CNO FINANCIAL GROUP, INC., 10-K filed on 2/24/2011
Annual Report
CONSOLIDATED BALANCE SHEET (USD $)
In Millions
Year Ended
Dec. 31,
2010
2009
Investments:
 
 
Fixed maturities, available for sale, at fair value (amortized cost: 2010 - $20,155.8; 2009 - $18,998.0)
$ 20,634 
$ 18,528 
Equity securities at fair value (cost: 2010 - $68.2; 2009 - $30.7)
68 
31 
Mortgage loans
1,761 
1,966 
Policy loans
284 
295 
Trading securities
373 
293 
Investments held by variable interest entities
421 
Securities lending collateral
180 
Other invested assets
241 
237 
Total investments
23,782 
21,530 
Cash and cash equivalents - unrestricted
572 
523 
Cash and cash equivalents held by variable interest entities
27 
Accrued investment income
328 
309 
Present value of future profits
1,009 
1,176 
Deferred acquisition costs
1,764 
1,791 
Reinsurance receivables
3,256 
3,559 
Income tax assets, net
839 
1,124 
Assets held in separate accounts
18 
17 
Other assets
305 
311 
Total assets
31,900 
30,344 
Liabilities for insurance products:
 
 
Interest-sensitive products
13,195 
13,219 
Traditional products
10,308 
10,064 
Claims payable and other policyholder funds
969 
994 
Liabilities related to separate accounts
18 
17 
Other liabilities
496 
610 
Investment borrowings
1,204 
684 
Borrowings related to variable interest entities
387 
Securities lending payable
186 
Notes payable - direct corporate obligations
999 
1,037 
Total liabilities
27,574 
26,811 
Commitments and contingencies
 
 
Shareholders' equity:
 
 
Common stock ($0.01 par value, 8,000,000,000 shares authorized, shares issued and outstanding: 2010 - 251,084,174; 2009 - 250,786,216)
Additional paid-in capital
4,424 
4,409 
Accumulated other comprehensive income (loss)
238 
(264)
Accumulated deficit
(340)
(615)
Total shareholders' equity
4,325 
3,532 
Total liabilities and shareholders' equity
$ 31,900 
$ 30,344 
PARENTHETICAL DATA TO THE CONSOLIDATED BALANCE SHEET (USD $)
In Millions, except Share data
Dec. 31, 2010
Dec. 31, 2009
Investments:
 
 
Fixed maturities, available for sale, amortized cost
$ 20,156 
$ 18,998 
Available for sale equity secuities cost
68 
31 
Shareholders' equity:
 
 
Common stock, par value
$ 0.01 
$ 0.01 
Common stock, shares authorized
8,000,000,000 
8,000,000,000 
Common stock, shares issued
251,084,174 
250,786,216 
Common stock, shares outstanding
251,084,174 
250,786,216 
CONSOLIDATED STATEMENT OF OPERATIONS (USD $)
In Millions, except Share data
Year Ended
Dec. 31,
2010
2009
2008
Revenues:
 
 
 
Insurance policy income
$ 2,670 
$ 3,094 
$ 3,254 
Net investment income (loss):
 
 
 
General account assets
1,295 
1,231 
1,255 
Policyholder and reinsurer accounts and other special- purpose portfolios
72 
62 
(76)
Realized investment gains (losses):
 
 
 
Net realized investment gains (losses), excluding impairment losses
180 
135 
(100)
Other-than-temporary impairment losses:
 
 
 
Total other-than-temporary impairment losses
(147)
(385)
(162)
Change in other-than-temporary impairment losses recognized in accumulated other comprehensive income (loss)
(3)
190 
Net impairment losses recognized
(150)
(195)
(162)
Total realized gains (losses)
30 
(61)
(262)
Fee revenue and other income
17 
16 
20 
Total revenues
4,084 
4,341 
4,190 
Benefits and expenses:
 
 
 
Insurance policy benefits
2,724 
3,067 
3,213 
Interest expense
113 
118 
107 
Amortization
444 
433 
368 
(Gain) loss on extinguishment or modification of debt
22 
(21)
Other operating costs and expenses
503 
528 
520 
Total benefits and expenses
3,790 
4,168 
4,186 
Income before income taxes and discontinued operations
294 
174 
Income tax expense:
 
 
 
Tax expense on period income
104 
60 
Valuation allowance for deferred tax assets
(95)
28 
404 
Income (loss) before discontinued operations
285 
86 
(410)
Discontinued operations, net of income taxes
(723)
Net income (loss)
285 
86 
(1,132)
Basic:
 
 
 
Weighted average shares outstanding
250,973,000 
188,365,000 
184,704,000 
Income (loss) before discontinued operations
1.13 
0.45 
(2.22)
Discontinued operations
(3.91)
Net income (loss)
1.13 
0.45 
(6.13)
Diluted:
 
 
 
Weighted average shares outstanding
301,858,000 
193,340,000 
184,704,000 
Income (loss) before discontinued operations
0.99 
0.45 
(2.22)
Discontinued operations
(3.91)
Net income (loss)
$ 0.99 
$ 0.45 
$ (6.13)
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (USD $)
In Millions
Common stock and additional paid-in capital
Accumulated other comprehensive income (loss)
Retained earnings (accumulated deficit)
Total
Balance at Dec. 31, 2007
$ 4,099 
$ (273)
$ 427 
$ 4,252 
Comprehensive income (loss), net of tax:
 
 
 
 
Net income (loss)
 
 
(1,132)
(1,132)
Change in unrealized appreciation (depreciation) of investments (net of applicable income tax benefit (expense))
 
(1,497)
 
(1,497)
Change in unrecognized net loss related to deferred compensation plan (net of applicable income tax benefit)
 
(1)
 
(1)
Total comprehensive income (loss)
 
 
 
(2,630)
Stock option and restricted stock plans
 
 
Balance at Dec. 31, 2008
4,106 
(1,771)
(705)
1,630 
Comprehensive income (loss), net of tax:
 
 
 
 
Net income (loss)
 
 
86 
86 
Change in unrealized appreciation (depreciation) of investments (net of applicable income tax benefit (expense))
 
1,577 
 
1,577 
Noncredit component of impairment losses on fixed maturities, available for sale (net of applicable income tax benefit (expense))
 
(65)
 
(65)
Total comprehensive income (loss)
 
 
 
1,597 
Issuance of common stock, net
296 
 
 
296 
Stock option and restricted stock plans
 
 
Effect of reclassifying noncredit component of previously recognized impairment losses on fixed maturities, available for sale (net of applicable income tax benefit)
 
(5)
 
Balance at Dec. 31, 2009
4,411 
(264)
(615)
3,532 
Comprehensive income (loss), net of tax:
 
 
 
 
Net income (loss)
 
 
285 
285 
Change in unrealized appreciation (depreciation) of investments (net of applicable income tax benefit (expense))
 
441 
 
441 
Noncredit component of impairment losses on fixed maturities, available for sale (net of applicable income tax benefit (expense))
 
68 
 
68 
Total comprehensive income (loss)
 
 
 
793 
Cumulative effect of accounting change
 
(6)
(10)
(16)
Beneficial conversion feature related to the issuance of convertible debentures
 
 
Stock option and restricted stock plans
11 
 
 
11 
Balance at Dec. 31, 2010
$ 4,427 
$ 238 
$ (340)
$ 4,325 
PARENTHETICAL DATA TO THE CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (USD $)
In Millions
Year Ended
Dec. 31,
2010
2009
2008
Comprehensive income (loss), net of tax:
 
 
 
Change in unrealized appreciation (depreciation) of investments, applicable income tax expense (benefit)
$ 242 
$ 880 
$ (834)
Change in unrecognized net loss related to deferred compensation plan, applicable income tax expense (benefit)
 
 
(0)
Noncredit component of impairment losses on fixed maturities, available for sale, applicable income tax expense (benefit)
38 
(36)
 
Effect of reclassifying noncredit component of previously recognized impairment losses on fixed maturities, available for sale, applicable income tax expense (benefit)
 
(3)
 
CONSOLIDATED STATEMENT OF CASH FLOWS (USD $)
In Millions
Year Ended
Dec. 31,
2010
2009
2008
Cash flows from operating activities:
 
 
 
Insurance policy income
$ 2,359 
$ 2,747 
$ 3,141 
Net investment income
1,305 
1,167 
1,340 
Fee revenue and other income
17 
16 
20 
Insurance policy benefits
(1,975)
(2,299)
(2,722)
Interest expense
(108)
(109)
(95)
Policy acquisition costs
(418)
(408)
(459)
Other operating costs
(445)
(496)
(587)
Taxes
(0)
(7)
Net cash provided by operating activities
734 
612 
640 
Cash flows from investing activities:
 
 
 
Sales of investments
8,633 
10,710 
6,833 
Maturities and redemptions of investments
894 
917 
695 
Purchases of investments
(10,739)
(12,540)
(8,194)
Net sales (purchases) of trading securities
(52)
32 
347 
Change in cash and cash equivalents held by variable interest entities
(20)
11 
Change in cash held by discontinued operations
46 
Other
(15)
(11)
(21)
Net cash used by investing activities
(1,299)
(890)
(283)
Cash flows from financing activities:
 
 
 
Issuance of notes payable, net
756 
172 
75 
Issuance of common stock
296 
Payments on notes payable
(794)
(461)
(44)
Expenses related to debt modification and extinguishment of debt
(15)
Amounts received for deposit products
1,730 
1,669 
1,863 
Withdrawals from deposit products
(1,704)
(1,670)
(1,573)
Investment borrowings and borrowings related to variable interest entities
625 
(84)
(146)
Net cash provided (used) by financing activities
613 
(92)
176 
Net increase (decrease) in cash and cash equivalents
49 
(371)
533 
Cash and cash equivalents, beginning of year
523 
895 
362 
Cash and cash equivalents, end of year
$ 572 
$ 523 
$ 895 
BUSINESS AND BASIS OF PRESENTATION
BUSINESS AND BASIS OF PRESENTATION
 

1.       BUSINESS AND BASIS OF PRESENTATION

CNO Financial Group, Inc., a Delaware corporation (“CNO”), (formerly known as Conseco, Inc. prior to its name change in May 2010) is a holding company for a group of insurance companies operating throughout the United States that develop, market and administer health insurance, annuity, individual life insurance and other insurance products.  CNO became the successor to Conseco, Inc., an Indiana corporation (our “Predecessor”), in connection with our bankruptcy reorganization which became effective on September 10, 2003 (the “Effective Date”).  The terms “CNO Financial Group, Inc.”, the “Company”, “we”, “us”, and “our” as used in these financial statements refer to CNO and its subsidiaries or, when the context requires otherwise, our Predecessor and its subsidiaries.  We focus on serving the senior and middle-income markets, which we believe are attractive, underserved, high growth markets.  We sell our products through three distribution channels: career agents, independent producers (some of whom sell one or more of our product lines exclusively) and direct marketing.

