ITEM 1A. I Risk Factors
The following are certain risk factors that could affect our business, financial position and results of operations. The risks that we have highlighted in the following section of this report are not the only ones that we face.
Our business involves various risks and uncertainties which are based on the lines of business we write as well as more global risks associated with the general business and insurance industry environments.
Further, to the effects of COVID-19 and resulting disruptions on our business and operations as discussed in Item 7 of this report and in the risk factors below, additional or unforeseen effects from COVID-19 and the global economic climate may give rise to or amplify many of the risk factors discussed below.
Risks Related to Economic Conditions, Market Conditions and Investments
Volatile financial markets and adverse economic environments can affect financial market risk as well as our financial condition and results of operations.
Financial markets in the U.S. and elsewhere can experience extreme volatility and disruption for uncertain periods of time. During such times, stresses affecting the global banking system can lead to economic volatility, which can exert significant downward pressure on prices of equity securities and many other investment asset classes and result in severely constrained credit and capital markets, particularly for financial institutions, and an overall loss of investor confidence. Many states and local governments can also be impacted by adverse economic conditions, which could have an impact on both our niche market and our investment portfolio. Like other financial institutions that face significant financial market risk in their operations, we have been adversely affected by these conditions and could be adversely impacted by similar circumstances in the future. Our ability to access the capital markets to refinance outstanding indebtedness or raise capital could be impaired during significant financial market disruptions.
As discussed further in subsequent risk factors, in addition to the effects of financial markets volatility, a prolonged economic recession may have other adverse impacts on our financial condition and results of operations.
If our investment strategy is not successful, we could suffer unexpected losses.
The success of our investment strategy is crucial to the success of our business. Specifically, our fixed maturity securities portfolio is subject to a number of risks including:
•interest rate risk, which is the risk that interest rates will decline and funds reinvested will earn less than expected;
•market value risk, which is the risk that invested assets will decrease in value due to changes in yields realized on the assets and prevailing market yields for similar assets, an unfavorable change in the liquidity of the asset or an unfavorable change in the financial prospects or a downgrade in the credit rating of the issuer of the asset;
•credit risk, which is the risk that the value of certain investments become impaired due to deterioration in the financial condition of one or more issuers of those instruments or the deterioration in performance or credit quality of the underlying collateral of certain structured securities and, ultimately, the risk of permanent loss in the event of default by an issuer or underlying credit;
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•market fundamentals risk, which is the risk that there are changes in the market that can have an unfavorable impact on securities valuation such as availability of credit in the capital markets, re-pricing of credit risk, reduced market liquidity due to broker-dealers' unwillingness to hold inventory, and increased market volatility;
•concentration risk, which is the risk that the portfolio may be too heavily concentrated in the securities of one or more issuers, sectors or industries, which could result in a significant decrease in the value of the portfolio in the event of deterioration in the financial condition of those issuers or the market value of their securities;
•liquidity risk, which is the risk that liabilities are surrendered or mature sooner than anticipated requiring the sale of assets at an undesirable time to provide for policyholder surrenders, withdrawals or claims; and,
•regulatory risk, which is the risk that regulatory bodies or governments, in the U.S. or in other countries, may make substantial investments or take significant ownership positions in, or ultimately nationalize, financial institutions or other issuers of securities held in our investment portfolio, which could adversely impact the seniority or contractual terms of the securities. Regulatory risk could also come from changes in tax laws or bankruptcy laws that could adversely impact the valuation and/or after tax yields of certain invested assets.
Although our defined benefit pension plan has been frozen since 2002, declining financial markets could also cause, and in the past have caused, the value of the investments in this plan to decrease, resulting in additional pension expense, a reduction in other comprehensive income and an increase in required contributions to this plan, which could have an adverse effect on our financial condition and results of operations.
The determination of fair value of our fixed maturity securities portfolio includes methodologies, estimations and assumptions that are subject to differing interpretations and could result in changes to investment valuations that may materially affect our financial condition and results of operations.
The determination of fair value is made at a specific point in time, based on available market information and judgments about financial instruments, including estimates of the timing and amounts of expected future cash flows and the credit standing of the issuer or counterparty. The use of different methodologies and assumptions may have a material effect on the estimated fair value amounts. During periods of market disruption, including periods of rapidly widening credit spreads or illiquidity, it may be difficult to value certain securities if trading becomes less frequent and/or market data becomes less observable. There may be certain asset classes that were in active markets with significant observable data that become illiquid due to the financial environment. In such cases, fair value determination may require more subjectivity and management judgment and those fair values may differ materially from the value at which the investments could ultimately be sold. Further, rapidly changing and unprecedented credit and equity market conditions could materially impact the valuation of securities and the period-to-period changes in fair value could vary significantly. The difference between fair value and amortized cost, net of applicable deferred income taxes and the related impact on DAC associated with annuity contracts and life insurance products with account values is reflected as a component of AOCI within shareholders' equity. Decreases in the fair value of investments could have a material adverse effect on our financial condition and results of operations.
Equity method adjustments on certain investments in limited partnership interests as well as fair value accounting for equity securities and derivatives may reduce profitability and/or cause volatility in our results of operations.
We invest in limited partnership interests, which are accounted for using the equity method of accounting. This means that our proportionate share of the changes in fair value of the underlying net asset values are reported in net investment income in the Consolidated Statements of Operations. As a result, the amount of net investment income recognized from these investments can vary substantially from period to period. Equity and credit market volatility may reduce net investment income from these types of investments and negatively impact the results of operations. Changes in fair value from applying fair value accounting to equity securities, which are reported in net investment gains (losses) in the Consolidated Statements of Operations, may cause volatility in our results of operations.
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The application of fair value accounting for derivatives and embedded derivatives in FIA and IUL products may cause volatility in our results of operations.
Risks Related to Property and Casualty Segment
Catastrophe events, as well as significant weather events not designated as catastrophes, can have a material adverse affect on our financial condition and results of operations.
Underwriting results of property and casualty insurers are subject to weather and other conditions prevailing in an accident year. While one year may be relatively free of major weather or other disasters — not all of which are designated by the insurance industry as a catastrophe, another year may have numerous such events causing results for such a year to be materially worse than for previous years.
Our Property and Casualty insurance subsidiaries have experienced, and we anticipate that in the future they will continue to experience, catastrophe losses. A catastrophe event, a series of multiple catastrophe events or a series of non-catastrophe severe weather events could have a material adverse effect on the financial condition and results of operations of our insurance subsidiaries.
Various events can cause catastrophes, including hurricanes, windstorms, hail, severe winter weather, wildfires, earthquakes, explosions and terrorism. The frequency and severity of these catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposures in the area affected by the event and the severity of the event. Although catastrophes can cause losses in a variety of property and casualty lines, most of the catastrophe-related claims of our insurance subsidiaries are related to property coverages. Our ability to provide accurate estimates of ultimate catastrophe losses is based on several factors, including:
•the proximity of the catastrophe occurrence date to the date of our estimate;
•potential inflation of property repair costs in the affected area;
•the occurrence of multiple catastrophes in a geographic area over a relatively short period of time; and
•the outcome of litigation which may be filed against us by policyholders, state attorneys general and other parties relative to loss coverage disputes and loss settlement payments.
Based on 2020 direct premiums earned, 57.5% of the total annual premiums for our Property and Casualty business were for policies issued in the ten largest states in which the insurance subsidiaries write property and casualty coverage. Included in this top ten group are certain states which are considered to be more prone to catastrophe occurrences: California, Texas, North Carolina, Minnesota, South Carolina, Louisiana and Colorado.
Climate change may adversely affect our financial position, results of operations and cash flows.
Climate change presents risk to us and there are concerns that the increased frequency and severity of weather-related catastrophes and other losses is indicative of changing weather patterns, whether as a result of climate-warming trends (global climate change) caused by human activities or otherwise, which could cause such events to persist. Increased weather-related catastrophes could lead to higher overall losses, which we may not be able to recoup, particularly in a highly regulated and competitive environment, and higher reinsurance costs. Certain catastrophe models assume an increase in frequency and severity of certain weather or other events, which could result in a disproportionate impact on insurers with certain geographic concentrations of risk. This could also likely increase the risks of writing property insurance in coastal areas or areas susceptible to wildfires or flooding, particularly in jurisdictions that restrict pricing and underwriting flexibility. The threat of rising sea levels or other catastrophe losses as a result of global climate change may also cause property values in coastal or such other communities to decrease, reducing the total amount of insurance coverage that is required.
In addition, global climate change could have an impact on our fixed maturity security and limited partnership portfolios, resulting in realized and unrealized losses in future periods that could have a material adverse effect on our financial position, results of operations and cash flows. It is not possible to foresee which, if any, assets, industries or markets may be materially and adversely affected, nor is it possible to foresee the magnitude of such effect. Further, it is also possible that the legal, regulatory and social responses to climate change could have an adverse effect on our financial condition, results of operations and cash flows.
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Our property and casualty loss reserves may not be adequate.
Our Property and Casualty insurance subsidiaries maintain loss reserves to provide for their estimated ultimate liability for losses and loss adjustment expenses with respect to reported and unreported claims incurred as of the end of each reporting date. If these loss reserves prove inadequate, a loss is recognized and measured by the amount of the shortfall and, as a result, the financial condition and results of operations of the insurance subsidiaries may be adversely affected, potentially affecting their ability to distribute cash to us.
Reserves do not represent an exact calculation of liability. Reserves represent estimates, generally involving actuarial projections at a given time, of what the insurance subsidiaries expect the ultimate settlement and adjustment of claims will cost, net of salvage and subrogation. Estimates are based on assessments of known facts and circumstances, assumptions related to the ultimate cost to settle such claims, estimates of future trends in claims severity and frequency, changing judicial theories of liability, and other factors. These variables are affected by both internal and external events, including changes in claims handling procedures, economic inflation, unpredictability of court decisions, plaintiffs' expanded theories of liability, risks inherent in major litigation and legislative changes. Many of these items are not directly quantifiable, particularly on a prospective basis. Significant reporting lags may exist between the occurrence of an insured event and the time it is actually reported. Our insurance subsidiaries adjust their reserve estimates regularly as experience develops and further claims are reported and settled.
Due to the inherent uncertainty in estimating reserves for losses and loss adjustment expenses, we cannot be certain that the ultimate liability will not exceed amounts reserved, with a resulting adverse effect on our financial condition and results of operations.
Risks Related to Supplemental Segment
Actual experience may differ from actuarial assumptions, which could adversely affect our results of operations and financial condition.
Historical results may not be indicative of future performance due to, among other things, changes in our mix of business, regulatory actions or changes in legal doctrine impacting our products or lines of business, or any number of economic cyclical effects. Reserves do not represent an exact calculation of future benefit liabilities but are instead actuarial and statistical-based estimates. Actual experience may differ from our reserve assumptions. There are no assurances that reserves will be sufficient to fund our future liabilities in all scenarios. Future loss development may require reserves to be increased, which could adversely affect earnings in current and future periods. Adjustments to reserve amounts may be required in the event of changes from the assumptions regarding future morbidity, mortality, persistency, and interest rates used in calculating the reserve amounts, which could have a material adverse affect on our financial condition and results of operations.
Risks Related to Life and Retirement Segments
A sustained period of low interest rates or interest rate fluctuations could negatively affect net interest margin derived from the difference between interest earned on investments and interest paid under fixed annuity and life insurance products with account values.
Significant changes in interest rates expose us to the risk of not earning the appropriate level of income or experiencing losses based on the differences between the interest earned on investments and the credited interest paid on outstanding fixed annuity and life insurance products with account values. Significant changes in interest rates may affect:
•the ability to maintain appropriate interest rate spreads over the rates guaranteed in fixed annuity and life products with account values;
•the book yield of the investment portfolio; and
•the net unrealized investment gains (losses) in the portfolio and the related after tax effect on shareholders' equity and total capital.
Both rising and declining interest rates can negatively affect the income derived from interest rate spreads on annuity and life insurance products with account values. During periods of falling interest rates or a sustained
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period of low interest rates, investment earnings will be lower because new investments in fixed maturity securities likely will bear lower interest rates. We may not be able to fully offset the decline in investment earnings with lower crediting rates on fixed annuity products, particularly in a multi-year period of low interest rates. As of the time of issuance of this Annual Report on Form 10-K, yields on new investments remain at historically low levels. If interest rates do remain low over an extended period of time, it could pressure investment income by having to invest insurance cash flows and reinvest the cash flows from the investment portfolio in lower yielding securities.
During periods of rising interest rates, there may be competitive pressure to increase the crediting rates on fixed annuity products. We may not, however, immediately have the ability to acquire investments with interest rates sufficient to offset an increase in crediting rates under fixed annuity products. Therefore, changes in interest rates could affect interest rate spreads.
Changes in interest rates may also affect business in other ways. For example, a rapidly changing interest rate environment may result in less competitive crediting rates on certain fixed rate products which could make those products less attractive, leading to lower sales and/or increases in the level of life insurance and fixed annuity product surrenders and withdrawals. New business volume also could be negatively impacted by product or agent compensation changes which we might make to mitigate the income effect of spread compression. Interest rate fluctuations that impact future profits may also impact DAC amortization.
The Retirement business may be, and in the past has been, adversely affected by volatile or declining financial market conditions.
Conditions in the U.S. and international financial markets affect the sale and profitability of retirement products. In general, sales of fee-based products decrease when financial markets are declining or experiencing a higher than normal level of volatility over an extended period of time. Therefore, weak and/or volatile financial market performance may adversely affect sales of fee-based products to potential customers, may cause current customers to withdraw or reduce the amounts invested in fee-based products and may reduce the market value of existing customers' investments in fee-based products, in turn reducing the amount of fee-based product revenues generated. In addition, some variable annuity products offer guaranteed minimum death benefit features, which provide for a benefit if the contractholder dies and the contract value is less than a specified amount. A decline in the financial markets could cause the contract value to fall below this specified amount, increasing exposure to losses from variable annuity products featuring guaranteed minimum death benefits. Declining or volatile financial markets that impact future profits may also impact DAC amortization.
