Management does not assume any obligation to update these estimates.
The following discussion addresses the financial condition of the Company as of September 30, 2009,
compared with December 31, 2008, and its results of operations for the third quarter of 2009 and
nine months ended September 30, 2009 compared with the same periods last year. This discussion
should be read in conjunction with MD&A included in the Company’s 2008 Form 10-K, to which the
reader is directed for additional information.
The preparation of interim consolidated financial statements necessarily relies heavily on
estimates. This and certain other factors, such as 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.
Certain reclassifications and restatements have been made to prior period amounts to conform to the
current presentation. In addition, certain amounts have been restated as a result of the
adoption of new accounting pronouncements. See Note 2 to the Consolidated Financial Statements for
additional information.
Overview
The Company constitutes one of the largest investor-owned health service organizations in the
United States. Its subsidiaries are major providers of health care and related benefits, the
majority of which are offered through the workplace. In addition, the Company has an international
operation that offers life, accident and supplemental health insurance products as well as
international health care products and services to businesses and individuals in selected markets.
The Company also has certain inactive businesses, including a Run-off Reinsurance segment.
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Ongoing Operations
The Company’s ability to increase revenue, shareholders’ net income and operating cash flow from
ongoing operations is directly related to progress on the execution of its strategic initiatives,
the success of which is measured by certain key factors, including the Company’s ability to:
Run-off Operations
Effectively managing the various exposures of its run-off operations is important to the Company’s
ongoing profitability, operating cash flows and available capital. The results are influenced by a
range of economic factors, especially movements in equity markets and interest rates. In order to
substantially reduce the impact of equity market movements on the liability for guaranteed minimum
death benefits (GMDB), the Company operates an equity hedge program. The Company actively monitors
the performance of the hedge program, and evaluates the cost/benefit of hedging other risks.
Results are also influenced by behavioral factors, including future partial surrender election
rates for GMDB contracts, annuity election rates for guaranteed minimum income benefits (GMIB)
contracts, annuitant lapse rates, as well as the collection of amounts recoverable from
retrocessionaires. The Company actively studies policyholder behavior experience and adjusts
future expectations based on the results of the studies, as warranted. The Company also performs
regular audits of ceding companies to ensure that premiums received and claims paid properly
reflect the underlying risks, and to maximize the probability of subsequent collection of claims
from retrocessionaires. Finally, the Company monitors the financial strength and credit standing
of the retrocessionaires and establishes or collects collateral when warranted.
Summary
The Company’s overall results are influenced by a range of economic and other factors, especially:
The Company regularly monitors the trends impacting operating results from the above mentioned key
factors and economic and other factors affecting its operations. The Company develops strategic and
tactical plans designed to improve performance and maximize its competitive position in the markets
it serves. The Company’s ability to achieve its financial objectives is dependent upon its ability
to effectively execute these plans and to appropriately respond to emerging economic and
company-specific trends.
The Company seeks to improve the performance of and profitably grow its ongoing businesses and
manage the risks associated with the run-off reinsurance operations.
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Acquisition of Great-West Healthcare
On April 1, 2008, the Company acquired the Healthcare division of Great-West Life and Annuity, Inc.
(“Great-West Healthcare” or the “acquired business”) through 100% indemnity reinsurance agreements
and the acquisition of certain affiliates and other assets and liabilities of Great-West
Healthcare. The purchase price was approximately $1.5 billion and consisted of a payment to the
seller of approximately $1.4 billion for the net assets acquired and the assumption of net
liabilities under the reinsurance agreement of approximately $0.1 billion. Great-West Healthcare
primarily sells medical plans on a self-funded basis with stop loss coverage to select and regional
employer groups. Great-West Healthcare’s offerings also include the following specialty
products: stop loss, life, disability, medical, dental, vision, prescription drug coverage, and
accidental death and dismemberment insurance. The acquisition, which was accounted for as a
purchase, was financed through a combination of cash and the issuance of both short and long-term
debt.
See Note 3 to the Consolidated Financial Statements for additional information.
Initiatives to Lower Operating Expenses
During 2009, the Company continued its previously announced comprehensive review to reduce the
operating expenses of its ongoing businesses. As a result, the Company recognized severance
related charges in other operating expenses as follows:
Substantially all of these charges were recorded in the Health Care segment, and are expected to be
paid in cash by June 30, 2010. As a result of these actions, the Company expects annualized
after-tax savings of approximately $30 million in 2010 and beyond. A portion of the savings is
being realized in 2009.