Beginning July 1, 2010, management changed the manner in which it disaggregates the Company’s operations for making operating decisions and assessing performance.  As a result, the Company manages its business through the following operating segments: Bankers Life, Colonial Penn and Washington National, which are defined on the basis of product distribution; Other CNO Business, comprised primarily of products we no longer sell actively; and corporate operations, comprised of holding company activities and certain noninsurance company businesses.  Our segments are described below.

·  
Bankers Life, which markets and distributes Medicare supplement insurance, interest-sensitive life insurance, traditional life insurance, fixed annuities and long-term care insurance products to the middle-income senior market through a dedicated field force of career agents and sales managers supported by a network of community-based branch offices.  The Bankers Life segment includes primarily the business of Bankers Life and Casualty Company (“Bankers Life”).  Bankers Life also markets and distributes Medicare Advantage plans primarily through a distribution arrangement with Humana, Inc. (“Humana”) and Medicare Part D prescription drug plans through a distribution and reinsurance arrangement with Coventry Health Care (“Coventry”).
 
·  
Washington National, which markets and distributes supplemental health (including specified disease, accident and hospital indemnity insurance products) and life insurance to middle-income consumers at home and at the worksite.  These products are marketed through Performance Matters Associates, Inc., a wholly owned subsidiary, and through independent marketing organizations and insurance agencies, including worksite marketing.  The products being marketed are underwritten by Washington National Insurance Company (“Washington National”).
 
·  
Colonial Penn, which markets primarily graded benefit and simplified issue life insurance directly to customers through television advertising, direct mail, the internet and telemarketing.  The Colonial Penn segment includes primarily the business of Colonial Penn Life Insurance Company (“Colonial Penn”).
 
·  
Other CNO Business, which consists of blocks of interest-sensitive life insurance, traditional life insurance, annuities, long-term care insurance and other supplemental health products.  These blocks of business are not being actively marketed and were primarily issued or acquired by Conseco Life Insurance Company (“Conseco Life”) and Washington National.
 
We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”).  We follow the accounting standards established by the Financial Accounting Standards Board (“FASB”) and the Securities and Exchange Commission (the “SEC”).

The accompanying financial statements include the accounts of the Company and its subsidiaries.  Our consolidated financial statements exclude the results of material transactions between us and our consolidated affiliates, or among our consolidated affiliates.

When we prepare financial statements in conformity with GAAP, we are required to make estimates and assumptions that significantly affect reported amounts of various assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting periods.  For example, we use significant estimates and assumptions to calculate values for deferred acquisition costs, the present value of future profits, certain investments (including derivatives), assets and liabilities related to income taxes, liabilities for insurance products, liabilities related to litigation, guaranty fund assessment accruals and amounts recoverable from loans to certain former directors and former employees.  If our future experience differs from these estimates and assumptions, our financial statements would be materially affected.

 
TRANSFER OF SENIOR HEALTH INSURANCE COMPANY OF PENNSYLVANIA TO AN INDEPENDENT TRUST
Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust


 
2.
TRANSFER OF SENIOR HEALTH INSURANCE COMPANY OF PENNSYLVANIA TO AN INDEPENDENT TRUST

On November 12, 2008, CNO and CDOC, Inc. (“CDOC”), a wholly owned subsidiary of CNO, completed the transfer (the “Transfer”) of the stock of Senior Health Insurance Company of Pennsylvania (“Senior Health”) to Senior Health Care Oversight Trust, an independent trust (the “Independent Trust”) for the exclusive benefit of Senior Health’s long-term care policyholders.  The Transfer was approved by the Pennsylvania Insurance Department.

In connection with the Transfer, the Company entered into a $125.0 million Senior Note due November 12, 2013 (the “Senior Health Note”), payable to Senior Health.  The note has a five-year maturity date; a 6 percent interest rate; and requires annual principal payments of $25.0 million.  As a condition of the order from the Pennsylvania Insurance Department approving the Transfer, CNO agreed that it would not pay cash dividends on its common stock while any portion of the $125.0 million note remained outstanding.

CNO recorded accounting charges totaling $1.0 billion related to the transaction, comprised of Senior Health’s equity (as calculated in accordance with generally accepted accounting principles), an additional valuation allowance for deferred tax assets, the capital contribution to Senior Health and the Independent Trust and transaction expenses.  The accounting charges are summarized as follows (dollars in millions):

      
Recognition of unrealized losses on investments transferred to the Independent Trust
 $380.5 
(a)
       
Gain on reinsurance recapture, net of tax                                                                                                    
  (19.3) 
       
Increase to deferred tax valuation allowance based on recent results which have had a significant impact on taxable income and the effects of the transaction
  298.0  
       
Write-off of remaining shareholder’s equity of Senior Health                                                                                                    
  159.2 
(a)
       
Additional capital contribution and transaction expenses                                                                                                    
  204.4 
(a)
       
Total charges                                                                                                    
 $1,022.8  
_________________
 
(a)
Amount is before the potential tax benefit.  A deferred tax valuation allowance was established for all future potential tax benefits generated by these charges since management had concluded that it is more likely than not that such tax benefits would not be utilized to offset future taxable income.

 


As a result of the Transfer, Senior Health’s long-term care business is presented as a discontinued operation for all periods presented.  The operating results from the discontinued operations are as follows (dollars in millions):

   
2008
 
     
Revenues:
   
Insurance policy income                                                                                 
 $227.9 
Net investment income                                                                                 
  156.9 
Net realized investment losses                                                                                 
  (380.1)
      
Total revenues                                                                             
  4.7 
      
Benefits and expenses:
    
Insurance policy benefits                                                                                 
  311.2 
Amortization                                                                                 
  16.7 
Gain on reinsurance recapture (a)                                                                                 
  (29.7)
Loss on Transfer and transaction expenses                                                                                 
  363.6 
Other operating costs and expenses                                                                                 
  54.0 
      
Total benefits and expenses                                                                             
  715.8 
      
Loss before income taxes                                                                             
  (711.1)
      
Income tax expense (benefit):
    
      
Tax benefit on period income                                                                                 
  (440.7)
      
Valuation allowance for deferred tax assets                                                                                 
   452.3 
      
Net loss from discontinued operations                                                                             
 $(722.7)
_______________
(a)  
In the third quarter of 2008, Senior Health recaptured a block of previously reinsured long-term care business which was included in the business transferred to the Independent Trust.

SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 
3.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The following summary explains the significant accounting policies we use to prepare our financial statements.

Investments

We classify our fixed maturity securities into one of three categories: (i) “available for sale” (which we carry at estimated fair value with any unrealized gain or loss, net of tax and related adjustments, recorded as a component of shareholders’ equity); (ii) “trading” (which we carry at estimated fair value with changes in such value recognized as trading income); or (iii) “held to maturity” (which we carry at amortized cost).  We had no fixed maturity securities classified as held to maturity during the periods presented in these financial statements.

Equity securities include investments in common stock and non-redeemable preferred stock.  We carry these investments at estimated fair value.  We record any unrealized gain or loss, net of tax and related adjustments, as a component of shareholders’ equity.  When declines in value considered to be other than temporary occur, we reduce the amortized cost to estimated fair value and recognize a loss in the statement of operations.

Mortgage loans held in our investment portfolio are carried at amortized unpaid balances, net of provisions for estimated losses.  Interest income is accrued on the principal amount of the loan based on the loan’s contractual interest rate.  Payment terms specified for mortgage loans may include a prepayment penalty for unscheduled payoff of the investment.  Prepayment penalties are recognized as investment income when received.

 


Policy loans are stated at current unpaid principal balances.

Certain of our trading securities are held in an effort to offset the portion of the income statement volatility caused by the effect of interest rate fluctuations on the value of certain embedded derivatives related to our fixed index annuity products and certain modified coinsurance agreements.  See the sections of this note entitled “Accounting for Derivatives” and “Investment Borrowings” for further discussion regarding embedded derivatives and the trading accounts.  In addition, the trading account includes investments backing the market strategies of our multibucket annuity products.  The change in fair value of these securities, which is recognized currently in income from policyholder and reinsurer accounts and other special-purpose portfolios (a component of investment income), is substantially offset by the change in insurance policy benefits for these products.  Our trading securities totaled $372.6 million and $293.3 million at December 31, 2010 and 2009, respectively.

Securities lending collateral primarily consisted of fixed maturities, equity securities and cash and cash equivalents.  We carried these investments at estimated fair value.  We recorded any unrealized gain or loss, net of tax, as a component of shareholders’ equity.  In the third quarter of 2010, the Company discontinued its securities lending program.

Other invested assets include:  (i) certain call options purchased in an effort to hedge the effects of certain policyholder benefits related to our fixed index annuity and life insurance products; and (ii) certain non-traditional investments.  We carry the call options at estimated fair value as further described in the section of this note entitled “Accounting for Derivatives”.  Non-traditional investments include investments in certain limited partnerships, which are accounted for using the equity method, and promissory notes, which are accounted for using the cost method.

We defer any fees received or costs incurred when we originate investments.  We amortize fees, costs, discounts and premiums as yield adjustments over the contractual lives of the investments without anticipation of prepayments.  We consider anticipated prepayments on mortgage-backed securities in determining estimated future yields on such securities.

When we sell a security (other than trading securities), we report the difference between the sale proceeds and amortized cost (determined based on specific identification) as a realized investment gain or loss.

We regularly evaluate our investments for possible impairment as further described in the note to the consolidated financial statements entitled “Investments”.

Cash and Cash Equivalents

Cash and cash equivalents include commercial paper, invested cash and other investments purchased with original maturities of less than three months.  We carry them at amortized cost, which approximates estimated fair value.