Deviations from assumptions regarding future market appreciation, interest spreads, business persistency, mortality and morbidity used in calculating life and annuity reserves and DAC amortization could have a material adverse effect on our financial condition and results of operations.
The processes of calculating reserves and DAC amortization for the life and annuity businesses involve the use of a number of assumptions, including those related to market appreciation (the rate of growth in market value of the underlying variable annuity sub-accounts due to price appreciation), interest spreads (the interest rates expected to be received on investments less the rate of interest credited to contractholders), business persistency (how long a contract stays with us), mortality (the relative incidence of death over a given period of time) and morbidity (the relative incidence of disability resulting from disease or physical impairment). We periodically review the adequacy of these reserves and DAC recoverability on an aggregate basis and, if future experience is estimated to differ significantly from previous assumptions, adjustments to reserves and DAC amortization may be required that could have a material adverse effect on our financial condition and results of operations.
A reduction or elimination of the tax advantages of retirement and life products and/or a change in the tax benefits of various government-authorized retirement programs, such as 403(b) products and individual retirement accounts (IRAs), could make our products less attractive to clients and adversely affect our results of operations.
A significant part of our retirement business involves fixed and variable 403(b) tax-qualified products, which are purchased voluntarily by individuals employed by public school systems or other tax-exempt organizations. Our financial condition and results of operations could be adversely affected by changes in federal and state laws and regulations that affect the relative tax and other advantages of our life and retirement products to clients or
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the tax benefits of programs utilized by our customers. As a result of persisting economic conditions, revenue challenges exist at federal, state and local government levels. These challenges could increase the risk of future adverse impacts on current tax-advantaged products or result in notable reforms to educator pension programs. Also, see Part I - Item 1, Regulation of this report.
Current federal income tax laws generally permit the tax-deferred accumulation of earnings on the premiums paid by holders of retirement and life insurance products. Taxes, if any, are generally payable on income attributable to a distribution under the contract for the year in which the distribution is made. From time to time, Congress has considered legislation that would reduce or eliminate the benefit of such deferral of taxation on the accretion of value within life insurance and non-qualified annuity contracts. Enactment of this legislation, or other tax reform efforts could result in fewer sales of life insurance and retirement products.
Strategic Risks
Lack of successful execution on acquisition integration strategies could result in impairment of goodwill and intangible assets that could adversely affect our results of operations.
We accounted for the NTA and BCG acquisitions using the acquisition method of accounting, which requires that the assets acquired and liabilities assumed be recognized on our consolidated balance sheet at their respective fair values as of the acquisition date, including recognition of intangible assets. Any excess of the purchase consideration over the fair value of the acquired net tangible and intangible assets is recognized as goodwill.
As of December 31, 2020, the Company's Consolidated Balance Sheet reflected goodwill of $24.1 million and intangible assets of $158.5 million recognized in connection with the NTA and BCG acquisitions (see Part II - Item 8, Note 6 of the Consolidated Financial Statements for more information). To the extent the acquisitions do not provide the modeled returns, the value of goodwill or intangible assets could become impaired and thus, we may be required to recognize material non-cash charges relating to such impairment, which could adversely affect our results of operations.
The personal lines insurance and retirement markets are highly competitive and our financial condition and results of operations may be adversely affected by competitive forces.
We operate in a highly competitive environment and compete with numerous insurance companies, as well as mutual fund families, independent agent companies and financial planners. In some instances and geographic locations, competitors have specifically targeted the educator marketplace with specialized products and programs. We compete in our target market with a number of national providers of personal automobile and property insurance and life insurance and retirement products.
The insurance industry consists of a large number of insurance companies, some of which have substantially greater financial resources, more diversified product lines, more sophisticated product pricing, greater economies of scale and/or lower-cost marketing approaches compared to us. In our target market, we believe that the principal competitive factors in the sale of property and casualty insurance products and supplemental insurance products are overall service, worksite sales and service, price, and name recognition. We believe that for our market, the principal competitive factors in the sale of retirement products and life insurance products are worksite sales and service, product features, perceived stability of the insurer, price, overall service and name recognition.
Particularly in the Property and Casualty business, our insurance subsidiaries have experienced pricing and profitability cycles. During these periods of intense competition, they may be unable to add policyholders and increase revenues without adversely impacting profit margins. With respect to these cycles, the factors having the greatest impact include significant and/or rapid changes in loss costs, including changes in loss frequency and/or severity, prior approval and restrictions in certain states for price increases, intense price competition, less restrictive underwriting standards, aggressive marketing, and increased advertising, which have resulted in higher industry-wide combined loss and expense ratios. During the current cycle, and potentially beyond, competition from direct writers and large, mass market carriers has been particularly aggressive, evidenced in part by their significant national advertising expenditures. In addition, advancements in vehicle technology and safety features, such as accident prevention technologies or the development of autonomous or partially autonomous vehicles — once widely available and utilized, as well as expanded availability of usage-based insurance, could materially alter the way that automobile insurance is marketed, priced and underwritten. The
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inability of our insurance subsidiaries to effectively anticipate the impact of these issues on our business and compete successfully in the property and casualty business could adversely affect their financial condition and results of operations and the resulting ability to distribute cash to us.
In the Retirement business, there are several factors driving increased competition. First, the current IRS Section 403(b) regulations have made the 403(b) market similar to the 401(k) market. These changes have increased and could continue to increase the number of competitors in the 403(b) market, as it has become more attractive to some of the larger companies experienced in 401(k) plans, including both insurance and mutual fund companies, that had not previously been active competitors in this business. Further, while not yet widespread, there has been continued pressure in some states to adopt state-sponsored or mandated 403(b) plans with single-provider or limited-provider options; this pressure has come from competitor lobbying efforts and state legislature pension reform initiatives. The inability of our insurance subsidiaries to compete successfully in these circumstances could adversely affect their financial condition and results of operations and the resulting ability to distribute cash to us.
If we are not able to effectively develop and expand our marketing operations, including agents and other points of distribution, our financial condition and results of operations could be adversely affected.
Our agencies are owned primarily by non-employee, independent contractor Exclusive Distributors with most agencies operating in outside offices with licensed producers. The economic viability of each agency is directly dependent on the productivity of the agency and the success at penetrating, serving and cross-selling our educator market.
Our success in marketing and selling our products is largely dependent upon the efforts of our agent sales force and the success of their agency operations. As we expand our business, we may need to expand the number of agencies marketing our products. If we are unable to appoint additional agents, fail to retain high-producing agents, are unable to maintain the productivity of those agency operations or are unable to maintain market penetration in existing territories, sales of our products could likely decline and our financial condition and results of operations could be adversely affected.
If we are not able to maintain secure access to educators, our financial condition and results of operations could be adversely affected.
Our ability to successfully increase new business in the educator market is largely dependent on our ability to effectively access educators either in their school buildings or through other approaches. While this is especially true for the sale of 403(b) tax-qualified retirement products via payroll deduction, any significant decrease in access, either through fewer payroll slots, increased security measures, impacts of state or federal level pension reform initiatives, requirements of national and state Do Not Call registries, or for other reasons, could adversely affect the sale of all lines of business and require us to change our traditional approach to worksite marketing and promotion, as well as contact with potential customers. With the current IRS regulations regarding Section 403(b) arrangements, including retirement products, our ability to maintain and increase our share of the 403(b) market, and the access it gives for other product lines, will depend on our ability to successfully compete in this market. Some school districts and benefit consultants have placed emphasis on the relative financial strength ratings of competing companies, as well as low cost product and distribution approaches, which may put us at a competitive disadvantage relative to other more highly-rated insurance companies.
Our ability to maintain and obtain product and corporate endorsements from, and/or marketing agreements with, local, state and national education-related associations is important to our marketing strategy. In addition to teacher organizations, we have established relationships with various other educator, principal, school administrator and school business official groups. These contacts and endorsements help to establish our brand name and presence in the educational community and to enhance access to educators.
Operational Risks
A large-scale pandemic, the occurrence of terrorism or military actions may have an adverse effect on our business.
A large-scale pandemic, the occurrence of terrorism or military and other actions, may result in loss of life, property damage, and disruptions to commerce and reduced economic activity. Some of the assets in our
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investment portfolio may be adversely affected by declines in the equity markets, changes in interest rates, reduced liquidity and economic activity caused by a large-scale pandemic. Additionally, a large-scale pandemic or terrorist act could have a material effect on sales, liquidity and operating results.
Further, the global pandemic caused by COVID-19 that was initially reported in December 2019 has developed into a worldwide crisis over subsequent months and is causing significant human suffering as well as widespread economic damage. The effects of the outbreak on the U.S. economy, our customers, our agents, our employees, our investments and our communities, as well as any preventative or protective actions that we, our employees and agency force, our third-party service providers and suppliers, or governments may take to mitigate the impact of COVID-19 could have an adverse effect on our ability to conduct business and on our financial condition and results of operations. Impacts to our business have been and could continue to be widespread and may result in the following:
•employees contracting COVID-19;
•reductions in our operating effectiveness as our employees work from home;
•sustained lack of access to schools and educators that could materially impact our sales and premium volumes;
•public school systems facing budget constraints due to the economic impacts of the pandemic that could result in educator layoffs;
•unprecedented volatility in financial markets that could materially affect our investment portfolio valuations and returns as well as our ability to generate targeted spreads on indexed products;
•regulatory mandates and/or legislative changes, including premium grace periods and premium credits;
•changes in frequency and/or severity of claims;
•increased credit risk;
•business disruption for insurance agents who market and sell our insurance products; and
•business disruptions to third parties at which we outsource certain business functions to or on which we rely for technology.
The full extent to which COVID-19 could affect the global economy, the financial markets and our business, our financial condition and our results of operations will depend on future developments and factors that cannot be predicted.
Data security breaches or denial of service on our websites could have an adverse effect on our business and reputation.
Unauthorized access to and unintentional dissemination of our confidential, highly-sensitive customer, employee or company data or other breaches of data security in our facilities, networks or databases, or those of our agents or third-party vendors - including information technology and software vendors, could result in loss or theft of assets or sensitive information, data corruption or operational disruption that may expose us to liability and/or regulatory action and may have an adverse impact on our customers, employees, investors, reputation and business. In addition, any compromise of the security of company data or prolonged denial of service on our websites could harm our business and reputation. Additionally, we recognize the increased external threats of data breaches in the marketplace resulting in non-public data of customers becoming increasingly available in the public domain.
Successful execution of our business growth strategy is dependent on effective implementation of new or enhanced technology systems and applications.
Our ability to effectively execute our business growth strategy and leverage potential economies of scale is dependent on our ability to provide the requisite technology components for that strategy. While we have effectively upgraded our infrastructure technologies with improvements in our data center, a new communications platform and enhancements to our disaster recovery capabilities, our ability to replace or supplement dated, monolithic legacy business systems — such as our Life, Retirement and Property and
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Casualty policy administrative systems — with more flexible, maintainable, and customer accessible solutions will be necessary to achieve our plans. The inherent difficulty in replacing and/or modernizing these older technologies, coupled with our limited experience in these endeavors, presents an increased risk of failing to deliver these technology solutions in a cost effective and timely manner. Our scale will require us to develop innovative solutions to address these challenges, including consideration of "software as a service" arrangements and other third-party based information technology capabilities. More modern approaches to software development and utilization of third-party vendors can augment our internal capacity for these implementations, but may not adequately reduce the operational risks of timely and cost effective delivery.
Loss of key vendor relationships could affect our operations.
We increasingly rely on services and products provided by a number of vendors in the U.S. and abroad. These include, for example, vendors of computer hardware and software, including on-demand software, and vendors of services such as investment management advisement, information technology services — such as those associated with the Life, Retirement and Property and Casualty policy administrative systems — and delivery services for customer policy-level communications. In the event that one or more of our vendors suffers a bankruptcy or otherwise becomes unable to continue to provide products or services, we may suffer operational difficulties and financial losses.
Our ability to attract, develop, and retain talent to maintain appropriate staffing levels, and establish a successful work culture is critical to our success.
Competition from within the insurance industry and from other industries, including the technology sector, for qualified employees with highly specialized knowledge in areas such as underwriting, data and analytics, technology and e-commerce, has often been intense and we have experienced increased competition in hiring and retaining employees.
Factors that affect our ability to attract and retain such employees include:
•Compensation and benefits
•Training and re-skilling programs
•Reputation as a successful business with a culture of fair hiring, and of training and promoting qualified employees
•Recognize and respond to changing trends and other circumstances that affect employees
The unexpected loss of key personnel could have a material adverse impact on our business because of the loss of their skills, knowledge of our products and offerings and years of industry experience and, in some cases, the difficulty of promptly finding qualified replacement personnel.
Financial Strength, Credit and Counterparty Risks
Losses due to defaults by others could reduce our profitability or negatively affect the value of our investments.
Third-party debtors may not pay or perform their obligations. These parties may include the issuers whose securities we hold, customers, reinsurers, borrowers under mortgage loans, trading counterparties, derivative counterparties, clearing agents, exchanges, clearing houses and other financial intermediaries. These parties may default on their obligations to us due to bankruptcy, lack of liquidity, downturns in the economy or real estate values, operational failure or other reasons.
During or following an economic downturn, our municipal bond portfolio could be subject to a higher risk of default or impairment due to declining municipal tax bases and revenue. States are currently barred from seeking protection in federal bankruptcy court. However, federal legislation could possibly be enacted to allow states to declare bankruptcy in connection with deficit reductions or mounting unfunded pension liabilities, which could adversely impact the value of our municipal bond portfolio.
The default of a major market participant could disrupt the securities markets or clearance and settlement systems in the U.S. or abroad. A failure of a major market participant could cause some clearance and
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settlement systems to assess members of that system, including our broker-dealer and Registered Investment Adviser regulatory entities, or could lead to a chain of defaults that could adversely affect us. A default of a major market participant could disrupt various markets, which could in turn cause market declines or volatility and negatively impact our financial condition and results of operations.