CONSOLIDATED RESULTS OF OPERATIONS
FINANCIAL SUMMARY
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Special Items
In order to facilitate an understanding and comparison of results of operations and permit analysis
of trends in underlying revenue, expenses and shareholders’ income from continuing operations,
presented below are special items, which management believes are not representative of the
underlying results of operations.
SPECIAL ITEMS
See Note 12 to the Consolidated Financial Statements for additional information related to the
curtailment gain and Note 6 to the Consolidated Financial Statements for further discussion of the
cost reduction charge. The other special item for 2009 is a result of the completion of the 2005
and 2006 IRS examinations. See Note 15 to the Consolidated Financial Statements for additional
information.
See Note 17 to the Consolidated Financial Statements for further discussion of the litigation
charge associated with the pension plan reported in the second quarter of 2008. The remaining
special item for 2008 consisted of charges related to certain litigation matters which were
reported in the Health Care segment.
Overview of Consolidated Results of Operations
Three Months Ended September 30, 2009 Compared with Three Months Ended September 30, 2008
Shareholders’ income from continuing operations for the three months ended September 30, 2009
increased significantly compared with the three months ended September 30, 2008, as a result of:
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Nine Months Ended September 30, 2009 Compared with Nine Months Ended September 30, 2008
Shareholders’ income from continuing operations was also significantly higher for the nine months
ended September 30, 2009 compared with the same period in 2008. In addition to the items cited
above related to the three months ended September, the increase for the nine months resulted from:
Higher
segment earnings in the Health Care segment also contributed to the increase in shareholders’ income
from continuing operations for the nine months ended September 30, 2009. Partially offsetting
these favorable effects were higher net realized investment losses in 2009.
See the Segment reporting section of the MD&A for further information regarding segment earnings
for each of the Company’s segments for both the three months and nine months ended September 30,
2009 compared with the same periods in 2008.
Outlook for 2009 and 2010
The Company expects full-year 2009 shareholders’ income from continuing operations, excluding
realized investment results, the results of the GMIB business, and special items, to be higher than
2008 due to lower losses in the Run-off Reinsurance segment. Overall
segment earnings in the ongoing
operating segments (Health Care, Disability and Life, and International) are expected to be
slightly higher than 2008. Information is not available for management to reasonably estimate the
future results of the GMIB business, realized investment gains (losses), or to identify or
reasonably estimate special items for the remainder of 2009. Special items for the remainder of
2009 may include potential charges associated with the previously announced cost reduction plan, as
well as litigation related items.
The Company expects 2010 shareholders’ income from continuing operations, excluding realized
investment results, the results of the GMIB business, and special
items, to be comparable to or slightly higher than 2009. As discussed above, information is not
available for management to reasonably estimate future realized investment gains (losses), the
results of the GMIB business or to identify or reasonably estimate future special items in 2010.
The Company’s outlook for both 2009 and 2010 reflects
management’s assumption that equity market
conditions and volatility will continue to be stable for the remainder of 2009 and 2010. However,
that assumption, together with the other earnings projections used to develop this outlook, is
subject to the factors cited in the Cautionary Statement beginning on page 82 and the sensitivities
discussed in the Critical Accounting Estimates section of the MD&A beginning on page 51 and in the
Company’s 2008 Form 10-K. If unfavorable equity market and interest rate movements occur, the
Company could experience losses related to investment impairments and the GMIB and GMDB business.
These losses could adversely impact the Company’s consolidated results of operations and financial
condition by potentially reducing the capital of the Company’s insurance subsidiaries and reducing
their dividend paying capabilities.
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Revenues
Total revenue decreased by 7% for the three months ended September 30, 2009, compared with the
three months ended September 30, 2008 and decreased by 4% for the nine months ended September 30,
2009 compared with the nine months ended September 30, 2008. Changes in the components of total
revenue are described more fully below.
Premiums and Fees
Premiums and fees decreased by 3% for the three months ended September 30, 2009, compared with the
three months ended September 30, 2008, primarily reflecting membership declines in the Health Care
segment largely due to disenrollment. See segment reporting discussions for additional detail and
drivers.
Premiums and fees decreased by 1% for the nine months ended September 30, 2009, compared with the
nine months ended September 30, 2008, reflecting membership declines in Health Care and the
unfavorable effect of foreign currency translation in International,
offset by the absence of premiums and fees from the acquired business
in the first quarter of 2008 since this business was acquired
April 1, 2008.