Deferred Acquisition Costs

The costs that vary with, and are primarily related to, producing new insurance business subsequent to September 10, 2003 are referred to as deferred acquisition costs.  For universal life or investment products, we amortize these costs in relation to the estimated gross profits using the interest rate credited to the underlying policies.  For other products, we amortize these costs in relation to future anticipated premium revenue using the projected investment earnings rate.

When we realize a gain or loss on investments backing our universal life or investment-type products, we adjust the amortization to reflect the change in estimated gross profits from the products due to the gain or loss realized and the effect on future investment yields.  We also adjust deferred acquisition costs for the change in amortization that would have been recorded if our fixed maturity securities, available for sale, had been sold at their stated aggregate fair value and the proceeds reinvested at current yields.  We limit the total adjustment related to the impact of unrealized losses to the total of costs capitalized plus interest related to insurance policies issued in a particular year.  We include the impact of this adjustment in accumulated other comprehensive income (loss) within shareholders’ equity.

The investment environment during the fourth quarter of 2008 resulted in significant net unrealized losses in our fixed maturity investment portfolio.  The total adjustment to accumulated other comprehensive income (loss)  related to the change in deferred acquisition costs for the negative amortization that would have been recorded if the fixed maturity securities had been sold at their stated aggregate fair value would have resulted in the balance of deferred acquisition costs exceeding the total of

 

costs capitalized plus interest for annuity blocks of business issued in certain years.  Accordingly, the adjustment made to deferred acquisition costs and accumulated other comprehensive income (loss) was reduced by $206 million.

We regularly evaluate the recoverability of the unamortized balance of the deferred acquisition costs.  We consider estimated future gross profits or future premiums, expected mortality or morbidity, interest earned and credited rates, persistency and expenses in determining whether the balance is recoverable.  If we determine a portion of the unamortized balance is not recoverable, it is charged to amortization expense.  In certain cases, the unamortized balance of the deferred acquisition costs may not be deficient in the aggregate, but our estimates of future earnings indicate that profits would be recognized in early periods and losses in later periods.  In this case, we increase the amortization of the deferred acquisition costs over the period of profits, by an amount necessary to offset losses that are expected to be recognized in the later years.

Present Value of Future Profits

The value assigned to the right to receive future cash flows from contracts existing at September 10, 2003 is referred to as the present value of future profits.  We also defer renewal commissions paid in excess of ultimate commission levels related to the existing policies in this account.  The balance of this account is amortized and evaluated for recovery in the same manner as described above for deferred acquisition costs.  We also adjust the present value of future profits for the change in amortization that would have been recorded if the fixed maturity securities, available for sale, had been sold at their stated aggregate fair value and the proceeds reinvested at current yields, similar to the manner described above for deferred acquisition costs.  We limit the total adjustment related to the impact of unrealized losses to the total present value of future profits plus interest.

The discount rate we used to determine the present value of future profits was 12 percent.

The Company expects to amortize the balance of the present value of future profits as of December 31, 2010 as follows:  13 percent in 2011, 11 percent in 2012, 10 percent in 2013, 8 percent in 2014 and 7 percent in 2015.

Assets Held in Separate Accounts

Separate accounts are funds on which investment income and gains or losses accrue directly to certain policyholders.  The assets of these accounts are legally segregated.  They are not subject to the claims that may arise out of any other business of CNO.  We report separate account assets at fair value; the underlying investment risks are assumed by the contractholders.  We record the related liabilities at amounts equal to the separate account assets.  We record the fees earned for administrative and contractholder services performed for the separate accounts in insurance policy income.

Recognition of Insurance Policy Income and Related Benefits and Expenses on Insurance Contracts

For universal life and investment contracts that do not involve significant mortality or morbidity risk, the amounts collected from policyholders are considered deposits and are not included in revenue.  Revenues for these contracts consist of charges for policy administration, cost of insurance charges and surrender charges assessed against policyholders’ account balances.  Such revenues are recognized when the service or coverage is provided, or when the policy is surrendered.

We establish liabilities for investment and universal life products equal to the accumulated policy account values, which include an accumulation of deposit payments plus credited interest, less withdrawals and the amounts assessed against the policyholder through the end of the period.  Sales inducements provided to the policyholders of these products are recognized as liabilities over the period that the contract must remain in force to qualify for the inducement.  The options attributed to the policyholder related to our fixed index annuity products are accounted for as embedded derivatives as described in the section of this note entitled “Accounting for Derivatives”.

Traditional life and the majority of our accident and health products (including long-term care, Medicare supplement and supplemental health products) are long duration insurance contracts.  Premiums on these products are recognized as revenues when due from the policyholders.

We also have a small block of short duration accident and health products.  Premiums on these products are recognized as revenue over the premium coverage period.

We establish liabilities for traditional life, accident and health insurance, and life contingent payment annuity products

 

using mortality tables in general use in the United States, which are modified to reflect the Company’s actual experience when appropriate.  We establish liabilities for accident and health insurance products using morbidity tables based on the Company’s actual or expected experience.  These reserves are computed at amounts that, with additions from estimated future premiums received and with interest on such reserves at estimated future rates, are expected to be sufficient to meet our obligations under the terms of the policy.  Liabilities for future policy benefits are computed on a net-level premium method based upon assumptions as to future claim costs, investment yields, mortality, morbidity, withdrawals, policy dividends and maintenance expenses determined when the policies were issued (or with respect to policies inforce at August 31, 2003, the Company’s best estimate of such assumptions on the Effective Date).  We make an additional provision to allow for potential adverse deviation for some of our assumptions.  Once established, assumptions on these products are generally not changed unless a premium deficiency exists.  In that case, a premium deficiency reserve is recognized and the future pattern of reserve changes are modified to reflect the relationship of premiums to benefits based on the current best estimate of future claim costs, investment yields, mortality, morbidity, withdrawals, policy dividends and maintenance expenses, determined without an additional provision for potential adverse deviation.

We establish claim reserves based on our estimate of the loss to be incurred on reported claims plus estimates of incurred but unreported claims based on our past experience.

Accounting for Long-term Care Premium Rate Increases

Many of our long-term care policies were subject to premium rate increases in the three years ending December 31, 2010.  In some cases, these premium rate increases were materially consistent with the assumptions we used to value the particular block of business at the fresh-start date.  With respect to the 2006 premium rate increases, some of our policyholders were provided an option to cease paying their premiums and receive a non-forfeiture option in the form of a paid-up policy with limited benefits.  In addition, our policyholders could choose to reduce their coverage amounts and premiums in the same proportion, when permitted by our contracts or as required by regulators.  The following describes how we account for these policyholder options:

·  
Premium rate increases – If premium rate increases reflect a change in our previous rate increase assumptions, the new assumptions are not reflected prospectively in our reserves.  Instead, the additional premium revenue resulting from the rate increase is recognized as earned and original assumptions continue to be used to determine changes to liabilities for insurance products unless a premium deficiency exists.

·  
Benefit reductions – A policyholder may choose reduced coverage with a proportionate reduction in premium, when permitted by our contracts.  This option does not require additional underwriting.  Benefit reductions are treated as a partial lapse of coverage, and the balance of our reserves and deferred insurance acquisition costs is reduced in proportion to the reduced coverage.

·  
Non-forfeiture benefits offered in conjunction with a rate increase – In some cases, non-forfeiture benefits are offered to policyholders who wish to lapse their policies at the time of a significant rate increase.  In these cases, exercise of this option is treated as an extinguishment of the original contract and issuance of a new contract.  The balance of our reserves and deferred insurance acquisition costs are released, and a reserve for the new contract is established.

·  
Florida Order – In 2004, the Florida Office of Insurance Regulation issued an order to Washington National, regarding home health care business in Florida.  The order required Washington National to offer a choice of three alternatives to holders of home health care policies in Florida subject to premium rate increases as follows:

·  
retention of their current policy with a rate increase of 50 percent in the first year and actuarially justified increases in subsequent years;
 
·  
receipt of a replacement policy with reduced benefits and a rate increase in the first year of 25 percent and no more than 15 percent in subsequent years; or
 
·  
receipt of a paid-up policy, allowing the holder to file future claims up to 100 percent of the amount of premiums paid since the inception of the policy.
 
Reserves for all three groups of policies under the order were prospectively adjusted using a prospective revision methodology, as these alternatives were required by the Florida Office of Insurance Regulation.  These policies had

 

no insurance acquisition costs established at the Effective Date.

Some of our policyholders may receive a non-forfeiture benefit if they cease paying their premiums pursuant to their original contract (or pursuant to changes made to their original contract as a result of a litigation settlement made prior to the Effective Date or an order issued by the Florida Office of Insurance Regulation).  In these cases, exercise of this option is treated as the exercise of a policy benefit, and the reserve for premium paying benefits is reduced, and the reserve for the non-forfeiture benefit is adjusted to reflect the election of this benefit.

Accounting for marketing and reinsurance agreements with Coventry

Prescription Drug Benefit

The Medicare Prescription Drug, Improvement and Modernization Act of 2003 provided for the introduction of a prescription drug benefit (“PDP”).  In order to offer this product to our current and potential future policyholders without investing in management and infrastructure, we entered into a national distribution agreement with Coventry to use our career and independent agents to distribute Coventry’s prescription drug plan, Advantra Rx.  We receive a fee based on the premiums collected on plans sold through our distribution channels.  In addition, CNO has a quota-share reinsurance agreement with Coventry for CNO enrollees that provides CNO with 50 percent of net premiums and related policy benefits subject to a risk corridor.  The Part D program was effective January 1, 2006.

The following describes how we account for and report our PDP business:

Our accounting for the national distribution agreement

·  
For contracts sold prior to 2009, we recognize distribution and licensing fee income from Coventry based upon negotiated percentages of collected premiums on the underlying Medicare Part D contracts.  For contracts sold in 2009 and thereafter, we recognize distribution income based on a fixed fee per PDP contract.  This fee income is recognized over the calendar year term as premiums are collected.

·  
We also pay commissions to our agents who sell the plans on behalf of Coventry.  These payments are deferred and amortized over the remaining term of the initial enrollment period (the one-year life of the initial policy).

Our accounting for the quota-share agreement

·  
We recognize premium revenue evenly over the period of the underlying Medicare Part D contracts.

·  
We recognize policyholder benefits and ceding commission expense as incurred.

·  
We recognize risk-share premium adjustments consistent with Coventry’s risk-share agreement with the Centers for Medicare and Medicaid Services.