Uncollectible reinsurance, as well as reinsurance availability and pricing, can have a material adverse effect on our business volume and profitability.
Reinsurance is a contract by which one insurer, called a reinsurer, agrees to cover a portion of the losses incurred by a second insurer in the event a claim is made under a policy issued by the second insurer. Although a reinsurer is liable to our insurance subsidiaries according to the terms of the reinsurance policy, the insurance subsidiaries remain primarily liable as the direct insurers on all risks reinsured. As a result, reinsurance does not eliminate the obligation of our insurance subsidiaries to pay all claims, and each insurance subsidiary is subject to the risk that one or more of its reinsurers will be unable or unwilling to honor its obligations.
Although we limit participation in our reinsurance programs to reinsurers with high financial strength ratings and also limit the amount of coverage from each reinsurer, our insurance subsidiaries cannot guarantee that their reinsurers will pay in a timely fashion, if at all. Reinsurers may become financially unsound by the time that they are called upon to pay amounts due, which may not occur for many years.
Additionally, the availability and cost of reinsurance are subject to prevailing market conditions beyond our control. For example, significant losses from hurricanes or terrorist attacks, an increase in capital requirements, or a future lapse of the provisions of the Terrorism Risk Insurance Act could have a significant adverse effect on the reinsurance market.
If one of our insurance subsidiaries is unable to obtain adequate reinsurance at reasonable rates, that insurance subsidiary would have to increase its risk exposure and/or reduce the level of its underwriting commitments, which could have a material adverse effect upon the business volume and profitability of the subsidiary. Alternatively, the insurance subsidiary could elect to pay the higher than reasonable rates for reinsurance coverage, which could have a material adverse effect upon its profitability until policy premium rates could be raised, in some cases subject to approval by state regulators, to incorporate this additional cost.
We are subject to the credit risk of our counterparties, including reinsurers who reinsure business from our insurance companies.
Our insurance subsidiaries may cede certain risks to third-party insurance companies through reinsurance. HMLIC entered into a reinsurance agreement with RGA to effectuate the reinsurance of a block of in force fixed and variable annuities on a coinsurance and modified coinsurance basis. The variable portion of the reinsured annuities is reinsured on a modified coinsurance basis and assets supporting the variable account liabilities are still held in separate accounts. Because the reinsurance agreement covers a large volume of our in force annuity business, the transaction exposes us to a concentration of credit risk with respect to this counterparty. RGA's financial obligations for the general account liabilities of the reinsured annuity contracts are secured by its assets placed in a comfort trust for our sole use and benefit. Upon RGA's material breach of the reinsurance agreement, deterioration of its risk-based capital ratio to a certain level, or certain other events, we may recapture the reinsured business. However, in the event of RGA's insolvency, our right to use the assets in the trust account may be delayed. Also, if at the time of its insolvency the trust account is not funded at a level to fully discharge all its obligations, our claims to the extent not covered by the assets in the trust would be those of a general creditor.
Any downgrade in or adverse change in outlook for our claims-paying ratings, financial strength ratings or credit ratings could adversely affect our financial condition and results of operations.
Claims-paying ratings and financial strength ratings have become an increasingly important factor in establishing the competitive position of insurance companies. In the evolving 403(b) retirement market, school districts and benefit consultants have placed an emphasis on the relative financial strength ratings of competing companies. Each rating agency reviews its ratings periodically and from time to time may modify its rating criteria including, among other factors, its expectations regarding capital adequacy, profitability and revenue growth. A downgrade in the ratings or adverse change in the ratings outlook of any of our insurance subsidiaries by a major rating agency could result in substantial loss of business for that subsidiary if school districts, policyholders or independent agents move their business to other companies having higher claims-paying ratings and financial
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strength ratings than we have. This loss of business could have a material adverse effect on the results of operations and financial condition of that subsidiary.
A downgrade of our debt rating also could adversely affect our cost and flexibility of borrowing, which could have an adverse effect on our liquidity, financial condition and results of operations.
An inability to access Federal Home Loan Bank (FHLB) funding could adversely affect our results of operations.
Any changes in requirements to retain membership in the FHLB, or changes in regulation, could impact our eligibility for continued FHLB membership or our FHLB funding capacity. Any event that adversely affects amounts received from FHLB could have an adverse effect on our results of operations. See Part II - Item 7, Financing Activities of this report for more information about FHLB activities.
Regulatory and Legal Risks
The results of the recent U.S. Presidential and Congressional elections may create significant changes in tax rates, laws or regulations which could adversely impact our financial results.
With the change in administration, there are initiatives at the federal level to reverse the corporate tax cuts in the favorable Tax Cuts and Jobs Act of 2017 (TCJA), increasing the federal corporate income tax from the current rate of 21%. Any future legislative action could increase our costs, the impact of which could be significant. We are unable to predict the outcome or effects of any of these potential actions or any other legislative or regulatory proposals as they relate to our businesses. For example, any proposals to make changes related to U.S. tax law, such as those involving a reduction or elimination of the tax advantages of retirement and life products as noted in Part I - Item 1A – Risk Factors, Risks Related to Life and Retirement Segments of this report, may have a material adverse effect on our future business, financial condition, results of operations, and growth prospects.
The insurance industry is highly regulated.
We are subject to extensive regulation and supervision in the jurisdictions in which we do business. Each jurisdiction has a unique and complex set of laws and regulations. Furthermore, certain federal laws impose additional requirements on businesses, including insurers. Regulation generally is designed to protect the interests of policyholders, as opposed to stockholders and non-policyholder creditors. Such regulations, among other things, impose restrictions on the amount and type of investments our insurance subsidiaries may hold. Certain states also regulate the rates insurers may charge for certain property and casualty products. Legislation and voter initiatives have expanded, in some instances, the states' regulation of rates and have increased data reporting requirements. Consumer-related pressures to roll back rates, even if not enacted by legislation or upheld upon judicial appeal, may affect our ability to obtain timely rate increases or operate at desired levels of profitability. Changes in insurance regulations, including those affecting the ability of our insurance subsidiaries to distribute cash to us and those affecting the ability of our insurance subsidiaries to write profitable property and casualty insurance policies in one or more states, may adversely affect the financial condition and results of operations of the insurance subsidiaries. In addition, consumer privacy requirements may increase our cost of processing business. Our ability to comply with laws and regulations, at a reasonable cost, and to obtain necessary regulatory action in a timely manner, is and will continue to be critical to our success.
The NAIC has adopted a system of assessing minimum capital adequacy that is applicable to our insurance subsidiaries. This system, known as risk-based capital, is used to identify companies that may merit further regulatory action by analyzing the adequacy of the insurer's surplus in relation to statutory requirements. Our insurance subsidiaries could be adversely affected by regulations that change statutory surplus and risk-based capital requirements. Insurance companies write business based, in part, upon guidelines including capital ratios considered by the NAIC and various rating agencies. Some of these ratios include risk-based capital ratios for property and casualty insurance companies, supplemental insurance companies and life insurance companies, as well as a ratio of premiums to surplus for property and casualty insurance companies. Risk-based capital ratios measure an insurer's capital adequacy and consider various risks such as underwriting, investment, credit, asset concentration and interest rate. If our insurance subsidiaries cannot maintain profitability in the future or if significant investment valuation losses are incurred, they may be required to draw on their surplus, thereby reducing capital adequacy, in order to pay dividends to us to enable us to meet our financial obligations. As their
Horace Mann Educators Corporation Annual Report on Form 10-K 29
surplus is reduced by the payment of dividends, continuing losses or both, our insurance subsidiaries' ability to write business and maintain acceptable financial strength ratings could also be reduced. This could have a material adverse effect upon the business volume and profitability of the insurance subsidiaries as well as result in increased regulatory scrutiny or action by state regulatory authorities.
Because state legislatures remain concerned about the availability and affordability of property and casualty insurance and the protection of policyholders, our insurance subsidiaries expect that they will continue to face efforts by those legislatures to expand regulations to address these concerns. Resulting new legislation could adversely affect the financial condition and results of operations of our insurance subsidiaries.
In the event of insolvency, liquidation or other reorganization of any of our insurance subsidiaries, our creditors and stockholders would have no right to proceed against any such insurance subsidiary or cause the liquidation or bankruptcy of any such insurance subsidiary under federal or state bankruptcy laws. The insurance laws of the domiciliary state would govern such proceedings and the relevant insurance commissioner would act as liquidator or rehabilitator for the insurance subsidiary. Creditors and policyholders of any such insurance subsidiary would be entitled to full payment from the assets of the insurance subsidiary before us, as a stockholder, would be entitled to receive any distribution.
The financial position of our insurance subsidiaries also may be affected by court decisions that expand insurance coverage beyond the intention of the insurer at the time it originally issued an insurance policy.
Dodd-Frank created FIO within the U.S. Department of the Treasury. FIO studies the current insurance regulatory system and is charged with monitoring and providing specific reports on various aspects of the insurance industry. However, FIO does not have general supervisory or regulatory authority over the business of insurance. FIO has suggested an expanded federal role in some circumstances. Additional regulations could adversely affect the efficiency and effectiveness of business processes, financial condition and results of operations of us, insurers of similar size and/or the insurance industry as a whole.
Regulatory initiatives, including the enactment of Dodd-Frank, could adversely affect liquidity and volatility of financial markets in which we participate.
In response to the credit and financial crisis, U.S. and overseas governmental and regulatory authorities are considering or implementing enhanced or new regulatory requirements intended to prevent future crises or stabilize the institutions under their supervision. Such measures are leading to stricter regulation of financial institutions. Changes from Dodd-Frank and other U.S. and overseas governmental initiatives have created uncertainty and could continue to adversely impact liquidity and increase volatility of the financial markets in which we participate and, in turn, negatively affect our financial condition or results of operations. The executive branch has requested a review of financial regulations including Dodd-Frank, which may eliminate or mitigate this risk.
Statutory and regulatory developments could adversely impact our business by increasing costs or making our business less profitable.
The costs of running our business and its profitability could be adversely impacted by laws, rules and regulations that affect the business and financial communities, including changes to the interpretation or enforcement of laws governing standards of care applicable to broker-dealers and investment advisors. New laws, rules and regulations, or changes to the interpretation or enforcement of existing laws, rules or regulations, could also result in limitations on the products and services we offer or plan to offer to clients, modifications to our current or future business practices, compressed margins, increased capital requirements, and additional costs. For example, in June 2019, the SEC adopted new Regulation Best Interest, which imposes an overarching of conduct that requires broker-dealers and their associated persons to act in the best interest of their retail customers when making securities recommendations and imposes a number of new compliance and disclosure obligations on broker-dealers. Other state legislatures (including Nevada, New Jersey and Massachusetts) have or are considering, statutes that impose fiduciary standards and other obligations on broker-dealers and investment advisers operating in their states. The DOL also recently adopted its final rule regarding ERISA fiduciary investment advice, which focuses on, among other things, the fiduciary status of rollover recommendations made by financial professionals to retirement investors. We expect that these laws, regulations and proposals could negatively impact our business, including by increasing our legal, compliance and information technology costs, and potentially other costs, including greater risks of client lawsuits and enforcement activity by regulators. These changes may also affect the products and services we choose to offer
30 Annual Report on Form 10-K Horace Mann Educators Corporation
to clients, as well as the compensation that we and our financial professionals receive in connection with such products and services, which could adversely impact our ability to recruit and retain key personnel.
It is also unclear how and whether other regulators, such as other state securities and insurance regulators may respond to, or enforce elements of, these new laws and regulations, or develop their own similar laws and regulations. The impacts, degree and timing of the effect of these laws and regulations on our business cannot now be anticipated or planned for, and may have further adverse impacts on our products and services, and the results of our operations.
Further, the Dodd-Frank Act enacted wide-ranging changes in the supervision and regulation of the financial industry providing greater oversight of financial industry participants, enhanced public company corporate governance practices and executive compensation disclosures, and greater protections to individual consumers and investors. Certain elements of the Dodd-Frank Act remain subject to implementing regulations that are yet to be adopted by the applicable regulatory agencies. Compliance with adopted regulations could affect the products and services we choose to offer and would likely result in increased compliance costs.
Our business costs and profitability may be adversely impacted by current and future rule making and enforcement activity by the various federal, state and other regulatory organizations to which we are subject.
Litigation may harm our financial strength or reduce our profitability.
Companies in the insurance industry have been subject to substantial litigation resulting from claims, disputes and other matters. Most recently, they have faced expensive claims, including class action lawsuits, alleging, among other things, improper sales practices and improper claims settlement procedures. Negotiated settlements of certain such actions have had a material adverse effect on many insurance companies. The resolution of similar future claims against any of our insurance subsidiaries, including the potential adverse effect on our reputation and charges against the earnings of our insurance subsidiaries as a result of legal defense costs, a settlement agreement or an adverse finding or findings against our insurance subsidiaries in such a claim, could have a material adverse effect on the financial condition and results of operations of our insurance subsidiaries.
Events, including those external to our operations, could damage our reputation.
There are many events which may harm our reputation, including, but not limited to, those discussed in this Item 1A regarding regulatory investigations, legal proceedings, and cyber or other information security incidents. Any negative public perception, founded or otherwise, can be widely and rapidly shared over social media or other means, and could cause damage to our reputation. Damage to our reputation could reduce demand for our insurance products, reduce our ability to recruit and retain employees, or lead to greater regulatory scrutiny of our operations.