Net Investment Income
Net investment income decreased by 3% for the three months ended September 30, 2009, compared with
the three months ended September 30, 2008, primarily due to lower income from real estate funds
which reflects declines in market values due to the continued weakness in commercial real estate
market fundamentals, and lower investment yields driven by declines in short-term interest rates
partially offset by higher assets.
For the nine months ended September 30, 2009, net investment income decreased by 6% compared with
the nine months ended September 30, 2008 due to lower income from real estate funds and security
partnerships and lower investment yields partially offset by higher invested assets.
Mail Order Pharmacy Revenues
Mail order pharmacy revenues increased by 5% for the three months ended September 30, 2009,
compared with the three months ended September 30, 2008 and increased by 7% for the nine months
ended September 30, 2009 compared with the nine months ended September 30, 2008. These changes
were primarily due to rate increases.
Other Revenues
Other revenues include the impact of the futures contracts associated with the GMDB equity hedge
program. The Company reported losses of $161 million for the three months ended and $232 million
for the nine months ended September 30, 2009 associated with the GMDB equity hedge program,
compared with gains of $70 million for the three months ended and $118 million for the nine months
ended September 30, 2008. The losses in 2009 reflect increases in stock market values, while the
gains in 2008 primarily reflect declines in stock market values. Excluding the impact of these
futures contracts, other revenues decreased by 5% for the three months ended September 30, 2009,
and decreased by 3% for the nine months ended September 30, 2009 compared with the same periods in
2008. These decreases primarily reflect declines in amortization of deferred gains on the sales of
the retirement benefits and individual life insurance and annuity businesses.
Realized Investment Results
Realized investment results improved significantly for the three months ended September 30, 2009,
compared with the three months ended September 30, 2008 primarily due to improving market
conditions which resulted in:
These favorable factors were substantially offset by the absence of a gain on sale of a real estate
venture in the third quarter of 2008.
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Realized investment losses were higher for the nine months ended September 30, 2009 compared with
the nine months ended September 30, 2008, primarily due to the absence of significant gains on the
sales of real estate ventures reported in the first and third quarters of 2008, partially offset by
the following items which largely resulted from improving market conditions:
See Note 9 to the Consolidated Financial Statements for additional information.
CRITICAL ACCOUNTING ESTIMATES
The preparation of consolidated financial statements in accordance with accounting principles
generally accepted in the United States of America (GAAP) requires management to make estimates and
assumptions that affect reported amounts and related disclosures in the consolidated financial
statements. Management considers an accounting estimate to be critical if:
Management has discussed the development and selection of its critical accounting estimates with
the Audit Committee of the Company’s Board of Directors and the Audit Committee has reviewed the
disclosures presented below.
The Company’s most critical accounting estimates, as well as the effects of hypothetical changes in
material assumptions used to develop each estimate, are described in the Company’s 2008 Form 10-K
beginning on page 49 and are as follows:
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The Company regularly evaluates items which may impact critical accounting estimates. During the
nine months ended September 30, 2009, the Company updated the following critical accounting
estimates:
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Investments — Fixed Maturities. Losses for “other-than-temporary” impairments of fixed
maturities must be recognized in shareholders’ net income based on an estimate of fair value or the
present value of expected cash flows by management. Determining whether a decline in value is
“other-than-temporary” includes an evaluation of the reasons for, the significance of, and the
duration of the decrease in value of the security and the Company’s intent to sell or likelihood of
a required sale of the security before recovery. For all fixed maturities with cost in excess of
their fair value, if this excess was determined to be “other-than-temporary”, shareholders’ net income as of September 30, 2009 would have decreased by $96 million after-tax.
See Note 9 to the Consolidated Financial Statements for more information.
Summary
There are other accounting estimates used in the preparation of the Company’s Consolidated
Financial Statements, including estimates of liabilities for future policy benefits other than
those identified above, as well as estimates with respect to unpaid claims and claim expenses,
post-employment and postretirement benefits other than pensions, certain compensation accruals and
income taxes.
Management believes the current assumptions used to estimate amounts reflected in the Company’s
Consolidated Financial Statements are appropriate. However, if actual experience differs from the
assumptions used in estimating amounts reflected in the Company’s Consolidated Financial
Statements, the resulting changes could have a material adverse effect on the Company’s
consolidated results of operations, and in certain situations, could have a material adverse effect
on liquidity and the Company’s financial condition.
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SEGMENT REPORTING
Operating segments generally reflect groups of related products, but the International segment is
generally based on geography. The Company measures the financial results of its segments using
“segment earnings (loss),” which is defined as shareholders’ income (loss) from continuing
operations excluding after-tax realized investment gains and losses.