Private-Fee-For-Service

CNO expanded its strategic alliance with Coventry by entering into a national distribution agreement under which our career agents began distributing Coventry’s Private-Fee-For-Service (“PFFS”) plan, beginning January 1, 2007.  The Advantra Freedom product is a Medicare Advantage plan designed to provide seniors with more choices and better coverage at lower cost than original Medicare and Medicare Advantage plans offered through HMOs.  Under the agreement, we received a fee based on the number of PFFS plans sold through our distribution channels.  In addition, CNO had a quota-share reinsurance agreement with Coventry for CNO enrollees that provided CNO with a specified percentage of the net premiums and related profits.  Coventry decided to cease selling PFFS plans effective January 1, 2010.  In July 2009, we announced a strategic alliance under which we would offer Humana’s Medicare Advantage plans to our policyholders and consumers through our career agency force and will receive marketing fees based on sales.  Effective January 1, 2010, we no longer assumed the underwriting risk related to PFFS business.

We received distribution fees from Coventry and we paid sales commissions to our agents for these enrollments.  In addition, we received a specified percentage of the income (loss) related to this business pursuant to a quota-share agreement with Coventry.

 


The following summarizes our accounting and reporting practices for the PFFS business.

Our accounting for the distribution agreement

·  
We received distribution income from Coventry and other parties based on a fixed fee per PFFS contract.  This income was deferred and recognized over the remaining calendar year term of the initial enrollment period.

·  
We also paid commissions to our agents who sell the plans on behalf of Coventry and other parties.  These payments were deferred and amortized over the remaining term of the initial enrollment period (the one-year life of the initial policy).

Our accounting for the quota-share agreement

·  
We recognized revenue evenly over the period of the underlying PFFS contracts.

·  
We recognized policyholder benefits and ceding commission expense as incurred.

Large Group Private-Fee-For-Service Blocks

During 2007 and 2008, CNO entered into three quota-share reinsurance agreements with Coventry related to the PFFS business written by Coventry under two large group policies.  CNO received a specified percentage of the net premiums and related profits associated with this business as long as the ceded revenue margin (as defined in the quota-share reinsurance agreements) was less than or equal to five percent.  CNO also received a specified percentage of the net premiums and related profits on the ceded margin in excess of five percent.  In order to reduce the required statutory capital associated with the assumption of this business, CNO terminated two group policy quota-share agreements as of December 31, 2008 and terminated the last agreement on June 30, 2009.  Premiums assumed through these reinsurance agreements totaled $47.5 million in 2009.  The income before income taxes related to the assumed business was $14.0 million during the year ended December 31, 2009.

Reinsurance

In the normal course of business, we seek to limit our loss exposure on any single insured or to certain groups of policies by ceding reinsurance to other insurance enterprises.  We currently retain no more than $.8 million of mortality risk on any one policy.  We diversify the risk of reinsurance loss by using a number of reinsurers that have strong claims-paying ratings.  In each case, the ceding CNO subsidiary is directly liable for claims reinsured in the event the assuming company is unable to pay.

The cost of reinsurance on life and health coverages is recognized over the life of the reinsured policies using assumptions consistent with those used to account for the underlying policy.  The cost of reinsurance ceded totaled $258.6 million, $179.4 million and $164.0 million in 2010, 2009 and 2008, respectively.  We deduct this cost from insurance policy income.  Reinsurance recoveries netted against insurance policy benefits totaled $471.6 million, $477.2 million and $536.3 million in 2010, 2009 and 2008, respectively.

From time-to-time, we assume insurance from other companies.  Any costs associated with the assumption of insurance are amortized consistent with the method used to amortize deferred acquisition costs described above.  Reinsurance premiums assumed totaled $92.6 million, $475.5 million and $641.0 million in 2010, 2009 and 2008, respectively. Reinsurance premiums included amounts assumed pursuant to marketing and quota-share agreements with Coventry of $67.2 million, $444.3 million and $609.5 million in 2010, 2009 and 2008, respectively.  Such premiums assumed included group policy quota-share agreements whereby we assumed:  (i) a specified percentage of the PFFS business written by Coventry under a large group policy effective July 1, 2007 (which was terminated on June 30, 2009); and (ii) a specified percentage of the PFFS business written by Coventry under another large group policy effective May 1, 2008 (which was terminated on December 31, 2008).  Coventry decided to cease selling PFFS plans effective January 1, 2010.  In July 2009, Bankers Life entered into an agreement with Humana under which it offers Humana’s Medicare Advantage/PFFS plans to its policyholders and consumers nationwide through its career agency force and receives marketing fees based on sales.  Effective January 1, 2010, the Company no longer assumes the underwriting risk related to PFFS business.

 

See the section of this note entitled “Accounting for Derivatives” for a discussion of the derivative embedded in the payable related to certain modified coinsurance agreements.

In 2008, Bankers Life entered into a reinsurance agreement, as amended, pursuant to which it ceded 70 percent of its new 2008 and 2009 long-term care business, excluding certain business sold in the state of Florida.  The amount reinsured decreased to 50 percent in the first quarter of 2010 and to 25 percent thereafter.  The pre-tax impact of this reinsurance agreement was not significant in 2008.

In September 2009, we completed a transaction under which Washington National and Conseco Insurance Company coinsured, with an effective date of January 1, 2009, about 104,000 non-core life insurance policies in the Other CNO Business segment with Wilton Reassurance Company (“Wilton Re”).  In the transaction, Wilton Re paid a ceding commission of $55.8 million and coinsures and administers 100 percent of these policies.  The CNO insurance companies transferred to Wilton Re $401.6 million in cash and policy loans and $457.4 million of policy and other reserves.  Most of the policies involved in the transaction were issued by companies prior to their acquisition by CNO.  We recorded a deferred gain of approximately $26 million in 2009 which is being recognized over the remaining life of the block of insurance policies coinsured with Wilton Re. We also increased our deferred tax valuation allowance by $20 million in 2009 as a result of reassessing the recovery of our deferred tax assets upon completion of the transaction.

In November 2009, we entered into a transaction under which Bankers Life coinsured, with an effective date of October 1, 2009, about 234,000 life insurance policies with Wilton Re.  In the transaction, Wilton Re paid a ceding commission of $44 million and is 50% coinsuring these policies, which continue to be administered by Bankers Life.  In the transaction, Bankers Life transferred to Wilton Re $73 million in investment securities and policy loans and $117 million of policy and other reserves.  As a result of the transaction, we recorded an increase to our deferred tax valuation allowance of $18 million in 2009, as a result of reassessing the recovery of our deferred tax assets upon completion of the transaction.  We also recorded a pre-tax deferred cost of reinsurance of $32 million in 2009, which, in accordance with GAAP, is being amortized over the life of the block.

Income Taxes

Our income tax expense includes deferred income taxes arising from temporary differences between the financial reporting and tax bases of assets and liabilities, capital loss carryforwards and net operating loss carryforwards (“NOLs”).  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply in the years in which temporary differences are expected to be recovered or paid.  The effect of a change in tax rates on deferred tax assets and liabilities is recognized in earnings in the period when the changes are enacted.

A reduction of the carrying amount of deferred tax assets by establishing a valuation allowance is required if, based on the available evidence, it is more likely than not that such assets will not be realized.  We evaluate the need to establish a valuation allowance for our deferred income tax assets on an ongoing basis.  In evaluating our deferred income tax assets, we consider whether the deferred income tax assets will be realized, based on the more-likely-than-not realization threshold criterion.  The ultimate realization of our deferred income tax assets depends upon generating sufficient future taxable income during the periods in which our temporary differences become deductible and before our capital loss carryforwards and NOLs expire.  This assessment requires significant judgment.  In assessing the need for a valuation allowance, appropriate consideration is given to all positive and negative evidence related to the realization of the deferred tax assets.  This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, excess appreciated asset value over the tax basis of net assets, the duration of carryforward periods, our experience with operating loss and tax credit carryforwards expiring unused, and tax planning alternatives.

At December 31, 2010, our valuation allowance for our net deferred tax assets was $1.1 billion, as we have determined that it is more likely than not that a portion of our deferred tax assets will not be realized.  This determination was made by evaluating each component of the deferred tax asset and assessing the effects of limitations and/or interpretations on the value of such component to be fully recognized in the future.

Investment Borrowings

Two of the Company’s insurance subsidiaries (Conseco Life and Bankers Life) are members of the Federal Home Loan Bank (“FHLB”).  As members of the FHLB, Conseco Life and Bankers Life have the ability to borrow on a collateralized basis from FHLB.  Conseco Life and Bankers Life are required to hold certain minimum amounts of FHLB

 

common stock as a requirement of membership in the FHLB, and additional amounts based on the amount of the borrowings.  At December 31, 2010, the carrying value of the FHLB common stock was $60.0 million.  As of December 31, 2010, collateralized borrowings from the FHLB totaled $1.2 billion (of which, $750.0 million was borrowed in 2010) and the proceeds were used to purchase fixed maturity securities.  The borrowings are classified as investment borrowings in the accompanying consolidated balance sheet.  The borrowings are collateralized by investments with an estimated fair value of $1.5 billion at December 31, 2010, which are maintained in a custodial account for the benefit of the FHLB.  Such investments are classified as fixed maturities, available for sale, in our consolidated balance sheet.  Interest expense of $20.8 million, $20.3 million and $21.9 million in 2010, 2009 and 2008, respectively, was recognized related to the borrowings.

The following summarizes the terms of the borrowings (dollars in millions):

Amount
 
Maturity
 
Interest rate
borrowed
 
date
 
at December 31, 2010
      
$54.0 
May 2012
 
Variable rate – 0.284%
 13.0 
July 2012
 
Variable rate – 0.349%
 100.0 
October 2013
 
Variable rate – 0.591%
 100.0 
September 2015
 
Variable rate – 0.611%
 100.0 
September 2015
 
Variable rate – 0.588%
 100.0 
October 2015
 
Variable rate – 0.616%
 150.0 
October 2015
 
Variable rate – 0.610%
 146.0 
November 2015
 
Fixed rate – 5.300%
 100.0 
November 2015
 
Fixed rate – 4.890%
 100.0 
December 2015
 
Fixed rate – 4.710%
 50.0 
November 2016
 
Variable rate – 0.573%
 50.0 
November 2016
 
Variable rate – 0.731%
 100.0 
October 2017
 
Variable rate – 0.715%
 37.0 
November 2017
 
Fixed rate – 3.750%
       
$1,200.0     

The variable rate borrowings are pre-payable on each interest reset date without penalty.  The fixed rate borrowings are pre-payable subject to payment of a yield maintenance fee based on current market interest rates.  At December 31, 2010, the aggregate fee to prepay all fixed rate borrowings was $61.2 million.