As an insurance company, we are paid to accept certain risks. Those who conduct our business, including executive officers and members of management, employees and independent agents, do so in part by making decisions that involve exposing us to risk. These include decisions such as maintaining effective underwriting and pricing discipline, maintaining effective claims management and customer service performance, managing our investment portfolio, delivering effective technology solutions, complying with established sales practices, executing our capital management strategy, exiting a line of business and/or pursuing strategic growth initiatives, and other decisions. Although we employ controls and procedures designed to monitor business decisions and prevent us from taking excessive risks or unintentionally failing to comply with internal policies and practices, there can be no assurance that these controls and procedures will be effective. If our employees and independent agents take excessive risks and/or fail to comply with internal policies and practices, the impact of those events may damage our market position and reputation.
Individual states may impose additional cybersecurity regulations, increasing the complexity of compliance.
Our businesses must comply with regulations to control the privacy of customer, employee and third party data. State and federal regulations regarding data privacy, including the California Consumer Privacy Act, are becoming increasingly more onerous. A misuse or mishandling of confidential or proprietary information could result in legal liability, regulatory action and reputational harm. Third parties, including third party administrators and cloud-based systems, are also subject to cyber-breaches of confidential information, along with the other risks outlined above, any one of which may result in us incurring substantial remediation costs and other
Horace Mann Educators Corporation Annual Report on Form 10-K 31
negative consequences, including a material adverse effect on our business, reputation, financial condition, results of operations and liquidity.
ITEM 1B. I Unresolved Staff Comments
None.
ITEM 2. I Properties
As of December 31, 2020, we owned our headquarters of approximately 225,000 square feet located at 1 Horace Mann Plaza in Springfield, Illinois. In addition, we lease office space in suburban Dallas, Texas (approximately 114,000 of rentable square feet), suburban Raleigh, North Carolina, and Cherry Hill, New Jersey which are utilized by one or more of all five reporting segments, depending on the location. For more information on reporting segments, see Part I - Item 1, Reporting Segments of this report. We believe our properties and facilities are suitable and adequate for current operations.
ITEM 3. I Legal Proceedings
At the time of issuance of this Annual Report on Form 10-K, we do not have pending litigation from which there is a reasonable possibility of material loss.
ITEM 4. I Mine Safety Disclosures
Not applicable.
32 Annual Report on Form 10-K Horace Mann Educators Corporation
PART II
ITEM 5. I Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Market Information and Dividends
Our common stock is traded on the NYSE under the symbol HMN. The following table provides the high and low closing prices of our common stock on the NYSE Composite Tape and the cash dividends paid per share of common stock during the periods indicated.
Market Price Dividend
Fiscal Period High Low Paid
The payment of dividends in the future is subject to the discretion of the Board and will depend upon general business conditions, legal restrictions and other factors the Board may deem to be relevant. Additional information is contained in Part I - Item 1, Cash Flow and in Part II - Item 8, Note 13 of the Consolidated Financial Statements in this report.
Horace Mann Educators Corporation Annual Report on Form 10-K 33
Shareholder Return Performance Graph
The graph below sets forth the total five-year shareholder return on our common stock. The graph assumes a $100 investment at December 31, 2015. The S&P 500 Index and the S&P 500 Insurance Index assume an annual reinvestment of dividends in calculating total return. We assume reinvestment of quarterly dividends when paid.
Comparison of Cumulative Five Year Total Return to Shareholders
Holders and Shares Issued
As of February 16, 2021, the number of holders of our common stock was approximately 33,000.
During 2020, stock options were exercised for the issuance of 77,291 shares or 0.2% of our common stock issued and outstanding at December 31, 2019. We received $2.4 million in proceeds from the exercise of stock options, which was used for general corporate purposes.
For information required by Item 201(d) of Regulation S-K regarding the equity compensation plan, see Part III - Item 12, of this report.
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Issuer Purchases of Equity Securities
On September 30, 2015, the Board authorized a share repurchase program allowing repurchases of up to $50.0 million of our common stock, par value $0.001 (Program). The Program authorizes the repurchase of common stock in open market or privately negotiated transactions, from time to time, depending on market conditions. The Program does not have an expiration date and may be limited or terminated at any time without notice.
For the quarterly periods ended 2020 and 2019, we repurchased shares of our common stock under the Program as follows:
Fourth Quarter 2020 — — — $20.6 million
Third Quarter 2020 — — — $20.6 million
Second Quarter 2020 — — — $20.6 million
Fourth Quarter 2019 — — — $22.8 million
Third Quarter 2019 — — — $22.8 million
Second Quarter 2019 — — — $22.8 million
First Quarter 2019 — — — $22.8 million
Horace Mann Educators Corporation Annual Report on Form 10-K 35
ITEM 6. I Selected Financial Data
The following consolidated statement of operations and balance sheet data have been derived from our consolidated financial statements, which have been prepared in accordance with GAAP. The selected financial data should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations in Part II - Item 7 of this report and the Consolidated Financial Statements of the Company and its subsidiaries presented in Part II - Item 8 of this report.
($ in millions, except per share data) Year Ended December 31,
Consolidated Statement of Operations Data:
Per Share Data:
Net income per share
Shares of Common Stock (in millions)
Balance Sheet Data, at Year End:
Segment Information: (3)
Insurance premiums written and contract deposits (4)
Net income (loss)
(1)The acquisition of NTA (Supplemental segment) closed on July 1, 2019.
(2)Net income in 2019 reflects an after tax realized investment gain of $106.9 million associated with an annuity reinsurance transaction. 2018 reflects after tax impacts of $90.1 million from catastrophes. 2017 reflects a one-time income tax benefit of $99.0 million from TCJA.
(3) Information regarding assets by segment at December 31, 2020, 2019 and 2018 is contained in Part II - Item 8, Note 18 of the Consolidated Financial Statements in this report.
(4) This measure is not based on accounting principles generally accepted in the U.S. (non-GAAP). An explanation of this non-GAAP measure is contained in the Glossary of Selected Terms included as an exhibit in the Company's reports filed with the SEC.
(5) The Corporate and Other segment primarily includes interest expense on debt, the impact of net investment gains (losses), corporate debt retirement costs, and certain public company expenses.
36 Annual Report on Form 10-K Horace Mann Educators Corporation
ITEM 7. I Management's Discussion and Analysis of Financial Condition and Results of Operations (MD&A)
($ in millions, except per share data)
Measures within this MD&A that are not based on accounting principles generally accepted in the United States of America (non-GAAP) are marked with an asterisk (*) the first time they are presented within this Part II - Item 7. An explanation of these measures is contained in the Glossary of Selected Terms included as Exhibit 99.1 to this Annual Report on Form 10-K and are reconciled to the most directly comparable measures prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) in the Appendix to the Company's Fourth Quarter 2020 Investor Supplement.
Increases or decreases in this MD&A that are not meaningful are marked "N.M.".
Forward-looking Information
Statements made in the following discussion that are not historical in nature are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995 and are subject to known and unknown risks, uncertainties and other factors. Horace Mann Educators Corporation (referred to in this report as "we", "our", "us", the "Company", "Horace Mann" or "HMEC") is an insurance holding company. We are not under any obligation to (and expressly disclaim any such obligation to) update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. It is important to note that our actual results could differ materially from those projected in forward-looking statements due to a number of risks and uncertainties inherent in our business. See Part I - Item 1A of this Annual Report on Form 10-K for additional information regarding risks and uncertainties.
Introduction
The purpose of this MD&A is to provide an understanding of our consolidated results of operations and financial condition. This MD&A should be read in conjunction with the Consolidated Financial Statements and Notes thereto contained in Part II - Item 8 of this report.
HMEC is an insurance holding company and through its subsidiaries, we market and underwrite personal lines of property and casualty insurance products, supplemental insurance products, retirement products and life insurance products in the United States of America (U.S.). We market our products primarily to K-12 teachers, administrators and other employees of public schools and their families.
This MD&A covers our consolidated financial highlights followed by consolidated results of operations, an outlook for future performance, details about critical accounting estimates, results of operations by segment, investment results, liquidity and financial resources, future adoption of new accounting standards and effects of inflation and changes in interest rates.
COVID-19 Considerations
Beginning in March 2020, the global pandemic associated with the novel coronavirus COVID-19 and related economic conditions introduced unprecedented challenges for our country. Those challenges are ongoing. We relied on our previously developed Corporate Pandemic Plan to address preparation, prevention and response measures specific to COVID-19 while allowing flexibility to quickly react to evolving circumstances and implement varying actions accordingly.
As discussed in our Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2020, we successfully transitioned the organization, through our employees and agents, from one that relied on in-person experience to one that has become primarily virtual. While the current environment continues to present challenges, our operations are being conducted successfully and we continue to support our agents and serve our customers in an effective manner.
As of the end of December 2020, the majority of our employees continue to work remotely. The return to office plans are being guided by data from the Center for Disease Control. We presently limit office occupancy to
Horace Mann Educators Corporation Annual Report on Form 10-K 37
approximately half of pre-COVID-19 levels to enable effective social distancing for some time. We have also implemented other prevention strategies to reduce the potential transmission of COVID-19, such as requiring face masks in common office areas.
Taking into account the virtual work environment, we have implemented additional cybersecurity measures including increasing security and network monitoring to proactively identify and prevent potential security threats and vulnerabilities. We also are identifying and assessing critical third-party vendors and ensuring their ability to continue to perform as anticipated.
Horace Mann markets primarily to K-12 teachers, administrators and other employees of public schools and their families and we estimate that 80% of our customer base are educators or other individuals employed by public school systems. In our experience, educators generally remain employed during periods of economic disruption. As the country entered the 2020 - 2021 school year facing continued pandemic-related challenges, educators have largely remained employed, although they may be even busier than before, as many are being asked to devote time to both in-person teaching as well as remote learning to minimize the spread of COVID-19 in their communities.
We continue to work with our network of exclusive agents to make sure they are using virtual tools that can allow them to reach current and potential educator customers when face-to-face interactions are not possible. We are implementing a variety of new and modified forums to provide access to the financial solutions we offer educators. However, growth in new sales has slowed since the pandemic began, particularly sales generated from in-person events at schools. This may be exacerbated if public school systems face budget constraints due to the economic impacts of the pandemic and/or access to "in school" events remains restricted.
For further discussion regarding the current period and potential future impacts of COVID-19 and related economic conditions on us, see Outlook for 2021 and other content within this MD&A as well as Part I - Item 1A of this report.
In addition, over the past several years, we proactively de-risked our portfolio in anticipation of an economic downturn and believe we are well positioned for any potential market dislocation. Although we have experienced the impacts of market volatility on our fixed maturity security and limited partnership interest valuations during 2020, the investment portfolio is well diversified. It is 90.9% investment grade-rated and has an average credit quality rating of A+. Because of the annuity reinsurance transaction, the spread in our retained annuity business is achieving our targeted returns and new business is priced to do so as well. We believe our capital and reserves are adequate to address any unusual loss patterns resulting from COVID-19.
Amid rapidly changing dynamics, we are continuing to evaluate all aspects of our operations and making necessary adjustments to manage our business. Ultimately, the extent of the impact will depend on how long it takes for the economy to return to some degree of normality. To date, these steps have been effective and have maintained business continuity. Based on assumptions that we will return to a normal operating environment within 12 months, our capital and liquidity situations are expected to remain at or above target levels. We believe we are financially strong despite the potential impact of COVID-19 and continued to produce solid operating results throughout 2020.
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Consolidated Financial Highlights
Per diluted share:
For 2020, our net income decreased $51.1 million compared to 2019. The favorable automobile loss experience and full year net income contribution from Supplemental in 2020 partially offset the recognition of a $106.9 million after tax realized investment gain in the second quarter of 2019 associated with the annuity reinsurance transaction. Net income for both years was impacted by goodwill and intangible asset impairment charges in Retirement. See Part II - Item 8, Notes 1, 5 and 6 of the Consolidated Financial Statements in this report for more information regarding Supplemental, the annuity reinsurance transaction and the goodwill and intangible asset impairment charges.
For 2019, our net income increased $166.1 million compared to 2018, primarily due to the realized investment gain arising from the annuity reinsurance transaction previously noted. Lower catastrophe losses of $49.0 million after tax in Property and Casualty as well as the addition of $18.0 million of net income from the Supplemental segment also contributed to the increase in consolidated net income.
See Results of Operations by Segment for further details.
Consolidated Results of Operations
Net investment gains (losses) (2.3) 153.3 (12.5) N.M. N.M.
Intangible asset amortization expense 14.4 8.8 — 63.6 % N.M.
Other expense - goodwill and intangible asset impairments 10.0 28.0 — N.M. N.M.
Horace Mann Educators Corporation Annual Report on Form 10-K 39
Insurance Premiums and Contract Charges Earned
For 2020, insurance premiums and contract charges earned increased $32.7 million compared to 2019, primarily due to the addition of a full year of reported earned premiums from Supplemental partially offset by lower premiums earned by Property and Casualty, including recognition of $10.2 million of automobile premium credits to our policyholders related to reduced driving activity due to COVID-19. For 2019, insurance premiums and contract charges earned increased $80.7 million compared to 2018, primarily due to the addition of Supplemental and increases in average premium per risk for both automobile and property.
Net Investment Income
Excluding accreted investment income on the deposit asset on reinsurance, 2020 net investment income decreased $34.0 million compared to 2019 for two reasons. First, we had a smaller invested asset base for full-year 2020. In 2019, the invested asset base was higher in the first quarter, prior to the transfer of $2.1 billion of invested assets as part of the annuity reinsurance transaction. Second, market weakness in early 2020 resulted in lower full-year returns from limited partnership interests.
2019 net investment income excluding accreted investment income on the deposit asset on reinsurance was $82.2 million below 2018 because of the transfer of invested assets. In addition, interest rates declined significantly in 2019 and our yield on new investments also reflected a strategic decision to further improve the quality of the portfolio. This was partially offset by stronger returns on alternative investments and increased prepayment activity.
The annualized yield on the total investment portfolio for the past three years was as follows:
During 2020, management continued to identify and purchase investments, including alternative investments, with attractive risk-adjusted yields relative to market conditions without venturing into asset classes or individual securities that would be inconsistent with our overall investment guidelines.