Health Care Segment
Segment Description
The Health Care segment includes medical, dental, behavioral health, prescription drug and other
products and services that may be integrated to provide consumers with comprehensive health care
solutions. This segment also includes group disability and life insurance products that were
historically sold in connection with certain experience-rated medical products. These products and
services are offered through a variety of funding arrangements such as guaranteed cost,
retrospectively experience-rated and administrative services only arrangements.
The Company measures the operating effectiveness of the Health Care segment using the following key
factors:
Results of Operations
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Excluding the special items noted in the table above, the Health Care segment’s earnings for
the three months ended September 30, 2009 were higher than the same period last year, primarily
due to:
These favorable effects were partially offset by:
Segment earnings for the nine months ended September 30, 2009, as compared with the nine months
ended September 30, 2008, were favorably impacted by the absence
of a $7 million after-tax adjustment related
to a large experience-rated life and non-medical account in run-out recorded in
the first quarter of 2008.
Excluding
this item and the special items noted in the table above, segment earnings for the nine
months ended September 30, 2009 were higher compared to the nine months ended September 30, 2008
reflecting:
These favorable effects were largely offset by:
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Revenues
The table below shows premiums and fees for the Health Care segment:
Premiums and fees decreased by 6% for the three months ended September 30, 2009 and decreased
by 2% for the nine months ended September 30, 2009, compared with the same periods of 2008. This
primarily reflects lower membership largely due to disenrollment.
This impact was partially offset by rate increases, as well as membership growth in the Medicare
private fee for services product.
Net investment income decreased by 4% for the three months ended September 30, 2009 and decreased
by 14% for the nine months ended September 30, 2009 compared with the same periods of 2008
reflecting lower income from real estate funds and security partnerships partially offset by higher
invested assets.
Other revenues for the Health Care segment consist of revenues earned on direct channel sales of
certain specialty products, including behavioral health and disease management.
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Benefits and Expenses
Health Care segment benefits and expenses consist of the following:
Medical claims expense decreased by 7% for the three months ended September 30, 2009 and
decreased by 5% for the nine months ended September 30, 2009 compared with the same periods in 2008
largely due to lower membership, particularly in the experience-rated and guaranteed cost
businesses; partially offset by increases in medical expenses related to claim trend and Medicare
member driven growth.
Other operating expenses include expenses related to:
Excluding the items noted above, as well as the special items noted in the Results of Operations
table, other operating expenses for the three months ended September 30, 2009 were lower than the
same period last year reflecting volume related declines, as well as a
favorable impact resulting from the comprehensive review of ongoing
expenses, including the impact of pension changes. Operating expenses increased for the nine
months ended September 30, 2009, compared with the nine months ended September 30, 2008, primarily
due to expenses related to the acquired business (effective April 1, 2008), partially offset by the
impact of pension changes.
Other Items Affecting Health Care Results
Medical Membership
The Company’s medical membership includes any individual for whom the Company retains medical
underwriting risk, who uses the Company’s network for services covered under their medical coverage
or for whom the Company administers medical claims. As of September 30 , estimated medical
membership was as follows:
The net decrease in the Company’s medical membership is 7% as of September 30, 2009 when
compared with September 30, 2008, primarily driven by disenrollment across all funding arrangements
as a result of the current economic environment.
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Operational Improvement Initiatives
The Company is focused on several initiatives including developing and enhancing a customer focused
service model. This effort is expected to require significant investments over the next three to
five years. These investments are expected to enable the Company to grow its membership and to
improve operational effectiveness and profitability by developing innovative products and services
that promote customer engagement at a competitive cost. Executing on these operational improvement
initiatives is critical to attaining a leadership position in the health care marketplace.
The operational improvement initiatives currently underway are discussed below.
Reducing other operating expenses. The Company operates in an intensely competitive marketplace
and its ability to establish a competitive cost advantage is key to achieving its initiatives.
Accordingly, the Company is focused on reducing operating expenses in three key areas primarily to
facilitate operating efficiency and responsiveness to customers. These three areas include:
customer acquisition, which encompasses spending on sales, the account management process,
underwriting and marketing; fulfillment, mainly claims processing and billing; and reducing
overhead in various administrative and staffing functions. In connection with these efforts, in
the fourth quarter of 2008, the Company reviewed staffing levels and organization and announced a
plan to reorganize its business model and supporting areas to more tightly align the ongoing
operating segments. As part of this ongoing review of operating expenses, during the third quarter
of 2009 the Company identified additional job eliminations, in order to facilitate operating
efficiency and meet the challenges and opportunities presented by the current economic environment.