At December 31, 2010, investment borrowings consisted of:  (i) collateralized borrowings from the FHLB of $1.2 billion; and (ii) other borrowings of $4.1 million.

At December 31, 2009, investment borrowings consisted of:  (i) collateralized borrowings from the FHLB of $450.0 million; (ii) $229.1 million of securities issued to other entities by a variable interest entity (“VIE”) which is consolidated in our financial statements as further discussed in the note to the consolidated financial statements entitled “Investments in Variable Interest Entities”; and (iii) other borrowings of $4.8 million.

Accounting for Derivatives

Our fixed index annuity products provide a guaranteed minimum rate of return and a higher potential return that is based on a percentage (the “participation rate”) of the amount of increase in the value of a particular index, such as the Standard & Poor’s 500 Index, over a specified period.  Typically, on each policy anniversary date, a new index period begins.  We are generally able to change the participation rate at the beginning of each index period during a policy year, subject to contractual minimums.  We typically buy call options (including call spreads) referenced to the applicable indices in an effort to hedge potential increases to policyholder benefits resulting from increases in the particular index to which the policy’s return is linked.  We reflect changes in the estimated fair value of these options in net investment income (classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios).  Net investment gains (losses) related to fixed index products were $28.2 million, $50.7 million and $(104.3) million in 2010, 2009 and 2008, respectively. These amounts were substantially offset by a corresponding change to insurance policy benefits.  The estimated fair value of these options was $89.4 million and $114.9 million at December 31, 2010 and 2009, respectively.  We classify these instruments as other invested assets.

 


The Company accounts for the options attributed to the policyholder for the estimated life of the annuity contract as embedded derivatives.  The expected future cost of options on fixed index annuity products is used to determine the value of embedded derivatives.  The Company purchases options to hedge liabilities for the next policy year on each policy anniversary date and must estimate the fair value of the forward embedded options related to the policies.  These accounting requirements often create volatility in the earnings from these products.  We record the changes in the fair values of the embedded derivatives in current earnings as a component of policyholder benefits.  Effective January 1, 2008, we adopted authoritative guidance related to fair value measurements which required us to value the embedded derivatives reflecting a hypothetical market perspective for fair value measurement.  We recorded a charge of $1.8 million to net income (after the effects of the amortization of the present value of future profits and deferred acquisition costs (collectively referred to as “amortization of insurance acquisition costs”) and income taxes), attributable to changes in the fair value of the embedded derivatives as a result of adopting such guidance.  The fair value of these derivatives, which are classified as “liabilities for interest-sensitive products”, was $553.6 million and $494.4 million at December 31, 2010 and 2009, respectively.  We maintain a specific block of investments in our trading securities account, which we carry at estimated fair value with changes in such value recognized as investment income (classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios).  The change in value of these trading securities attributable to interest fluctuations is intended to offset a portion of the change in the value of the embedded derivative.

If the counterparties for the call options we hold fail to meet their obligations, we may have to recognize a loss.  We limit our exposure to such a loss by diversifying among several counterparties believed to be strong and creditworthy.  At December 31, 2010, all of our counterparties were rated “BBB+” or higher by Standard & Poor’s Corporation (“S&P”).

Certain of our reinsurance payable balances contain embedded derivatives.  Such derivatives had an estimated fair value of $(.4) million and $1.6 million at December 31, 2010 and 2009, respectively.  We record the change in the fair value of these derivatives as a component of investment income (classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios).  We maintain a specific block of investments related to these agreements in our trading securities account, which we carry at estimated fair value with changes in such value recognized as investment income (also classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios).  The change in value of these trading securities attributable to interest fluctuations is intended to offset the change in value of the embedded derivatives.  However, differences will occur as corporate spreads change.

Multibucket Annuity Product

The Company’s multibucket annuity is an annuity product that credits interest based on the experience of a particular market strategy.  Policyholders allocate their annuity premium payments to several different market strategies based on different asset classes within the Company’s investment portfolio.  Interest is credited to this product based on the market return of the given strategy, less management fees, and funds may be moved between different strategies.  The Company guarantees a minimum return of premium plus approximately 3 percent per annum over the life of the contract.  The investments backing the market strategies of these products are designated by the Company as trading securities.  The change in the fair value of these securities is recognized as investment income (classified as income from policyholder and reinsurer accounts and other special-purpose portfolios), which is substantially offset by the change in insurance policy benefits for these products.  As of December 31, 2010, we hold insurance liabilities of $63.7 million related to multibucket annuity products.

Stock Based Compensation

In December 2004, the FASB issued authoritative guidance which provided additional guidance on accounting for share-based payments and required all such awards to be measured at fair value with the related compensation cost recognized in the statement of operations over the related service period.  CNO implemented the guidance using the modified prospective method on January 1, 2006.  Under this method, the Company began recognizing compensation cost for all awards granted on or after January 1, 2006.  In addition, we are required to recognize compensation cost over the remaining requisite service period for the portion of outstanding awards that were not vested as of January 1, 2006 and were not previously expensed on a pro forma basis pursuant to the guidance.  The guidance also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow rather than as an operating cash flow, as previously required.  During 2010, 2009 and 2008, we did not capitalize any stock-based compensation expense as deferred acquisition costs or any other asset category.

 

Fair Value Measurements

Effective January 1, 2008, we adopted authoritative guidance which clarifies a number of considerations with respect to fair value measurement objectives for financial reporting and expands disclosures about the use of fair value measurements.  The guidance is intended to increase consistency and comparability among fair value estimates used in financial reporting and the disclosure requirements are intended to provide users of financial statements with the ability to assess the reliability of an entity’s fair value measurements.  The initial adoption of the guidance resulted in a charge of $1.8 million to net income (after the effects of the amortization of insurance acquisition costs and income taxes) in the first quarter of 2008, attributable to changes in the liability for the embedded derivatives associated with our fixed index annuity products.  The change resulted from the incorporation of risk margins into the estimated fair value calculation for this liability.

Definition of Fair Value

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date and, therefore, represents an exit price, not an entry price.  We hold fixed maturities, equity securities, trading securities, investments held by variable interest entities, derivatives, separate account assets and embedded derivatives, which are carried at fair value.

The degree of judgment utilized in measuring the fair value of financial instruments is largely dependent on the level to which pricing is based on observable inputs.  Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our view of market assumptions in the absence of observable market information.  Financial instruments with readily available active quoted prices would be considered to have fair values based on the highest level of observable inputs, and little judgment would be utilized in measuring fair value.  Financial instruments that rarely trade would often have fair value based on a lower level of observable inputs, and more judgment would be utilized in measuring fair value.

Valuation Hierarchy

There is a three-level hierarchy for valuing assets or liabilities at fair value based on whether inputs are observable or unobservable.

·  
Level 1 – includes assets and liabilities valued using inputs that are quoted prices in active markets for identical assets or liabilities.  Our Level 1 assets include exchange traded securities.

·  
Level 2 – includes assets and liabilities valued using inputs that are quoted prices for similar assets in an active market, quoted prices for identical or similar assets in a market that is not active, observable inputs, or observable inputs that can be corroborated by market data.  Level 2 assets and liabilities include those financial instruments that are valued by independent pricing services using models or other valuation methodologies.  These models are primarily industry-standard models that consider various inputs such as interest rate, credit spread, reported trades, broker/dealer quotes, issuer spreads and other inputs that are observable or derived from observable information in the marketplace or are supported by observable levels at which transactions are executed in the marketplace.  Financial instruments in this category primarily include:  certain public and private corporate fixed maturity securities; certain government or agency securities; certain mortgage and asset-backed securities; and non-exchange-traded derivatives such as call options to hedge liabilities related to our fixed index annuity products.

·  
Level 3 – includes assets and liabilities valued using unobservable inputs that are used in model-based valuations that contain management assumptions.  Level 3 assets and liabilities include those financial instruments whose fair value is estimated based on non-binding broker prices or internally developed models or methodologies utilizing significant inputs not based on, or corroborated by, readily available market information.  Financial instruments in this category include certain corporate securities (primarily private placements), certain mortgage and asset-backed securities, and other less liquid securities.  Additionally, the Company’s liabilities for embedded derivatives (including embedded derivatives related to our fixed index annuity products and to a modified coinsurance arrangement) are classified in Level 3 since their values include significant unobservable inputs including actuarial assumptions.

At each reporting date, we classify assets and liabilities into the three input levels based on the lowest level of input that is significant to the measurement of fair value for each asset and liability reported at fair value.  This classification is impacted

 

by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and overall market conditions.  Our assessment of the significance of a particular input to the fair value measurement and the ultimate classification of each asset and liability requires judgment.

The vast majority of our fixed maturity securities and separate account assets use Level 2 inputs for the determination of fair value.  These fair values are obtained primarily from independent pricing services, which use Level 2 inputs for the determination of fair value.  Substantially all of our Level 2 fixed maturity securities and separate account assets were valued from independent pricing services.  Third party pricing services normally derive the security prices through recently reported trades for identical or similar securities making adjustments through the reporting date based upon available market observable information.  If there are no recently reported trades, the third party pricing services may use matrix or model processes to develop a security price where future cash flow expectations are developed and discounted at an estimated risk-adjusted market rate.  The number of prices obtained is dependent on the Company’s analysis of such prices as further described below.

For securities that are not priced by pricing services and may not be reliably priced using pricing models, we obtain broker quotes.  These broker quotes are non-binding and represent an exit price, but assumptions used to establish the fair value may not be observable and therefore represent Level 3 inputs.  Approximately 16 percent and 1 percent of our Level 3 fixed maturity securities were valued using broker quotes or independent pricing services, respectively.  The remaining Level 3 fixed maturity investments do not have readily determinable market prices and/or observable inputs.  For these securities, we use internally developed valuations.  Key assumptions used to determine fair value for these securities may include risk-free rates, risk premiums, performance of underlying collateral and other factors involving significant assumptions which may not be reflective of an active market.  For certain investments, we use a matrix or model process to develop a security price where future cash flow expectations are developed and discounted at an estimated market rate.  The pricing matrix utilizes a spread level to determine the market price for a security.  The credit spread generally incorporates the issuer’s credit rating and other factors relating to the issuer’s industry and the security’s maturity.  In some instances, issuer-specific spread adjustments, which can be positive or negative, are made based upon internal analysis of security specifics such as liquidity, deal size and time to maturity.