Net Investment Gains (Losses)
For 2020, net investment gains decreased primarily due to recognition of a pretax realized investment gain of $135.3 million in the second quarter of 2019 in connection with the transfer of investments related to the aforementioned annuity reinsurance transaction. The aforementioned transaction is what drove the increase in net investment gains in 2019 compared to 2018.
The break down of net investment gains (losses) by transaction type is shown in the following table:
($ in millions) Year Ended December 31,
Change in fair value - equity securities (0.2) 7.3 (18.3)
Net investment gains (losses) $ (2.3) $ 153.3 $ (12.5)
From time to time, we may sell securities subsequent to a reporting date that were considered temporarily impaired at the reporting date. Such sales are due to issuer specific events occurring subsequent to the reporting date that result in a change in our intent to hold an invested asset.
40 Annual Report on Form 10-K Horace Mann Educators Corporation
Other Income
For 2020, other income increased $10.3 million due, in part, to a full year contribution from Supplemental. For 2019, other income increased $3.8 million compared to 2018, due, in part, to a six month contribution from Supplemental.
Benefits, Claims and Settlement Expenses
For 2020, benefits, claims and settlement expenses were lower due to favorable loss experience as a result of lower frequency of losses related to reduced driving activity due to COVID-19, partially offset by higher catastrophe losses and a full year of reported benefits and settlement expenses from the Supplemental segment. For 2019, benefits, claims and settlement expenses were lower compared to 2018, due to reduced catastrophe losses and improved automobile experience, partially offset by the inclusion of losses from the new Supplemental segment.
Interest Credited
For 2020, interest credited decreased $8.2 million compared to 2019, driven primarily by lower interest rates and a lower level of Federal Home Loan Bank (FHLB) funding agreements. Under the deposit method of accounting, the interest credited on the reinsured annuity block continues to be reported. The average deferred annuity credited rate, excluding the reinsured block was 2.4% and 2.5% for 2020 and 2019, respectively. For 2019, interest credited increased $6.6 million compared to 2018 primarily due to higher interest costs on FHLB funding agreements.
Operating Expenses
For 2020, operating expenses increased $3.2 million compared to 2019, primarily due to the inclusion of $42.7 million of operating expenses from Supplemental operations compared to $22.3 million in 2019, offset by expense reduction initiatives as well as lower levels of spending on travel and other expenses because of COVID-19. For 2019, operating expenses increased $29.2 million compared to 2018, driven by the inclusion of NTA and BCG operations as well as $5.5 million of severance charges incurred in 2019 pertaining to expense reduction initiatives.
DAC Unlocking and Amortization Expense
For 2020, DAC unlocking and amortization expense decreased $9.3 million compared to 2019, primarily due to accelerated amortization of the DAC asset associated with the reinsured annuity block that occurred in Retirement in 2019 and a lower level of amortization of Property and Casualty DAC in 2020 attributed to lower levels of production. For 2019, DAC unlocking and amortization expense was comparable to 2018. For Life, DAC unlocking resulted in immaterial changes to amortization for the three years ended 2020, 2019 and 2018.
Intangible Asset Amortization Expense
For 2020, intangible asset amortization expense increased $5.6 million compared to 2019, primarily due a full year of reported intangible asset amortization expense for NTA. For 2019, the increase in intangible asset amortization expense compared to 2018 was due to the acquisitions of NTA and BCG.
Interest Expense
For 2020, interest expense decreased slightly compared to 2019 due to lower interest rates. For 2019, interest expense increased $2.6 million compared to 2018, primarily due to utilizing our senior revolving credit facility in the third quarter of 2019 to partially fund the acquisition of NTA.
Other Expense - Goodwill and Intangible Asset Impairments
For 2020, other expense represents goodwill and intangible asset impairment charges with regards to BCG. For 2019, other expense represents an annuity goodwill impairment charge in Retirement resulting from the annuity reinsurance transaction. See Part II - Item 8, Note 6 of the Consolidated Financial Statements in this report for further information.
Income Tax Expense
The effective income tax rate on our pretax income, including net investment gains (losses) was 16.5%, 22.0% and 6.2% for the years ended December 31, 2020, 2019 and 2018, respectively. Income from investments in tax-advantaged securities reduced the effective income tax rates by 3.6, 2.3 and 21.2 percentage points for 2020, 2019 and 2018, respectively. The goodwill and intangible asset impairment charges in the Retirement
Horace Mann Educators Corporation Annual Report on Form 10-K 41
segment decreased the effective income tax rate by 0.1 percentage points at December 31, 2020 and increased the effective income tax rate by 2.3 percentage points at December 31, 2019.
On March 27, 2020, H.R. 748, the Coronavirus Aid, Relief, and Economic Security Act, “the CARES Act”, was signed into legislation. The CARES Act includes tax provisions relevant to businesses, and some of the significant changes include allowance of a five-year carryback of net operating losses for 2018-2020 and the suspension of the 80% limitation of taxable income for net operating loss carryforwards for 2018-2020. The effects of the CARES Act are reflected in our income tax expense calculations for the year ended December 31, 2020. Accounting Standards Codification Topic 740: Income Taxes requires that the impact of the CARES Act be recognized in the period in which the law was enacted. As a result, total income tax expense for the year ended December 31, 2020, includes a benefit of $2.8 million (that reduced the effective income tax rate by 2.8 percentage points) to reflect a net operating loss carryback to taxable years for which the corporate rate was 35% as compared to the current corporate rate of 21%.
We record liabilities for uncertain tax filing positions where it is more likely than not that the position will not be sustainable upon audit by taxing authorities. These liabilities are reevaluated routinely and are adjusted appropriately based on changes in facts or law. We have no unrecorded liabilities from uncertain tax filing positions.
At December 31, 2020, our federal income tax returns for years prior to 2014 are no longer subject to examination by the Internal Revenue Service. We do not anticipate any assessments for tax years that remain subject to examination to have a material effect on our financial position or results of operations. See Part II - Item 8, Note 10 of the Consolidated Financial Statements in this report for further information.
Outlook for 2021
The following discussion provides outlook information for our results of operations and capital position.
The impacts of the COVID-19 pandemic and related economic conditions on the Company's results continue to be highly uncertain and outside the Company's control. The scope, duration and magnitude of the direct and indirect effects of the pandemic continue to evolve in ways that are difficult or impossible to anticipate. For additional information on the risks posed by the pandemic, see “A large-scale pandemic, the occurrence of terrorism or military actions may have an adverse effect on our business” included in Part I - Item 1A—Risk Factors in this Annual Report on Form 10-K.
At the time of issuance of this Annual Report on Form 10-K, we estimate that 2021 full year net income will be within a range of $3.00 to $3.20 per diluted share, generating a core return on equity* of over 9%. The outlook assumes a federal statutory corporate tax rate of 21%.
Property and Casualty Segment
Net written premiums* for 2021 are anticipated to be below 2020 levels. We expect new sales* will remain under pressure while COVID-19 vaccines are being rolled out across the country, with a return to pre-pandemic sales levels likely to begin in the fourth quarter.
We expect the pandemic's impact on automobile loss costs will continue in 2021, reflecting continued lower frequency related to new driving patterns, as well as a partial offset because of the anticipated uptick in uninsured/underinsured motorist claims. Over the course of 2021, we anticipate loss ratios gradually rising toward our long-term target levels. Our outlook presumes that some changes to driving patterns will become more permanent, but those would be offset by some of the factors that increased severity in 2020. We anticipate fairly stable automobile rates in 2021. We estimate that a 10% drop in automobile frequency represents approximately $2 million in pretax earnings per month, excluding the potential for higher severity.
We expect the underlying property loss ratio* will be stable in 2021 with rates expected to rise in the low-single digits.
As a result, the Property and Casualty full-year combined ratio is expected to be 95% - 96%, assuming catastrophe losses add approximately 9.5 points. Net income for Property and Casualty is anticipated to be in the range of $54 million to $58 million.
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Supplemental Segment
In 2021, we expect Supplemental's pretax profit margin will move closer to our long-term mid 20% target range, as the favorable trends in benefits paid from changes in policyholder behavior due to COVID-19 significantly decline in 2021 while sales* gradually return to pre-pandemic levels. Net investment income should continue to benefit from the portfolio repositioning. Including these factors, net income for Supplemental is anticipated to be in the range of $33 million to $35 million.
Retirement Segment
We expect Retirement to generate net income in the range of $38 million to $40 million in 2021, reflecting higher net investment income from the alternatives portfolio as well as an increase in fees on our annuity business.
Life Segment
We expect Life to generate net income between $17 million and $19 million in 2021, reflecting modeled mortality costs and increased net investment income from the alternatives portfolio. Sales* are expected to gradually return to pre-pandemic levels.
Investments
For 2021, we expect total net investment income between $370 million and $390 million, including approximately $100 million of accreted investment income on the deposit asset on reinsurance in the Retirement segment. The return on the alternatives portfolio is expected to be in the mid to high single digits in 2021, compared with a below-target 5% in 2020 due to market volatility early in the year.
As described in Critical Accounting Estimates, certain of our significant accounting measurements require the use of estimates and assumptions. As additional information becomes available, adjustments may be required. Those adjustments are charged or credited to net income for the period in which the adjustments are made and may impact actual results compared to our estimates above. Additionally, see forward-looking information in Part I - Items 1 and 1A of this Annual Report on Form 10-K concerning other important factors that could impact actual results. We believe that a projection of net income is not appropriate on a forward-looking basis because it is not possible to provide a valid forecast of net investment gains (losses), which can vary substantially from one period to another and may have a significant impact on net income.
Critical Accounting Estimates
The preparation of consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions based on information available at the time the consolidated financial statements are prepared. These estimates and assumptions affect the reported amounts of our consolidated assets, liabilities, shareholders' equity and net income. Certain accounting estimates are particularly sensitive because of their significance to our consolidated financial statements and because of the possibility that subsequent events and available information may differ markedly from management's judgments at the time the consolidated financial statements were prepared. We have discussed with our Audit Committee the quality, not just the acceptability, of our accounting principles as applied in our financial reporting. The discussions generally included such matters as to the consistency of our accounting policies and their application, and the clarity and completeness of our consolidated financial statements, which include related disclosures. Information regarding our accounting policies pertaining to these topics is located in the Notes to Consolidated Financial Statements as listed in Part II - Item 8 of this report.
We have identified the following accounting estimates as critical in that they involve a higher degree of judgment and are subject to a significant degree of variability:
•Valuation of hard-to-value fixed maturity securities, including evaluation of other-than-temporary impairments
•Evaluation of goodwill and intangible assets for impairment
•Valuation of annuity and life deferred policy acquisition costs
•Valuation of liabilities for property and casualty unpaid claims and claim expenses
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•Valuation of certain investment contracts and policy reserves
Although variability is inherent in these accounting estimates, we believe the amounts provided are appropriate based upon the facts available during preparation of the consolidated financial statements.
Valuation of Hard-to-Value Fixed Maturity Securities
The fair value of a fixed maturity security is the estimated amount at which the security could be exchanged in an orderly transaction between knowledgeable, unrelated and willing parties. We utilize investment managers and our custodian bank to obtain fair value prices from independent third-party valuation service providers, broker-dealer quotes, and model prices. Each month, we obtain fair value prices from our investment managers and custodian bank, each of which use a variety of independent, nationally recognized pricing sources to determine market valuations for fixed maturity securities. Differences in prices between the sources that we consider significant are researched and we utilize the price that we consider most representative of an exit price. Typical inputs used by these pricing sources include, but are not limited to, reported trades, bids, offers, benchmark yield curves, benchmarking of like securities, rating designations, sector groupings, issuer spreads and/or estimated cash flows, prepayment and default speeds, among others. Our fixed maturity securities portfolio is primarily publicly traded, which allows for a high percentage of the portfolio to be priced through pricing services. Approximately 91.9% of the portfolio, based on fair value, was priced through pricing services or index priced using observable inputs as of December 31, 2020.
The valuation of hard-to-value fixed maturity securities (generally 100 -150 securities) is more subjective because the markets are less liquid and there is a lack of observable market-based inputs. This may increase the potential that the estimated fair value of an investment is not reflective of the price at which an actual transaction would occur. When the pricing sources cannot provide fair value determinations, the investment managers and custodian bank obtain non-binding price quotes from broker-dealers. For those securities where the investment manager cannot obtain broker-dealer quotes, they will model the security, generally using anticipated cash flows of the underlying collateral. Broker-dealers' valuation methodologies as well as investment managers’ modeling methodologies are sometimes matrix-based, using indicative evaluation measures and adjustments for specific security characteristics and market sentiment. The selection of the market inputs and assumptions used to estimate the fair value of hard-to-value fixed maturity securities requires judgment and includes: benchmark yield, liquidity premium, estimated cash flows, prepayment and default speeds, spreads, weighted average life, and credit rating. The extent of the use of each market input depends on the market sector and market conditions. Depending on the security, the priority of the use of inputs may change or some market inputs may not be relevant. For some securities, additional inputs may be necessary.
We gain assurance that our portfolio of fixed maturity securities including hard-to-value fixed maturity securities is appropriately valued through the execution of various processes and controls designed to ensure the overall reasonableness and consistent application of valuation methodologies, including inputs and assumptions, and compliance with accounting standards. Our processes and controls are designed to ensure (1) the valuation methodologies are appropriate and consistently applied, (2) the inputs and assumptions are reasonable and consistent with the objective of determining fair value, and (3) the fair values are accurately recorded. For example, on a continuing basis, we assess the reasonableness of individual fair values that have stale security prices or that exceed certain thresholds as compared to previous fair values received from valuation service providers. We perform procedures to understand and assess the methodologies, processes and controls of valuation service providers. In addition, we may validate the reasonableness of fair values by comparing information obtained from valuation service providers or broker-dealers to other third-party valuation sources for selected securities.