Maintaining and upgrading information technology systems. The Company’s current business model and
long-term strategy require effective and reliable information technology systems. The Company’s
current systems architecture will require continuing investment to meet the challenges of
increasing customer demands from both our existing and emerging client base to support its business
growth and strategies, improve its competitive position and provide appropriate levels of service
to customers. The Company is focused on providing these enhanced strategic capabilities in
response to increasing customer expectations, while continuing to provide a consistent, high
quality customer service experience with respect to the Company’s current programs. Accordingly, in
2009, the Company’s efforts will be focused primarily on optimizing the technology underlying our
claims processing and call servicing capabilities with specific emphasis on reducing handling time
and improving customer service. Continued integration of the Company’s multiple administrative
and customer facing platforms is also required to support the Company’s growth strategies, and to
ensure reliable, efficient and effective customer service both in today’s employer focused model as
well as in a customer directed model. The Company’s ability to effectively deploy capital to make
these investments will influence the timing and the impact these initiatives will have on its
operations.
Profitable sales and customer retention. The Company continues to focus on selling profitable new
business and retaining current customers by:
The Company is also focused on segment and product expansion. With respect to segment expansion,
our focus is predominantly in the “Select” (employers with 51-250 employees), and individual
segments. As part of its effort to achieve these objectives, the Company completed the acquisition
of Great-West Healthcare of Denver, Colorado on April 1, 2008. This acquisition will enable the
Company to broaden its distribution reach and health care professional network, particularly in the
western regions of the United States, and expand the range of health benefits and product
offerings.
The Company has also recently developed new product offerings for its guaranteed cost and
experienced-rated portfolios. These offerings will provide our employer clients with lower-cost
options for providing medical, pharmacy and dental benefits.
Driving additional cross-selling is also key to our integrated benefits value proposition. We are
expanding network access for our dental product and improving network flexibility to ensure better
alignment with our customers’ needs. Also, with the acquisition of Great-West Healthcare, we will
be working in 2009 to transition this book to CIGNA pharmacy and increase pharmacy penetration
across the entire book.
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Offering products that meet emerging customer and market trends. In order to meet emerging customer
and market trends, the Company’s suite of products (CIGNATURE®, CareAllies®, and CIGNA Choice
Fund®) offers various options to customers and employers and is key to our customer engagement
strategy. Offerings include: choice of benefit, participating provider network, funding, medical
management, and health advocacy options. Through the CIGNA Choice Fund®, the Company offers a set
of customer-directed capabilities that includes options for health reimbursement arrangements
and/or health savings accounts and enables customers to make effective health decisions using
information tools provided by the Company.
Underwriting and pricing products effectively. One of the Company’s key priorities is to achieve
strong profitability in a competitive health care market. The Company is focused on effectively
managing pricing and underwriting decisions at both the case and overall book of business level,
particularly for the guaranteed cost book, as well as its experience-rated, ASO businesses and stop
loss coverages.
Effectively managing medical costs. The Company operates under a centralized medical management
model, which helps facilitate consistent levels of care for its members and reduces infrastructure
expenses.
The Company is focused on continuing to effectively manage medical utilization and unit costs. The
Company believes that by increasing the quality of medical care and improving access to care we can
drive reductions in total medical cost and better outcomes, resulting in healthier members. To
help achieve this, the Company continues to focus on contracting with providers, enhancing clinical
activities, as well as engaging our members and clients/employers. In addition, the Company seeks
to strengthen its network position in selected markets. In connection with the Great-West
Healthcare acquisition in April 2008, the Company has made significant progress converting and
integrating these acquired members to its extensive preferred provider network which offers access
to a broad range of utilization review and case management services at a reduced medical cost. The
integration is progressing well, with savings from medical cost management initiatives (including
contract integration and enhancement of clinical activities) projected to be on target, with most
to be achieved by the end of 2009.
Delivering quality service to customers and health care professionals. The Company is focused on
delivering competitive service to customers, health care professionals and clients. The Company
believes that further enhancing quality service can improve customer retention and, when combined
with useful health information and tools, can help motivate customers to become more engaged in
their personal health, and will help promote healthy outcomes thereby removing cost from the
system. The evolution of the consumer-driven health care market is driving increased product and
service complexity and is raising customers’ expectations with respect to service levels, which is
expected to require significant investment, management attention and heightened interaction with
customers.