Privately placed securities comprise approximately 66 percent of our fixed maturities, available for sale, classified as Level 3.  Privately placed securities are classified as Level 3 when their valuation is based on internal valuation models which rely on significant inputs that are not observable in the market.  Our model applies spreads above the risk-free rate which are determined based on comparison to securities with similar ratings, maturities and industries that are rated by independent third party rating agencies.  Our process also considers the ratings assigned by the National Association of Insurance Commissioners (the “NAIC”) to the Level 3 securities on an annual basis.  Each quarter, a review is performed to determine the reasonableness of the initial valuations from the model.  If an initial valuation appears unreasonable based on our knowledge of a security and current market conditions, we make appropriate adjustments to our valuation inputs.  The remaining securities classified as Level 3 are primarily valued based on internally developed models using estimated future cash flows.  We recognized other-than-temporary impairments on securities classified as Level 3 investments of $75.9 million during 2010 ($72.0 million, prior to the $(3.9) million of impairment losses recognized through accumulated other comprehensive income (loss)).

As the Company is responsible for the determination of fair value, we perform monthly quantitative and qualitative analysis on the prices received from third parties to determine whether the prices are reasonable estimates of fair value.  The Company’s analysis includes:  (i) a review of the methodology used by third party pricing services; (ii) a comparison of pricing services’ valuation to other pricing services’ valuations for the same security; (iii) a review of month to month price fluctuations; (iv) a review to ensure valuations are not unreasonably stale; and (v) back testing to compare actual purchase and sale transactions with valuations received from third parties.  As a result of such procedures, the Company may conclude the prices received from third parties are not reflective of current market conditions.  In those instances, we may request additional pricing quotes or apply internally developed valuations.  However, the number of instances is insignificant and the aggregate change in value of such investments is not materially different from the original prices received.

The categorization of the fair value measurements of our investments priced by independent pricing services was based upon the Company’s judgment of the inputs or methodologies used by the independent pricing services to value different asset classes.  Such inputs include:  benchmark yields, reported trades, broker dealer quotes, issuer spreads, benchmark securities, bids, offers and reference data.  The Company categorizes such fair value measurements based upon asset classes and the underlying observable or unobservable inputs used to value such investments.

 

The classification of fair value measurements for derivative instruments, including embedded derivatives requiring bifurcation, is determined based on the consideration of several inputs including closing exchange or over-the-counter market price quotations; time value and volatility factors underlying options; market interest rates; and non-performance risk.  For certain embedded derivatives, we may use actuarial assumptions in the determination of fair value.

The categorization of fair value measurements, by input level, for our fixed maturity securities, equity securities, trading securities, certain other invested assets, assets held in separate accounts and embedded derivative instruments included in liabilities for insurance products at December 31, 2010 is as follows (dollars in millions):

   
Quoted prices in active markets for identical assets or liabilities (Level 1)
  
Significant other observable inputs (Level 2)
    
Significant unobservable inputs (Level 3)
    
Total
 
Assets:
                
Fixed maturities, available for sale:
                
Corporate securities
 $-  $12,254.7    $2,092.5    $14,347.2 
United States Treasury securities and obligations of United States government corporations and agencies
  10.0   282.2     2.0     294.2 
States and political subdivisions
  -   1,772.1     11.4     1,783.5 
Debt securities issued by foreign governments
  -   .9     -     .9 
Asset-backed securities
  -   638.1     6.0     644.1 
Collateralized debt obligations
  -   -     256.5     256.5 
Commercial mortgage-backed securities
  -   1,363.7     -     1,363.7 
Mortgage pass-through securities
  27.8   -     3.5     31.3 
Collateralized mortgage obligations
  -   1,715.4     197.1     1,912.5 
Total fixed maturities, available for sale 
  37.8   18,027.1     2,569.0     20,633.9 
                      
Equity securities
  -   37.5     30.6     68.1 
                      
Trading securities:
                    
Corporate securities
  3.2   47.5     4.3     55.0 
United States Treasury securities and obligations of United States government corporations and agencies
  -   293.8     -     293.8 
States and political subdivisions
  -   16.1     -     16.1 
Asset-backed securities
  -   .6     -     .6 
Commercial mortgage-backed securities
  -   5.2     -     5.2 
Mortgage pass-through securities
  .3   -     -     .3 
Collateralized mortgage obligations
  -   1.2     .4     1.6 
Total trading securities
  3.5   364.4     4.7     372.6 
Investments held by variable interest entities
  -   414.2     6.7     420.9 
Other invested assets
  -   192.0 
(a)
  -     192.0 
Assets held in separate accounts
  -   17.5     -     17.5 
                      
Liabilities:
                    
Liabilities for insurance products:
                    
Interest-sensitive products
  -   -     553.2 
(b)
  553.2 
_____________
(a)  
Includes company-owned life insurance and derivatives.
(b)  
Includes $553.6 million of embedded derivatives associated with our fixed index annuity products and $(.4) million of embedded derivatives associated with a modified coinsurance agreement.

 


The categorization of fair value measurements, by input level, for our fixed maturity securities, equity securities, trading securities, certain other invested assets, assets held in separate accounts and embedded derivative instruments included in liabilities for insurance products at December 31, 2009 is as follows (dollars in millions):

   
Quoted prices in active markets for identical assets or liabilities (Level 1)
  
Significant other observable inputs (Level 2)
    
Significant unobservable inputs (Level 3)
    
Total
 
Assets:
                
Fixed maturities, available for sale:
                
Corporate securities
 $-  $12,044.3    $2,247.1    $14,291.4 
United States Treasury securities and obligations of United States government corporations and agencies
  19.4   248.0     2.2     269.6 
States and political subdivisions
  -   842.9     10.7     853.6 
Debt securities issued by foreign governments
  -   5.1     -     5.1 
Asset-backed securities
  -   176.3     15.8     192.1 
Collateralized debt obligations
  -   -     92.8     92.8 
Commercial mortgage-backed securities
  -   752.3     13.7     766.0 
Mortgage pass-through securities
  37.1   1.3     4.2     42.6 
Collateralized mortgage obligations
  -   2,003.8     11.4     2,015.2 
Total fixed maturities, available for sale 
  56.5   16,074.0     2,397.9     18,528.4 
                      
Equity securities
  .1   -     30.9     31.0 
                      
Trading securities:
                    
Corporate securities
  3.8   49.4     3.7     56.9 
United States Treasury securities and obligations of United States government corporations and agencies
  -   220.3     -     220.3 
States and political subdivisions
  -   4.4     -     4.4 
Asset-backed securities
  -   .6     -     .6 
Commercial mortgage-backed securities
  -   4.9     -     4.9 
Mortgage pass-through securities
  .5   -     -     .5 
Collateralized mortgage obligations
  -   5.7     -     5.7 
Total trading securities
  4.3   285.3     3.7     293.3 
                      
Securities lending collateral:
                    
Corporate securities
  -   81.0     13.7     94.7 
Asset-backed securities
  -   16.2     22.9     39.1 
Total securities lending collateral
  -   97.2     36.6     133.8 
                      
Other invested assets
  -   192.6 
(a)
  2.4 
(b)
  195.0 
Assets held in separate accounts
  -   17.3     -     17.3 
                      
Liabilities:
                    
Liabilities for insurance products:
                    
Interest-sensitive products
  -   -     496.0 
(c)
  496.0 


 

 
____________
(a)  
Includes company-owned life insurance and derivatives.
(b)  
Includes equity-like holdings in special-purpose entities.
(c)  
Includes $494.4 million of embedded derivatives associated with our fixed index annuity products and $1.6 million of embedded derivatives associated with a modified coinsurance agreement.

 

The following table presents additional information about assets and liabilities measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value for the year ended December 31, 2010 (dollars in millions):
 
   
December 31, 2010
 
Amount of total gains (losses) for the year ended
December 31, 2010 included
in our net
income relating
to assets and liabilities still held as of the reporting date
   
Beginning
balance
as of
December 31,
2009
  
Cumulative
effect of
accounting
change (a)
  
Purchases,
sales,
issuances
and
settlements,
net
  
Total
realized
and
unrealized
gains
(losses)
included
in net
income
  
Total realized
and unrealized
gains (losses)
included in accumulated other
comprehensive
income (loss)
  
Transfers
into
Level 3
(b)
  
Transfers
out of
Level 3
(b) (c)
  
Ending
balance
as of
December 31,
2010
 
Assets:
                            
Fixed maturities, available for sale:
                            
Corporate securities
 $2,247.1  $(5.9) $148.8  $(72.7) $74.5  $19.6  $(318.9) $2,092.5    $-  
United States Treasury securities and obligations of United States government corporations and agencies
  2.2   -   (.1)  -   (.1)  -   -   2.0     -  
States and political subdivisions
  10.7   -   -   -   .4   2.1   (1.8)  11.4     -  
Asset-backed securities
  15.8   -   (12.3)  (11.4)  13.9   -   -   6.0     -  
Collateralized debt obligations
  92.8   (5.7)  160.2   (.3)  9.5   -   -   256.5     -  
Commercial mortgage-backed securities
  13.7   -   -   -   -   -   (13.7)  -     -  
Mortgage pass-through securities
  4.2   -   (.7)  -   -   -   -   3.5     -  
Collateralized mortgage obligations
  11.4   -   174.8   (.8)  5.5   17.3   (11.1)  197.1     -  
Total fixed maturities, available for sale
  2,397.9   (11.6)  470.7   (85.2)  103.7   39.0   (345.5)  2,569.0     -  
Equity securities
  30.9   -   .1   -   (.4)  -   -   30.6     -  
Trading securities:
                                       
 Corporate securities
  3.7   -   -   -   .6   -   -   4.3     .6  
 Collateralized mortgage obligations
   -   -   -   -   .1   .3   -   .4     .1  
Total trading securities
  3.7   -   -   -   .7   .3   -   4.7     .7  
Investments held by variable interest  
  entities:
                                       
Corporate securities
  -   6.9   (1.0)  -   .8   -   -   6.7     -  
Securities lending collateral:
                                       
Corporate securities
  13.7   -   (13.7)  -   -   -   -   -     -  
Asset-backed securities
  22.9   -   (20.9)  -   -   -   (2.0)  -     -  
Total securities lending collateral
  36.6   -   (34.6)  -   -   -   (2.0)  -     -  
Other invested assets
  2.4   (2.4  -   -   -   -   -   -     -  
Liabilities:
                                       
Liabilities for insurance products:
                                       
Interest-sensitive products
  (496.0)  -   (20.0)  (37.2)  -   -   -   (553.2
 
  (37.2
 

 

________
(a)  
Amounts represent adjustments to investments related to a variable interest entity that was required to be consolidated effective January 1, 2010, as well as the reclassification of investments of a variable interest entity which was consolidated at December 31, 2009.
(b)  
Transfers in/out of Level 3 are reported as having occurred at the beginning of the period.
(c)  
Included in the transfers out of Level 3 is approximately $282 million of privately issued securities that were priced using observable market data at December 31, 2010 and were, therefore, transferred to Level 2.