At December 31, 2020, Level 3 invested assets comprised 5.3% of our total investment portfolio based on fair value. Invested assets are classified as Level 3 when fair value is determined based on unobservable inputs that are supported by little or no market activity and those inputs are significant to the determination of fair value.
Evaluation of Other-than-Temporary Impairments
Our methodology of assessing other-than-temporary impairment (OTTI) for fixed maturity securities is based on security-specific facts and circumstances as of the reporting date. We have a policy and process to evaluate fixed maturity securities (at the cusip/issuer level) on a quarterly basis to assess whether there has been OTTI. These reviews, in conjunction with our investment managers' monthly credit reports and relevant factors such as (1) the financial condition and near-term prospects of the issuer, (2) the length of time and extent to which the fair value has been less than amortized cost, (3) our intent to sell a security or whether it is more likely than not
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that we will be required to sell the security before the anticipated recovery of value, (4) the market leadership position of the issuer, (5) the debt ratings of the issuer, and (6) the cash flows and liquidity of the issuer or the underlying cash flows for asset-backed securities, are all considered in the impairment assessment.
For fixed maturity securities that we do not intend to sell or for which it is more likely than not that we would not be required to sell before an anticipated recovery in value, we separate the credit loss component of the impairment from the amount related to all other factors and report the credit loss component in net investment gains (losses). The impairment related to all other factors (non-credit factors) is reported in other comprehensive income (OCI). The allowance is adjusted for any additional credit losses and subsequent recoveries. Upon recognizing a credit loss, the cost basis is not adjusted. Also, see Part II - Item 8, Note 1 of the Consolidated Financial Statements in this report.
Evaluation of Goodwill and Intangible Assets for Impairment
Goodwill represents the excess of the amounts paid to acquire a business over the fair value of its net assets at the date of acquisition. Goodwill is not amortized, but is tested for impairment at the reporting unit level at least annually or more frequently if events occur or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. Goodwill impairment is the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. A goodwill impairment charge could have a material adverse effect on our results of operations. Our reporting units, for which goodwill has been allocated, are equivalent to our operating segments. As of December 31, 2020, our allocation of goodwill by reporting unit was as follows: $9.5 million, Property and Casualty; $19.6 million, Supplemental; $4.5 million, Retirement; and $9.9 million, Life. Also see Part II - Item 8, Notes 1 and 6 of the Consolidated Financial Statements in this report.
The goodwill impairment test, as defined in GAAP, allows an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying value. If an entity determines it is more likely than not that the fair value of a reporting unit is less than its carrying value, then the entity performs a quantitative goodwill impairment test by comparing the fair value of a reporting unit to its carrying value for purposes of confirming and measuring an impairment.
The process of evaluating goodwill for impairment requires management to make multiple judgments and assumptions to determine the fair value of each reporting unit, including discounted cash flow calculations, the level of our own share price and assumptions that market participants would make in valuing each reporting unit. Fair value estimates are based primarily on an in-depth analysis of historical experience, projected future cash flows and relevant discount rates, which consider market participant inputs and the relative risk associated with the projected cash flows. Other assumptions include levels of economic capital, future business growth, earnings projections and assets under management for each reporting unit. Estimates of fair value are subject to assumptions that are sensitive to change and represent our reasonable expectation regarding future developments. We also consider other valuation techniques such as peer company price-to-earnings and price-to-book multiples.
The assessment of goodwill recoverability requires significant judgment and is subject to inherent uncertainty. The use of different assumptions, within a reasonable range, could cause the fair value of a reporting unit to be below carrying value. Subsequent goodwill assessments could result in impairment, particularly for each reporting unit with at-risk goodwill, due to the impact of a volatile financial markets on earnings, discount rate assumptions, liquidity and market capitalization. For 2020, lower than anticipated BCG wealth management sales outside of the education markets triggered a requirement to evaluate the goodwill associated with the BCG business of the Retirement reporting unit resulting in a write-down of a certain amount of goodwill in the fourth quarter of 2020. For 2019, the annuity reinsurance transaction triggered an assessment resulting in a write-down of a certain amount of goodwill for impairment during the second quarter of 2019 (see Part II - Item 8, Note 6 of the Consolidated Financial Statements in this report for more information). There were no other events or material changes in circumstances during 2020 that indicated that an adverse material change in the fair value of our reporting units had occurred.
The value of business acquired (VOBA) represents the difference between the fair value of insurance contracts and insurance policy reserves measured in accordance with our accounting policies for insurance contracts acquired. VOBA was based on an actuarial estimate of the present value of future distributable earnings for insurance in force on the acquisition date. VOBA was $83.6 million as of December 31, 2020 and is being amortized by product based on the present value of future premiums to be received. We estimate that we will
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recognize VOBA amortization of $6.6 million in 2021, $6.2 million in 2022, $5.8 million in 2023, $5.4 million in 2024 and $5.1 million in 2025.
We account for the value of distribution acquired (VODA) associated with the acquisition of NTA based on an actuarial estimate of the present value of future business to be written by the existing distribution channel. VODA was $44.7 million as of December 31, 2020 and is being amortized on a straight-line basis. We estimate that we will recognize VODA amortization of $2.9 million in each of the years 2021 through 2025, respectively.
We account for VODA associated with the acquisition of BCG based on our estimate of the present value of future business to be written by the existing distribution channel. VODA was $0.7 million as of December 31, 2020 and is being amortized based on the present value of future profits to be received. We estimate that we will recognize cumulative VODA amortization of $0.3 million for the years 2021 through 2025.
We account for the value of agency relationships based on the present value of commission overrides retained by NTA. Agency relationships was $12.9 million as of December 31, 2020 and is being amortized based on the present value of future premiums to be received. We estimate that we will recognize agency relationships amortization of $2.2 million in 2021, $1.9 million in 2022, $1.6 million in 2023, $1.4 million in 2024 and $1.2 million in 2025.
We account for the value of customer relationships based on the present value of expected profits from existing BCG customers in force at the date of acquisition. Customer relationships was $5.9 million as of December 31, 2020 and is being amortized based on the present value of future profits to be received. We estimate that we will recognize customer relationships amortization of $1.2 million in 2021, $1.1 million in 2022, $0.9 million in 2023, $0.7 million in 2024 and $0.6 million in 2025.
Trade names represent the present value of future savings accruing to NTA and BCG by virtue of not having to pay royalties for the use of the trade names, valued using the relief from royalty method. State licenses represents the regulatory licenses held by NTA that were valued using the cost approach. Both trade names and state licenses are indefinite-lived intangibles that are not subject to amortization.
VOBA is reviewed for recoverability from future income, including net investment income, and costs which are deemed unrecoverable are expensed in the period in which the determination is made. No such costs were deemed unrecoverable during the year ended December 31, 2020.
Amortizing intangible assets (i.e., VODA, agency relationships and customer relationships) are tested for recoverability whenever events or changes in circumstances indicate that its carrying value may not be recoverable. The carrying amount of an amortizing intangible asset is not recoverable if it exceeds the sum of undiscounted cash flows expected to result from the use and eventual disposition of the asset. If the carrying amount is not recoverable from undiscounted cash flows, the impairment is measured as the difference between the carrying amount and fair value. The results from our annual impairment assessment for VODA at October 1, 2020 resulted in the write-down of a certain amount for impairment related to the 2019 acquisition of BCG. See Part II - Item 8, Note 6 of the Consolidated Financial Statements in this report for more information.
Intangible assets that are not subject to amortization (i.e., trade names and state licenses) are tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test consists of a comparison of the fair value of an intangible asset with its carrying amount. If the carrying amount of an intangible asset that is not subject to amortization exceeds its fair value, an impairment loss is to be recognized in an amount equal to that excess. The test results from our annual impairment assessment for trade names at October 1, 2020 resulted in the write-down of a certain amount for impairment. See Part II - Item 8, Note 6 of the Consolidated Financial Statements in this report for more information.
Valuation of Annuity and Life Deferred Policy Acquisition Costs
DAC, consisting of commissions, policy issuance and other costs which are incremental and directly related to the successful acquisition of new or renewal business, are deferred and amortized on a basis consistent with the type of insurance coverage. For all annuity contracts, DAC is amortized over 20 years in proportion to estimated gross profits. DAC is amortized in proportion to estimated gross profits over 20 years for certain life insurance products with account values and over 30 years for IUL. For further information, see Part II - Item 8, Note 1 of the Consolidated Financial Statements in this report.
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The most significant assumptions that are involved in the estimation of annuity gross profits include interest rate spreads, future financial market performance, business surrender/lapse rates, expenses and the impact of net investment gains (losses). For the variable deposit portion of Retirement, we amortize DAC utilizing a future financial market performance assumption of an 8.0% reversion to the mean approach with a 200 basis point corridor around the mean during the reversion period, representing a cap and a floor on our long-term assumption. Our practice with regard to future financial market performance assumes that long-term appreciation in the financial markets is not changed by short-term market fluctuations, but is only changed when sustained annual deviations are experienced. We monitor these fluctuations and only change the assumption when the long-term expectation changes. The potential effect of an increase by 100 basis points in the assumed future rate of return is reasonably likely to result in an estimated decrease in DAC amortization expense of approximately $3.5 million. The potential effect of an decrease by 100 basis points in the assumed future rate of return is reasonably likely to result in an estimated increase in DAC amortization expense of approximately $2.0 million. Although this evaluation reflects likely outcomes, it is possible an actual outcome may fall below or above these estimates. At December 31, 2020, the ratio of DAC to the total annuity accumulated cash value was 1.7%.
In the event actual experience differs significantly from assumptions or assumptions are significantly revised, we may be required to record a material charge or credit to current period amortization expense for the period in which the adjustment is made. As noted above, there are key assumptions involved in the evaluation of DAC. In terms of the sensitivity of this amortization to three of the more significant assumptions, based on DAC as of December 31, 2020 and assuming all other assumptions are met, (1) a 10 basis point deviation in the annual targeted interest rate spread assumption would impact amortization between $0.3 million and $0.4 million, (2) a 1.0% deviation from the targeted financial market performance for the underlying mutual funds of our variable annuities would impact amortization between $0.3 million and $0.4 million and (3) a $1.0 million net investment gain (loss) would impact amortization by approximately $0.2 million. These results may change depending on the magnitude and direction of any actual deviations but represent a range of reasonably likely experience for the noted assumptions. Detailed discussion of the impact of adjustments to DAC amortization expense is included in Results of Operations by Segment for the Three Years Ended December 31, 2020.
The most significant assumptions that are involved in the estimation of life insurance gross profits include interest rates expected to be received on investments, business persistency, and mortality. Conversions from term to permanent insurance cause an immediate write down of the associated DAC. The impact on amortization due to assumption changes has an immaterial impact on the results of operations.
Annually, we perform a gross premium valuation on life insurance policies to assess whether a loss recognition event has occurred. This involves discounting expected future benefits and expenses less expected future premiums. To the extent that this amount is greater than the liability for future benefits less the DAC asset, in aggregate for the life insurance block, a loss would be recognized by first writing off the DAC and then increasing the liability.
Valuation of Liabilities for Property and Casualty Unpaid Claims and Claim Expenses
Underwriting results of Property and Casualty are significantly influenced by estimates of our ultimate liability for insured events. There is a high degree of uncertainty inherent in the estimates of ultimate losses underlying the liabilities for unpaid claims and claim expenses. This inherent uncertainty is particularly significant for liability-related exposures due to the extended period, often many years that transpire between a loss event, receipt of related claims data from policyholders and ultimate settlement of the claim. Reserves for Property and Casualty claims include provisions for payments to be made on reported claims (case reserves), IBNR claims and associated settlement expenses (together, loss reserves).
The process by which these reserves are established requires reliance upon estimates based on known facts and on interpretations of circumstances, including our experience with similar cases and historical trends involving claim payments and related patterns, pending levels of unpaid claims and product mix, as well as other factors including court decisions, economic conditions, public attitudes and medical costs. We calculate and record a single best estimate of the reserve (which is equal to the actuarial point estimate) as of each reporting date.
Reserves are re-estimated quarterly. Changes to reserves are recorded in the period in which development factor changes result in reserve re-estimates. A detailed discussion of the process utilized to estimate loss reserves, risk factors considered and the impact of adjustments recorded during recent years is included in Part II - Item 8, Note 7 of the Consolidated Financial Statements in this report. Due to the nature of our personal lines
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business, we have no exposure to losses related to claims for toxic waste cleanup, other environmental remediation or asbestos-related illnesses other than claims under property insurance policies for environmentally related items such as mold.
Based on our products and coverages, historical experience, and modeling of various actuarial methodologies used to develop reserve estimates, we estimate that the potential variability of the Property and Casualty loss reserves within a reasonable probability of other possible outcomes may be approximately plus or minus 6.0%, which equates to plus or minus approximately $12.0 million of net income based on net reserves as of December 31, 2020. Although this evaluation reflects the most likely outcomes, it is possible the final outcome may fall below or above these estimates.
There are a number of assumptions involved in the determination of our Property and Casualty loss reserves. Among the key factors affecting recorded loss reserves for both long-tail and short-tail related coverages, claim severity and claim frequency are of particular significance. We estimate that a 2.0% change in claim severity or claim frequency for the most recent 36 month period is a reasonably likely scenario based on recent experience and would result in a change in the estimated net reserves of between $5.0 million and $9.0 million for long-tail liability related exposures (automobile liability coverages) and between $1.0 million and $3.0 million for short-tail liability related exposures (property and automobile physical damage coverages). Actual results may differ, depending on the magnitude and direction of the deviation.
Our actuaries discuss their loss and loss adjustment expense actuarial analysis with management. As part of this discussion, the indicated point estimate of the IBNR loss reserve by line of business (coverage) is reviewed. Our actuaries also discuss any indicated changes to the underlying assumptions used to calculate the indicated point estimate. Any variance between the indicated reserves from these changes in assumptions and the previously carried reserves is reviewed. After discussion of these analyses and all relevant risk factors, management determines whether the reserve balances require adjustment. Our best estimate of loss reserves may change depending on a revision in the underlying assumptions.