The Company is focused on the development and enhancement of a service model that is capable of
meeting the challenges brought on by the increasing product and service complexity and the
heightened expectations of health care customers. The Company continues to make significant
investments in the development and implementation of systems and technology to improve the provider
service experience for customers and health care professionals, enhance its capabilities and
improve its competitive position.
The Company’s health advocacy
capabilities support its recent membership efforts. The
Company must be able to deliver those capabilities efficiently and cost-effectively. The Company
continues to identify additional cost savings to further improve its competitive cost
position. Savings generated from the Company’s operating efficiency initiatives provide capital to
make investments that will enhance its capabilities in the areas of customer engagement,
particularly product development, the delivery of customer service and health advocacy and related
technology.
Disability and Life Segment
Segment Description
The Disability and Life segment includes group disability, life, accident and specialty insurance
and case management services for disability and workers’ compensation.
Key factors for this segment are:
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Results of Operations
FINANCIAL SUMMARY
Segment
earnings for the three months ended September 30, 2009 include a
special item for a cost reduction charge. Excluding the special item,
segment results reflect lower earnings from the disability business
primarily resulting from higher expenses including an
expense charge related to a settlement, less favorable life and
specialty claims experience and lower net investment income, partially offset by
favorable accident claims experience. Segment earnings continue
to reflect competitively strong
margins driven by the sustained value the Company delivers to its
customers from its disability management programs.
Segment earnings for the nine months ended September 30, 2009 include the favorable after-tax
impact of reserve studies of $34 million of which $20 million reflects strong results from
the Company’s disability management programs over the past several years, an expense charge and
special items for the pension curtailment gain, cost reduction charge and completion of an IRS
examination. Segment earnings for the nine months ended September 30, 2008 include the favorable
after-tax impact of reserve studies of $16 million. Excluding the impact of the reserve studies,
an expense charge and special items, segment earnings decreased due to lower investment
income and less favorable life, specialty and disability claims experience, partially offset by
favorable accident claims experience.
Revenues
Premiums and fees increased 4% for the three months ended September 30, 2009 and 5% for the nine
months ended September 30, 2009 compared with the same periods of 2008 reflecting new sales growth
and solid customer retention in the disability and life lines of business, partially offset by less
favorable customer retention in the specialty line of business.
Net investment income decreased 5% for the three months ended September 30, 2009 and 7% for the
nine months ended September 30, 2009 reflecting lower yields and lower real estate and security
partnership income.
Benefits and Expenses
Benefits
and expenses for the three months ended September 30, 2009 include the favorable pre-tax
impact of reserve studies of $7 million, an expense charge and
the special item for cost reduction charge. Benefits and expenses for
the three months ended September 30, 2008 include the favorable
pre-tax impact of reserve studies of $7 million. Excluding the
impact of the reserve studies, an expense charge and the special item
for cost reduction charge, benefits and
expenses increased 4%, primarily reflecting disability and life
business growth and less favorable
life, specialty and disability claims experience, partially offset by more favorable accident
claims experience. The less favorable life claims experience was driven by the higher average
size of death claims. The less favorable disability claims experience was driven by higher new
claims partially offset by higher resolutions. The more favorable accident claim experience was
driven by lower claim counts. The overall flat expense ratio reflects effective operating expense
management offset by investments in the claim operations and strategic information technology
initiatives.
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Benefits and expenses for the nine months ended September 30, 2009 include the net favorable
pre-tax impact of reserve studies of $49 million, an expense charge and special items.
Benefits and expenses for the nine months ended September 30, 2008 include the favorable pre-tax
impact of reserve studies of $23 million. Excluding the impact of the reserve studies,
an expense charge and special items, benefits and expenses increased 5%, primarily
reflecting disability and life business growth and less favorable life, specialty and disability
claims experience partially offset by more favorable accident claims experience. The less
favorable life claims experience was driven by the higher average size of death claims. The less
favorable disability claims experience was driven by higher new claims partially offset by higher
resolutions. The more favorable accident claim experience was driven by lower claim counts. The
overall flat expense ratio reflects effective operating expense management offset by investments in the
claim operations and strategic information technology initiatives.
International Segment
Segment Description
The International segment includes life, accident and supplemental health insurance products and
international health care products and services, including those offered to expatriate employees of
multinational corporations.
The key factors for this segment are:
Results of Operations
FINANCIAL SUMMARY
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