The following table presents additional information about assets and liabilities measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value for the year ended December 31, 2009 (dollars in millions):

   
December 31, 2009
   
   
Beginning
balance
as of
December 31,
2008
  
Purchases,
sales,
issuances
and
settlements,
net
  
Total
realized
and
unrealized
gains
(losses)
included
in net
income
  
Total realized
and unrealized
gains (losses)
included in
accumulated other
comprehensive
income (loss)
  
Transfers
into
Level 3
(a)
  
Transfers
out of
Level 3
(a)
  
Ending
balance
as of
December 31,
2009
 
Amount of total gains (losses) for the year ended
December 31, 2009 included
in our net
income relating
to assets and liabilities still held as of the reporting date
 
Assets:
                        
Fixed maturities, available for sale:
                        
Corporate securities
 $1,715.6  $231.1  $(5.2) $284.8  $30.3  $(9.5) $2,247.1  $- 
United States Treasury securities and obligations of United States government corporations and agencies
  2.6   (.1)  -   (.3)  -   -   2.2   - 
States and political subdivisions
  10.5   (.5)  -   (1.1)  1.8   -   10.7   - 
Asset-backed securities
  27.5   (4.4)  (5.2)  2.0   -   (4.1)  15.8   (1.2)
Collateralized debt obligations
  96.7   (36.3)  (4.2)  36.6   -   -   92.8   (2.7)
Commercial mortgage-backed securities
  9.6   (.7)  (.6)  5.4   -   -   13.7   - 
Mortgage pass-through securities
  4.9   (.8)  -   -   .1   -   4.2   - 
Collateralized mortgage obligations
  8.7   10.8   -   .1   -   (8.2)  11.4   - 
Total fixed maturities, available for sale
  1,876.1   199.l  (15.2)  327.5   32.2   (21.8)  2,397.9   (3.9)
Equity securities
  32.4   (.3)  -   (1.2)  -   -   30.9   - 
Trading securities:
                                
Corporate securities
  2.7   -   1.0   -   -   -   3.7   1.0 
Securities lending collateral:
                                
Corporate securities
  34.9   (17.0)  -   .3   -   (4.5)  13.7   - 
Equity securities
  .1   (.1)  (.3)  .3   -   -   -   (.3)
Asset-backed securities
   13.1   -   (.6)  (10.0)  20.4   -   22.9   (.6)
Total securities lending collateral
  48.1   (17.1)  (.9)  (9.4)  20.4   (4.5)  36.6   (.9)
Other invested assets
  2.3   -   (3.4)  3.5   -   -   2.4   (3.4)
Liabilities:
                                
Liabilities for insurance products:
                                
Interest-sensitive products
  (437.2)  (63.8)  5.0   -   -   -   (496.0  7.3 
_________
(a)  
Transfers in/out of Level 3 are reported as having occurred at the beginning of the period.

At December 31, 2010, 86 percent of our Level 3 fixed maturities, available for sale, were investment grade and 81 percent of our Level 3 fixed maturities, available for sale, consisted of corporate securities.

Realized and unrealized investment gains and losses presented in the preceding tables represent gains and losses during the time the applicable financial instruments were classified as Level 3.

 


Realized and unrealized gains (losses) on Level 3 assets are primarily reported in either net investment income for policyholder and reinsurer accounts and other special-purpose portfolios, net realized investment gains (losses) or insurance policy benefits within the consolidated statement of operations or accumulated comprehensive income (loss) within shareholders’ equity based on the appropriate accounting treatment for the instrument.

Purchases, sales, issuances and settlements, net, represent the activity that occurred during the period that results in a change of the asset or liability but does not represent changes in fair value for the instruments held at the beginning of the period.  Such activity primarily consists of purchases and sales of fixed maturity, equity and trading securities, purchases and settlements of derivative instruments, and changes to embedded derivative instruments related to insurance products resulting from the issuance of new contracts, or changes to existing contracts.

We review the fair value hierarchy classifications each reporting period.  Transfers in and/or (out) of Level 3 in 2010 and 2009 were primarily due to changes in the observability of the valuation attributes resulting in a reclassification of certain financial assets or liabilities.  Such reclassifications are reported as transfers in and out of Level 3 at the beginning fair value for the reporting period in which the changes occur.  There were no significant transfers between Level 1 and Level 2 in 2010.

The amount presented for gains (losses) included in our net loss for assets and liabilities still held as of the reporting date primarily represents impairments for fixed maturities, available for sale, changes in fair value of trading securities and certain derivatives and changes in fair value of embedded derivative instruments included in liabilities for insurance products that exist as of the reporting date.

We use the following methods and assumptions to determine the estimated fair values of other financial instruments:

Cash and cash equivalents.  The carrying amount for these instruments approximates their estimated fair value.

Mortgage loans and policy loans.  We discount future expected cash flows for loans included in our investment portfolio based on interest rates currently being offered for similar loans to borrowers with similar credit ratings.  We aggregate loans with similar characteristics in our calculations.  The fair value of policy loans approximates their carrying value.

Other invested assets.  We use quoted market prices, where available.  When quotes are not available, we estimate the fair value based on discounted future expected cash flows or independent transactions which establish a value for our investment.  Investments in limited partnerships are accounted for under the equity method which approximates estimated fair value.

Insurance liabilities for interest-sensitive products.  We discount future expected cash flows based on interest rates currently being offered for similar contracts with similar maturities.

Investment borrowings, notes payable and borrowings related to variable interest entities.  For publicly traded debt, we use current fair values.  For other notes, we use discounted cash flow analyses based on our current incremental borrowing rates for similar types of borrowing arrangements.

 


The estimated fair values of our financial instruments at December 31, 2010 and 2009, were as follows (dollars in millions):

   
2010
  
2009
 
   
Carrying
  
Fair
  
Carrying
  
Fair
 
   
Amount
  
Value
  
Amount
  
Value
 
              
Financial assets:
            
Fixed maturities, available for sale
 $20,633.9  $20,633.9  $18,528.4  $18,528.4 
Equity securities                                                
  68.1   68.1   31.0   31.0 
Mortgage loans                                                
  1,761.2   1,762.6   1,965.5   1,756.8 
Policy loans                                                
  284.4   284.4   295.2   295.2 
Trading securities                                                
  372.6   372.6   293.3   293.3 
Investments held by securitization entities
  420.9   420.9   -   - 
Securities lending collateral                                                
  -   -   180.0   180.0 
Other invested assets                                                
  240.9   240.9   236.8   236.8 
Cash and cash equivalents                                                
  598.7   598.7   526.8   526.8 
                  
Financial liabilities:
                
Insurance liabilities for interest-sensitive products (a)
 $13,194.7  $13,194.7  $13,219.2  $13,219.2 
Investment borrowings                                                
  1,204.1   1,265.3   683.9   677.6 
Borrowings related to securitization entities
  386.9   345.1   -   - 
Notes payable – direct corporate obligations
  998.5   1,166.4   1,037.4   1,041.7 
____________________
(a)  
The estimated fair value of insurance liabilities for interest-sensitive products was approximately equal to its carrying value at December 31, 2010 and 2009.  This was because interest rates credited on the vast majority of account balances approximate current rates paid on similar products and because these rates are not generally guaranteed beyond one year.

Sales Inducements

Certain of our annuity products offer sales inducements to contract holders in the form of enhanced crediting rates or bonus payments in the initial period of the contract.  Certain of our life insurance products offer persistency bonuses credited to the contract holders balance after the policy has been outstanding for a specified period of time.  These enhanced rates and persistency bonuses are considered sales inducements in accordance with GAAP.  Such amounts are deferred and amortized in the same manner as deferred acquisition costs.  Sales inducements deferred totaled $20.0 million, $28.4 million and $47.1 million in 2010, 2009 and 2008, respectively.  Amounts amortized totaled $31.2 million, $30.2 million and $16.7 million in 2010, 2009 and 2008, respectively.  The unamortized balance of deferred sales inducements was $166.4 million and $177.6 million at December 31, 2010 and 2009, respectively.  The balance of insurance liabilities for persistency bonus benefits was $85.3 million and $136.2 million at December 31, 2010 and 2009, respectively.

Out-of-Period Adjustments

We recorded the net effects of certain out-of-period adjustments which decreased our net income by $5.5 million (or two cents per diluted share) in 2010.  We evaluated these errors taking into account both qualitative and quantitative factors and considered the impact of these errors in relation to 2010, as well as the materiality to the periods in which they originated.  Management believes these errors are immaterial to the consolidated annual financial statements.

 


Recently Issued Accounting Standards

Pending Accounting Standards

In October 2010, the FASB issued authoritative guidance that modifies the definition of the types of costs incurred by insurance entities that can be capitalized in the acquisition of new and renewal contracts.  The guidance specifies that an insurance entity shall only capitalize incremental direct costs related to the successful acquisition of new or renewal insurance contracts.  The guidance also states that advertising costs should be included in deferred acquisition costs only if the capitalization criteria in the direct-response advertising guidance are met.  The guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011.  The guidance should be applied prospectively upon adoption.  Retrospective application to all prior periods presented upon the date of adoption also is permitted, but not required.  We are in the process of evaluating the impact the guidance will have on our consolidated financial statements and we believe that the guidance will reduce the amount of costs that we can capitalize.