Our liabilities for unpaid claims and claim expenses for Property and Casualty were as follows:
CaseReserves IBNRReserves Total (1) CaseReserves IBNRReserves Total (1)
(1)These amounts are gross, before reduction for ceded reinsurance reserves.
The facts and circumstances leading to our re-estimate of reserves relate to revisions of the development factors used to predict how losses are likely to develop from the end of a reporting period until all claims have been paid. Re-estimates occur because actual loss amounts are different than those predicted by the estimated development factors used in prior reserve estimates. At December 31, 2020, the impact of a reserve re-estimation resulting in a 1.0% increase in net reserves would be a decrease of approximately $2.0 million in net income. A reserve re-estimation resulting in a 1.0% decrease in net reserves would increase net income by approximately $2.0 million.
Favorable prior years' reserve re-estimates increased net income in 2020 by approximately $10.2 million pretax, primarily the result of favorable loss trends in automobile and property for accident years 2019 and prior which includes the recognition of $4.8 million pretax of subrogation received on the 2018 Camp Fire event. The lower than expected claims emergence and resultant lower expected loss ratios caused us to lower our reserve estimate at December 31, 2020.
Valuation of Certain Investment Contracts and Policy Reserves
Liabilities for future benefits on annuity and life policies are established in amounts adequate to meet the estimated future obligations on policies in force.
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Liabilities for future benefits on deferred annuity contracts, excluding fixed indexed annuity (FIA) products, are carried at accumulated policyholder values without reduction for potential surrender or withdrawal charges. Liabilities for FIA products are bifurcated into an embedded derivative and a host contract. The embedded derivative is recognized at fair value and is reported in Other policyholder funds on the Consolidated Balance Sheets, and is determined using the option budget method. The host contract is accounted for as a debt instrument with the initial amount determined as the consideration amount less the initial embedded derivative, as described above. Any discount to the minimum account value is accreted over the life of the products using the effective yield method. Key assumptions used in the estimation of the liabilities for FIA products include the risk free interest rate, the value of options currently in force, the future expected option budget based on product pricing targets, mortality and lapses.
Liabilities for future benefits on payout annuity contracts are determined as the present value of expected future benefit payments. Key assumptions used in the calculation include the future investment yield and mortality, for those contracts with life contingencies.
Liabilities for future policy benefits on supplemental insurance policies are computed using the net level premium method and are based on assumptions as to future investment yields, morbidity, mortality, persistency, expenses and other assumptions based on our experience, including provisions for adverse deviation. Mortality, morbidity and lapse assumptions for all policies have been based on standard actuarial tables which are modified as appropriate to reflect our own experience. In the event actual experience is worse than the assumptions, additional reserves may be required. This would result in recognition of a loss in the period for which the increase in reserves occurred.
Liabilities for future policy benefits on life insurance policies, excluding indexed universal life (IUL) products, are computed using the net level premium method and are based on assumptions as to future investment yield, mortality and lapses. Mortality and lapse assumptions for all policies have been based on actuarial tables which are consistent with our own experience. In the event actual experience is worse than the assumptions, additional reserves may be required. This would result in recognition of a loss in the period for which the increase in reserves occurred. Also, see Part II - Item 8, Note 1 of the Consolidated Financial Statements in this report. Liabilities for IUL products are bifurcated into an embedded derivative and a host contract. The embedded derivative is recognized at fair value and is set equal to the fair value of the current call options purchased to hedge the liability. The host contract is measured using the retrospective deposit method which is equal to the account balance.
Results of Operations by Segment for the Three Years Ended December 31, 2020
Consolidated financial results primarily reflect the results of four operating segments as well as the corporate and other line. These segments are defined based on financial information management uses to evaluate performance and to determine the allocation of resources (see Part II - Item 8, Note 1 of this report for a description of changes to our reporting segments).
•Property and Casualty
•Supplemental
•Retirement
•Life
•Corporate and Other
The determination of segment data is described in more detail in Part II - Item 8, Note 18 of the Consolidated Financial Statements in this report. The following sections provide analysis and discussion of results of operations for each of the reporting segments as well as investment results.
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Property and Casualty
2020 net income reflected the following factors:
•Written premiums* and earned premiums reduced by lower new business and $10.2 million of COVID-19 related premium credits
•8.2 points of improvement in the Property and Casualty underlying loss ratio* driven by lower automobile loss frequency
•3.3 points of improvement in the reported loss ratio as the lower automobile loss frequency and a $5.2 million property subrogation recovery more than offset a 5.4 point increase from catastrophe losses
•0.5 point improvement in the expense ratio due to expense reduction initiatives as well as lower levels of spending on travel and other expenses because of COVID-19
•A one-time tax benefit of $2.8 million as a result of the CARES Act
2019 core earnings reflected 12.8 points of improvement in the Property and Casualty combined ratio for the year due to lower catastrophe losses, favorable prior years' reserve development and improved automobile underwriting results compared to 2018. 2018 results included losses from the Camp Fire in California, which was our largest single catastrophe event since Hurricane Katrina in 2005. The Camp Fire generated gross losses of $150.0 million, and, net costs after reinsurance of $37.9 million pretax in 2018.
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The following table provides certain financial information for the Property and Casualty segment for the periods indicated.
Financial Data:
Written premiums*:
Change in unearned insurance premiums (14.6) (0.4) 15.8 N.M. -102.5 %
Incurred claims and claims expenses:
Prior years' reserve development (10.2) (7.5) (0.3) 36.0 % N.M.
Income (loss) before income taxes 91.9 66.7 (20.9) 37.8 % N.M.
Operating Statistics:
Total Property and Casualty
Loss and loss adjustment expense ratio 66.3 % 69.6 % 82.3 % -3.3 pts -12.7 pts
Prior years' reserve development -1.6 % -1.1 % — % -0.5 pts -1.1 pts
Automobile
Loss and loss adjustment expense ratio 61.2 % 70.6 % 76.3 % -9.4 pts -5.7 pts
Prior years' reserve development -0.5 % -1.2 % — % 0.7 pts -1.2 pts
Property
Loss and loss adjustment expense ratio 76.1 % 67.4 % 95.4 % 8.7 pts -28.0 pts
Prior years' reserve development -3.7 % -0.9 % -0.1 % -2.8 pts -0.8 pts
Risks in force (in thousands)
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Catastrophe costs incurred were as follows:
($ in millions) Year Ended December 31,
Three months ended
As a result of the emergence of PG&E Corporation and Pacific Gas and Electric Company (together, PG&E) from bankruptcy on July 1, 2020, we recognized favorable prior years' reserve development of $5.2 million pretax, net of reinsurance, as well as return of reinsurance reinstatement premiums of $3.7 million, for a total of $8.9 million, largely related to the 2018 Camp Fire in California.
On a reported basis, the 9.6 points of improvement in the automobile combined ratio in 2020 was mainly attributable to a 10.2 point reduction in the automobile underlying loss ratio*, reflecting lower automobile loss frequency as well as the ongoing benefit of profitability initiatives. We experienced a lower level of automobile loss frequency resulting from temporary changes in policyholder driving patterns due to COVID-19. The average decline in automobile loss frequency experienced in 2020 was approximately 20% lower than in 2019. The reported property combined ratio increased 7.8 points in 2020 due to a 14.4 point increase in catastrophe losses. In 2020, the underlying property loss ratio* improved 2.9 points, primarily due to the return of reinsurance reinstatement premiums of $3.7 million.
In 2020, total written premiums* decreased $47.6 million compared to 2019, primarily due to a reduction in automobile written premiums*. In 2020, average approved rate changes were 0.5% for automobile and 1.0% for property. Growth in sales* slowed in 2020 due to COVID-19.
Automobile written premiums* decreased $44.9 million compared to 2019, primarily due to lower automobile risks in force and a lower level of rate increases implemented as well as $10.2 million of COVID-19 related premium credits. In 2020, the number of automobile risks in force declined and the average written premium per risk and average earned premium per risk declined 2.5% and 1.0%, respectively, compared to 2019. In 2019, automobile premiums written decreased $8.2 million compared to 2018. In 2019, the average written premium per risk and average earned premium per risk increased 4.1% and 5.3%, respectively, compared to 2018. Based on risks in force, the automobile 12 month retention rate for new and renewal risks was 81.2%, 81.1% and 81.9% at December 31, 2020, 2019 and 2018, respectively, with the decrease due to recent rate and underwriting actions. The number of educator risks has been stable relative to overall automobile risks over the past three years as educators represented 85.2%, 85.5% and 85.5% of the automobile risks in force as of December 31, 2020, 2019 and 2018, respectively.
Property and other written premiums* decreased slightly compared to 2019. While the number of property risks in force has declined, the average written premium per risk and average earned premium per risk increased 2.3% and 4.3%, respectively, compared to 2019. In 2019, the average written premium per risk and average earned premium per risk increased 6.2% and 5.4%, respectively, compared to 2018. Based on risks in force, the 12 month retention rate for new and renewal risks was 86.8%, 87.1% and 88.0% at December 31, 2020, 2019 and 2018, respectively. The number of educator risks has been stable relative to overall property risks over the past three years as educators represented 82.6%, 82.5% and 82.6% of the property risks in force as of December 31, 2020, 2019 and 2018, respectively.
The Property and Casualty expense ratio was 26.4%, 26.9% and 27.0% for 2020, 2019 and 2018, respectively.
We continue to evaluate and implement actions to further mitigate our risk exposure. Such actions could include, but are not limited to, non-renewal of property risks, restricted agent geographic placement, limitations on agent new business sales, further tightening of underwriting standards and increased utilization of third-party vendor products.
52 Annual Report on Form 10-K Horace Mann Educators Corporation
Supplemental
The Supplemental segment was formed when we acquired NTA in July 2019.
2020 net income reflected the following factors:
•12 month contribution to net income compared to a six month contribution in 2019
•Favorable trends in benefits from temporary changes in policyholder behavior due to COVID-19
•Improved investment yield resulting from portfolio repositioning
The following table provides certain information for the Supplemental segment for the periods indicated.
Financial Data:
Insurance premiums and contract deposits* $ 130.3 $ 65.7 N/A N/A N/A
Insurance premiums and contract charges earned 130.7 65.8 N/A N/A N/A
Net investment income 17.8 7.5 N/A N/A N/A
Benefits and settlement expenses 38.2 21.7 N/A N/A N/A
Intangible asset amortization expense 12.6 6.6 N/A N/A N/A
Income before income taxes 55.1 23.0 N/A N/A N/A
Net income 43.1 18.0 N/A N/A N/A
Core earnings* 43.1 18.0 N/A N/A N/A
Operating Statistics:
Supplemental insurance in force (thousands) 287 297 N/A N/A N/A
Benefits ratio (2) 32.8 % 37.5 % N/A N/A N/A
Operating expense ratio (3) 26.7 % 27.3 % N/A N/A N/A
Pretax profit margin (3) 36.4 % 30.8 % N/A N/A N/A
Persistency 90.5 % 89.3 % N/A N/A N/A
(1) The acquisition of NTA closed on July 1, 2019. Twelve month comparisons are not applicable.
(2) Benefits ratio measured to earned premium.
(3) Operating expense ratio and pretax profit margin measured to total revenues.
In 2020, Supplemental sales* were $7.2 million compared to $8.2 million in 2019, reflecting significantly lower sales volume, primarily due to limited school access because of COVID-19. Persistency was slightly up at 90.5%.
In 2020, Supplemental contributed $43.1 million to net income, reflecting favorable trends in reserves and some short-term benefit from changes in policyholder behavior due to COVID-19. The non-cash impact from
Horace Mann Educators Corporation Annual Report on Form 10-K 53
amortization of intangible assets recognized in connection with the purchase accounting of NTA reduced pretax net income by $12.6 million and $6.6 million in 2020 and 2019, respectively. The pretax profit margin remains above our longer-term expectations because of pandemic-related changes in policyholder behavior.
Retirement
2020 net income reflected the following factors:
•Lower levels of net investment income in 2020, reflecting lower invested asset levels resulting from the prior year annuity reinsurance transaction and subsequent use of capital to purchase NTA, as well as lower returns on limited partnership interests
•$1.8 million pretax of favorable DAC unlocking in 2020 compared to $3.5 million of unfavorable DAC unlocking in 2019 due to accelerated amortization of the DAC asset associated with the reinsured annuity block
•Goodwill and intangible asset impairment charges of $10.0 million in 2020 associated with the BCG acquisition compared to a $28.0 million goodwill impairment charge in 2019 associated with the annuity business due to the reinsurance of the legacy annuity block
Compared to 2018, 2019 net income decreased $46.5 million due to the impacts of the annuity reinsurance transaction coupled with a $28.0 million goodwill impairment charge triggered by the transaction. 2019 core earnings* decreased $18.5 million compared to 2018, reflecting the impact of the annuity reinsurance transaction, which ceded $2.9 billion of fixed and variable reserves (see Part II - Item 8, Note 5 of the Consolidated Financial Statements for further details). 2019 results also include higher operating expenses from the inclusion of BCG.
54 Annual Report on Form 10-K Horace Mann Educators Corporation
The following table provides certain information for the Retirement segment for the periods indicated.
Financial Data:
Net interest margin - Reinsured block (3.6) (3.4) — -5.9 % N.M.
Mortality loss and other reserve charges (5.3) (5.3) (7.6) — % 30.3 %
Other expenses - goodwill and intangible asset impairments 10.0 28.0 — N.M. N.M.
Income (loss) before income taxes 22.2 (1.8) 51.7 N.M. -103.5 %
Operating Statistics:
Annuity contract deposits*
Assets under administration (AUA)
Recordkeeping assets under administration (2) 1,518.1 1,499.2 — 1.3 % N.M.
Persistency
Fixed spread - YTD annualized (basis points) 212 194 171 18 bps 23 bps
(1) Amount reported as of December 31, 2020 excludes $752.1 million of assets under management held under modified coinsurance reinsurance.
(2) 2019 includes the results of BCG acquired on January 2, 2019.
For 2020, Retirement segment net income reflected an after-tax impairment charge of $8.1 million for goodwill and intangible assets associated with BCG due to lower than anticipated BCG wealth management sales outside of the education markets. Operational benefits from the BCG acquisition remain on track. In 2019, we impaired $28.0 million of goodwill that had been associated with the annuity business due to the reinsurance of the legacy annuity block.
For 2020, annuity contract deposits* increased $20.9 million compared to 2019. Variable and fixed annuity deposits increased $8.9 million and $12.0 million, respectively, as educators continue to find value in our retirement savings products, including our competitively priced annuity products. Compared to 2018, variable and fixed annuity deposits increased $11.5 million and $11.9, respectively.
Horace Mann Educators Corporation Annual Report on Form 10-K 55
At December 31, 2020, annuity assets under management were $462.2 million above a year ago, driven primarily by positive net inflows and market appreciation. Assets under administration, which includes broker and advisory as well as recordkeeping assets added through the acquisition of BCG in 2019, were up 5.0% from December 31, 2019. The full-year 2020 annualized net interest spread on fixed annuities, excluding reinsurance, increased 18 basis points, reflecting the benefits of the 2019 annuity reinsurance transaction.
We actively manage our interest rate risk exposure, considering a variety of factors, including earned interest rates, credited interest rates and the relationship between the expected durations of assets and liabilities. We estimate that over the next 12 months approximately $562.4 million of the combined Retirement and Life investment portfolio and related investable cash flows will be reinvested at current market rates. As interest rates remain at low levels, borrowers may prepay or redeem the securities with greater frequency in order to borrow at lower market rates, which could increase investable cash flows and exacerbate the reinvestment risk.
As a general guideline, for a 100 basis point decline in the average reinvestment rate and based on our existing policies and investment portfolio, the impact from investing in that lower interest rate environment could further reduce Retirement net investment income by approximately $2.1 million in year one and $6.4 million in year two, further reducing the annualized net interest spread by approximately 7 basis points and 21 basis points in the respective periods, compared to the current period annualized net interest spread. We could also consider potential changes in rates credited to policyholders, tempered by any restrictions on the ability to adjust policyholder rates due to minimum guaranteed crediting rates.
The expectation for future annualized net interest spreads is also an important component in the amortization of DAC. In terms of the sensitivity of this amortization to the annualized net interest spread, based on DAC as of December 31, 2020 and assuming all other assumptions are met, a 10 basis point deviation in the current year targeted annualized net interest rate spread assumption would impact amortization between $0.3 million and $0.4 million. This result may change depending on the magnitude and direction of any actual deviations but represents a range of reasonably likely experience for the noted assumption.
Because of the annuity reinsurance transaction, the spread in our retained annuity business is achieving our targeted returns and new business is priced to do so as well. Information regarding the interest crediting rates and balances equal to the minimum guaranteed rate for deferred annuity account values is shown below.
($ in millions) December 31, 2020
Deferred Annuities at
Total Deferred Annuities Minimum Guaranteed Rate
Minimum guaranteed interest rates:
We will continue to be disciplined in executing strategies to mitigate the negative impact on profitability of a sustained low interest rate environment. However, the success of these strategies may be affected by the factors discussed in Part I - Item 1A and other factors of this report.
56 Annual Report on Form 10-K Horace Mann Educators Corporation
Life
For 2020, net income decreased $7.2 million compared to 2019, reflecting higher mortality costs and lower net investment income. For 2019, net income decreased $1.2 million compared to 2018, reflecting lower net investment income and higher expenses partially offset by lower mortality costs.
The ordinary life insurance in force lapse ratio was 4.2%, 4.6% and 4.6% for 2020, 2019 and 2018, respectively.
The following table provides certain information for the Life segment for the periods indicated.
Financial Data:
DAC amortization expense, excluding unlocking 7.7 8.1 7.3 -4.9 % 11.0 %
DAC unlocking (0.3) (0.3) 0.3 — % N.M.
Operating Statistics:
Number of policies in force* (in thousands) 202 201 199 0.5 % 1.0 %
Lapse ratio (ordinary life insurance in force) 4.2 % 4.6 % 4.6 % -0.4 pts — pts
Horace Mann Educators Corporation Annual Report on Form 10-K 57
Corporate and Other
The following table provides certain financial information for Corporate and Other for the periods indicated.
Net investment gains (losses) pretax (2.3) 153.3 (12.5) N.M. N.M.
Tax on net investment gains (losses) (0.6) 33.1 (2.4) N.M. N.M.
Net investment gains (losses) after tax (1.7) 120.2 (10.1) N.M. N.M.
Net income in 2020 decreased from the prior year primarily due to recognition of a $106.9 million after tax realized investment gain in 2019 with respect to the transfer of investments as consideration with the annuity reinsurance transaction. In 2019, core earnings* decreased $3.1 million compared to 2018, driven by increased interest expense as we utilized our senior revolving credit facility on July 1, 2019 to partially fund the acquisition of NTA.
Investment Results
Our investment strategy is primarily focused on generating income to support product liabilities and balances principal protection and risk. Total net investment income includes net investment income from our investment portfolio as well as accreted investment income from the deposit asset on reinsurance related to our reinsured block of approximately $2.9 billion of policy liabilities related to legacy individual annuities written in 2002 or earlier that was effective April 1, 2019.
Investment income - deposit asset on reinsurance 97.3 70.8 — 37.4 % N.M.
Pretax net investment gains (losses) (2.3) 153.3 (12.5) N.M. N.M.
For 2020, net investment income from our investment portfolio decreased $34.0 million compared to 2019 for two reasons. First, we had a smaller invested asset base for full-year 2020. In 2019, the invested asset base was higher in the first quarter, prior to the transfer of $2.1 billion of invested assets as part of the annuity reinsurance transaction. Second, market weakness in early 2020 resulted in lower full-year returns from limited partnership interests.
For 2019, net investment income from our investment portfolio was $82.2 million below 2018 because of the transfer of invested assets. In addition, interest rates declined significantly in 2019 and our yield on new investments also reflected a strategic decision to further improve the quality of our investment portfolio. This was partially offset by stronger returns on alternative investments and increased prepayment activity.
For 2020, pretax net unrealized investment gains on fixed maturity securities were up $222.0 million compared to 2019, reflecting U.S. Treasury rates that declined 101 basis points with mostly flat investment grade credit spreads. For 2019, pretax net unrealized investment gains on fixed maturity securities were up $193.3 million compared to 2018, reflecting U.S. Treasury rates that declined 76 basis points and tighter credit spreads across most asset classes.
58 Annual Report on Form 10-K Horace Mann Educators Corporation
Fixed Maturity and Equity Securities Portfolios
The table below presents our fixed maturity securities portfolio by major asset class, including the ten largest sectors of our corporate bond holdings (based on fair value) as well as our equity securities portfolio.
($ in millions) December 31, 2020
Number ofIssuers FairValue AmortizedCost orCost Pretax NetUnrealizedGain (Loss)
Fixed maturity securities
Corporate bonds
Mortgage-backed securities
Government bonds
Equity securities
Non-redeemable preferred stocks 23 $ 90.7
Closed-end fund 1 23.0
(1)At December 31, 2020, the fair value amount included $15.6 million which were non-investment grade.
(2)The All Other Corporates category contains 19 additional industry classifications. Broadcasting and media, telecommunications, consumer products, metal and mining, and industry manufacturing represented $243.2 million of fair value at December 31, 2020, with the remaining 14 classifications each representing less than $218.7 million.
(3)At December 31, 2020, 100% were investment grade, with an overall credit rating of AA+, and the positions were well diversified by property type, geography and sponsor.
(4)Holdings are geographically diversified, 51.9% are tax-exempt and 76.9% are revenue bonds tied to essential services, such as mass transit, water and sewer. The overall credit quality of the municipal bond portfolio was AA- at December 31, 2020.
(5)Based on fair value, 94.1% of the collateralized loan obligation securities were rated investment grade by Standard & Poor's Global Inc. (S&P), Moody's Investors Service, Inc. (Moody's) and/or Fitch Ratings, Inc. (Fitch) at December 31, 2020.
Horace Mann Educators Corporation Annual Report on Form 10-K 59
At December 31, 2020, our diversified fixed maturity securities portfolio consisted of 3,558 investment positions, issued by 2,257 entities, and totaled approximately $6.3 billion in fair value. This portfolio was 91.4% investment grade, based on fair value, with an average credit quality rating of A+. Our investment guidelines generally limit single corporate issuer concentrations to 0.5% of invested assets for AA or AAA rated securities, 0.35% of invested assets for A or BBB rated securities, and 0.2% of invested assets for non-investment grade securities.
Fixed Maturity Securities - COVID-19 Related Impacts
In late 2016, we determined the economy was approaching later stages of the credit cycle and began to upgrade portfolio quality. Over the past three years, recessionary expectations were extended due to the fiscal stimulus, which lengthened the credit cycle. In 2019, we determined that we had achieved our investment initiatives and the portfolio was well positioned for any dislocation in the markets.
That proactive effort to improve portfolio quality resulted in a significant reduction in BBB-rated corporate credit, high yield and below-investment-grade structured securities. During this same period, purchases focused on government agency and agency mortgage-backed securities and high quality corporate bonds and municipal securities. Today, that proactive flight to quality has our investment portfolio in all insurance subsidiaries well positioned for market disruptions with ample liquidity.
Further, we believe our investment portfolio is well positioned to withstand an extended period of elevated investment market volatility, and have relatively modest exposure to asset sectors that we expect to be most impacted by the public health response to COVID-19. While we expect other segments of the economy may be disrupted, we believe these effects could be most acute in the sectors listed below. These sectors have experienced more pronounced price dislocation due to their perceived exposure to COVID-19 related impacts. Exposure to these sectors totals 7.4% of our investment portfolio, and as of December 31, 2020, informed by extensive stress testing and portfolio review, we continue to hold the following securities:
($ in millions) December 31, 2020
Fixed maturity securities (1)
(1) Below investment grade and non-rated securities included in this population account for $40.2 million of amortized cost, $40.5 million of fair value, and $0.3 million of net unrealized investment gains. There are 97 issuers with an average rating of BB-. The majority of these securities are concentrated in the travel and leisure and retail sectors.
60 Annual Report on Form 10-K Horace Mann Educators Corporation
Rating of Fixed Maturity Securities and Equity Securities (1)
The following table presents the composition and fair value of our fixed maturity and equity securities portfolios by rating category. At December 31, 2020, 90.9% of these combined portfolios were investment grade, based on fair value, with an overall average credit quality rating of A+. We have classified the entire fixed maturity securities portfolio as available for sale, which is carried at fair value.
($ in millions) December 31, 2020
Percentof TotalFairValue FairValue AmortizedCost or Cost
Fixed maturity securities
Equity securities
AAA — —
AA — —
B — —
CCC or lower — —
(1)Ratings are as assigned primarily by S&P when available, with remaining ratings as assigned on an equivalent basis by Moody's or Fitch. Ratings for publicly traded securities are determined when the securities are acquired and are updated monthly to reflect any changes in ratings.
(2)At December 31, 2020, the AA rated fair value amount included $429.3 million of U.S. Government and federally sponsored agency securities and $669.0 million of mortgage-backed and asset-backed securities issued by U.S. Government and federally sponsored agencies.
(3)This category primarily represents private placement and municipal securities not rated by either S&P, Moody's or Fitch.
At December 31, 2020, the fixed maturity securities portfolio had $28.4 million of pretax gross unrealized investment losses on $985.2 million of fair value related to 431 positions. Of the investment positions with gross unrealized investment losses, there were 21 securities trading below 80.0% of the carrying value at December 31, 2020.
We view the unrealized investment losses of all of the securities at December 31, 2020 as temporary. Future changes in circumstances related to these and other securities could require subsequent recognition of OTTI.
Horace Mann Educators Corporation Annual Report on Form 10-K 61
Liquidity and Financial Resources
Off-Balance Sheet Arrangements
At December 31, 2020, 2019 and 2018, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or for other contractually narrow or limited purposes. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships as of December 31, 2020.
Investments
Information regarding our investment portfolio, which is comprised primarily of investment grade, fixed maturity securities, is presented in Part II - Item 7, Results of Operations by Segment for the Three Years Ended December 31, 2020, Part I - Item 1, Investments and in Part II - Item 8, Note 2 of the Consolidated Financial Statements in this report.
Cash Flow
Our short-term liquidity requirements, within a 12 month operating cycle, are for the timely payment of claims and benefits to policyholders, operating expenses, interest payments and federal income taxes. Cash flow generated from operations has been, and is expected to be, adequate to meet our operating cash needs in the next 12 months. Cash flow in excess of operational needs has been used to fund business growth, pay dividends to shareholders and repurchase shares of our common stock. Long-term liquidity requirements, beyond one year, are principally for the payment of future insurance and annuity policy claims and benefits, as well as retirement of debt. The following table summarizes our consolidated cash flows activity for the periods indicated.
Net (decrease) increase in cash (3.2) 13.6 4.3 N.M. N.M.
Operating Activities
As a holding company, we conduct our principal operations in the personal lines portion of the property and casualty, supplemental and life insurance industries through our subsidiaries. Our insurance subsidiaries generate cash flow from premium and investment income, generally well in excess of their immediate needs for policy obligations, operating expenses and other cash requirements. Cash provided by operating activities primarily reflects net cash flows generated by the insurance subsidiaries.
For 2020, net cash provided by operating activities increased $132.2 million compared to 2019, primarily due to lower claims paid on insurance policies in the current year partially offset by lower investment income collected as a result of a $2.1 billion reduction of invested assets from investments transferred under the annuity reinsurance transaction in the second quarter of 2019.
Investing Activities