In January 2010, the FASB issued authoritative guidance which requires additional disclosures related to purchases, sales, issuances and settlements in the rollforward of Level 3 fair value measurements.  This guidance is effective for reporting periods beginning after December 15, 2010.  We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

Adopted Accounting Standards

In March 2010, the FASB issued authoritative guidance clarifying the scope exception for embedded credit derivatives and when those features would be bifurcated from the host contract.  Under the new guidance, only embedded credit derivative features that are in the form of subordination of one financial instrument to another would not be subject to the bifurcation requirements.  Accordingly, entities will be required to bifurcate any embedded credit derivative features that no longer qualify under the amended scope exception, or, for certain investments, an entity can elect the fair value option and record the entire investment at fair value.  This guidance is effective for fiscal quarters beginning after June 15, 2010.  The adoption of this guidance did not have a material impact on our consolidated financial statements.

In January 2010, the FASB issued authoritative guidance which requires new disclosures and clarifies existing disclosure requirements related to fair value.  An entity is also required to disclose significant transfers in and out of Levels 1 and 2 of the fair value hierarchy.  In addition, the guidance amends the fair value disclosure requirement for pension and postretirement benefit plan assets to require this disclosure at the investment class level.  The guidance is effective for interim and annual reporting periods beginning after December 15, 2009.  Such disclosures are included in the note to the consolidated financial statements entitled “Fair Value Measurements”.  The adoption of this guidance did not have a material impact on our consolidated financial statements.

In June 2009, the FASB issued authoritative guidance that is intended to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets.  The guidance must be applied as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter.  The guidance must be applied to transfers occurring on or after the effective date.  The adoption of this guidance did not have a material impact on our consolidated financial statements.

 


In June 2009, the FASB issued authoritative guidance that requires an entity to perform a qualitative analysis to determine whether a primary beneficiary interest is held in a VIE.  Under the new qualitative model, the primary beneficiary must have both the power to direct the activities of the VIE and the obligation to absorb either losses or gains that could be significant to the VIE.  The guidance also requires ongoing reassessments to determine whether a primary beneficiary interest is held and additional disclosures, including the financial statement effects of the entity’s involvement with VIEs.  The guidance is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter.  The impact of adoption of this guidance is as follows (dollars in millions):

   
January 1, 2010
 
   
Amounts prior to effect of adoption of authoritative
  
Effect of adoption of authoritative
  
As
 
   
guidance
  
guidance
  
adjusted
 
           
Total investments
 $21,530.2  $247.6  $21,777.8 
              
Cash and cash equivalents held by variable interest entities
  3.4   3.8   7.2 
Accrued investment income
  309.0   .9   309.9 
Income tax assets, net
  1,124.0   8.6   1,132.6 
Other assets
  310.7   14.2   324.9 
Total assets
  30,343.8   275.1   30,618.9 
              
Other liabilities
  610.4   8.8   619.2 
Borrowings related to variable interest entities
  229.1   282.2   511.3 
Total liabilities
  26,811.4   291.0   27,102.4 
              
Accumulated other comprehensive income (loss)
  (264.3)  (6.2)  (270.5)
Accumulated deficit
  (614.6)  (9.7)  (624.3)
Total shareholders’ equity
  3,532.4   (15.9)  3,516.5 
              
Total liabilities and shareholders’ equity
  30,343.8   275.1   30,618.9 

On April 9, 2009, the FASB issued authoritative guidance regarding the recognition and presentation of an other-than-temporary impairment and requires additional disclosures.  The recognition provision within this guidance applies only to fixed maturity investments that are subject to the other-than-temporary impairments.  If an entity intends to sell or if it is more likely than not that it will be required to sell an impaired security prior to recovery of its cost basis, the security is other-
than-temporarily impaired and the full amount of the impairment is recognized as a loss through earnings.  Otherwise, losses on securities which are other-than-temporarily impaired are separated into:  (i) the portion of loss which represents the credit loss; and (ii) the portion which is due to other factors.  The credit loss portion is recognized as a loss through earnings while the loss due to other factors is recognized in accumulated other comprehensive income (loss), net of taxes and related amortization.  The guidance requires a cumulative effect adjustment to accumulated deficit and a corresponding adjustment to accumulated other comprehensive income (loss) to reclassify the non-credit portion of previously other-than-temporarily impaired securities which were held at the beginning of the period of adoption and for which we do not intend to sell and it is more likely than not that we will not be required to sell such securities before recovery of the amortized cost basis.  We adopted the guidance effective January 1, 2009.  The cumulative effect of adopting this guidance was a $4.9 million net decrease to accumulated deficit and a corresponding increase to accumulated other comprehensive income (loss).

On April 9, 2009, the FASB issued authoritative guidance which provided additional guidance on estimating fair value when the volume and level of activity for an asset or liability have significantly decreased in relation to normal market activity for the asset or liability and clarifies that the use of multiple valuation techniques may be appropriate.  The guidance also discusses circumstances that may indicate a transaction is not orderly.  The guidance re-emphasizes that fair value continues to be the exit price in an orderly market.  Further, this guidance requires additional disclosures about fair value measurement in annual and interim reporting periods.  The guidance is effective for interim and annual reporting periods ending after June 15, 2009 with early adoption permitted.  We adopted the guidance effective for the period ending March 31,

 

2009, and this guidance did not have a material effect on our consolidated financial statements.

On April 9, 2009, the FASB issued authoritative guidance which requires that the fair value of financial instruments be disclosed in an entity’s financial statements in both interim and annual periods.  The guidance also requires disclosure of methods and assumptions used to estimate fair values.  The guidance is effective for interim reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.  We adopted the guidance for the quarter ended June 30, 2009, which did not have a material effect on our consolidated balance sheet or statement of operations.

In May 2008, the FASB issued authoritative guidance that specifies that issuers of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) should separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods.  The guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years.  The guidance was applied retrospectively to all periods presented unless instruments were not outstanding during any period included in the financial statements.  In October 2009, the Company reissued its financial statements as December 31, 2008 and 2007, and for the three years ended December 31, 2008, to reflect the adoption of this authoritative guidance on a retrospective basis.  The adoption of the guidance affected the accounting for our 3.5% Convertible Debentures due September 30, 2035 (the “3.5% Debentures”).  Upon adoption of the guidance, the effective interest rate on our 3.5% Debentures increased to 7.4 percent, which resulted in the recognition of a $45 million discount to these notes with the offsetting after tax amount recorded to paid-in capital.  Such discount is amortized as interest expense over the remaining life of the 3.5% Debentures.

Amounts related to the 3.5% Debentures are reflected in our consolidated balance sheet at December 31, 2009, as follows (dollars in millions):

   
December 31,
 
   
2009
 
     
Increase to additional paid-in capital                                                              
 $28.0 
      
Par value of 3.5% Debentures                                                              
 $116.5 
Unamortized discount                                                              
  (3.3)
      
Carrying value of 3.5% Debentures                                                          
 $113.2 

 
Interest expense related to the 3.5% Debentures includes the following at December 31, 2009 and 2008 (dollars in millions):

   
2009
  
2008
 
        
Contractual interest expense                                                              
 $9.4  $11.3 
Amortization of discount                                                              
  9.4   9.5 
Amortization of debt issue costs                                                              
  1.1   1.3 
          
Total interest expense                                                          
 $19.9  $22.1 

 
In January 2009, the FASB issued authoritative guidance which amended certain impairment guidance by removing the exclusive reliance upon market participant assumptions about future cash flows when evaluating the impairment of certain securities.  The guidance permits the use of reasonable management judgment of the probability that the holder will be unable to collect all amounts due.  The guidance is effective prospectively for interim and annual reporting periods ending after December 15, 2008.  The Company adopted the guidance on December 31, 2008 and the adoption did not have a material effect on our consolidated financial statements.

In March 2008, the FASB issued authoritative guidance regarding whether unvested share based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are to be treated as participating securities prior to vesting and, therefore, must be included in the earnings allocation in calculating earnings per share under the two-class method.  The guidance is effective for financial statements issued for fiscal years beginning after December 15,

 

2008, and interim periods within those years and requires retrospective application.  Our adoption of the guidance did not have a material effect on our earnings per share calculations due to the immateriality of unvested restricted shares that are considered to be participating securities.

In March 2008, the FASB issued authoritative guidance which required enhanced disclosures about an entity’s derivative and hedging activities.  The guidance is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008.  The adoption of the guidance did not have a material effect on our consolidated financial statements.

In December 2007, the FASB issued authoritative guidance which establishes new standards governing the accounting for and reporting of noncontrolling interests (previously referred to as minority interests).  The guidance establishes reporting requirements which include, among other things, that noncontrolling interests be reflected as a separate component of equity, not as a liability.  It also requires that the interests of the parent and the noncontrolling interest be clearly identifiable.  Additionally, increases and decreases in a parent’s ownership interest that leave control intact shall be reflected as equity transactions, rather than step acquisitions or dilution gains or losses.  The guidance is effective for fiscal years beginning on or after December 15, 2008.  The initial adoption of this guidance had no effect on our consolidated financial statements.

In December 2007, the FASB issued authoritative guidance which requires the acquiring entity in a business combination to recognize all assets acquired and liabilities assumed in a transaction at the acquisition date fair value, with certain exceptions.  Additionally, the guidance requires changes to the accounting treatment of acquisition related items, including, among other items, transaction costs, contingent consideration, restructuring costs, indemnification assets and tax benefits.  The guidance also provides for a substantial number of new disclosure requirements.  The guidance is effective for business combinations initiated on or after the first annual reporting period beginning after December 15, 2008.  We expect that the guidance will have an effect on our accounting for business combinations, if any, that are made in the future.  In addition, the guidance changes the previous requirement that reductions in a valuation allowance for deferred tax assets established in conjunction with the implementation of fresh-start accounting be recognized as a direct increase to additional paid-in capital.  Instead, the revised standard requires that any such reduction be reported as a decrease to income tax expense through the consolidated statement of operations.  Accordingly, any reductions to our valuation allowance for deferred tax assets will be reported as a decrease to income tax expense, after the effective date of the guidance.

In December 2008, the FASB issued authoritative guidance which required public entities to provide additional disclosures about transferors’ continuing involvements with transferred financial assets and to provide additional disclosures about their involvement with VIEs.  The guidance was effective for financial statements issued for fiscal years and interim periods ending after December 15, 2008.  We adopted the guidance on December 31, 2008 and it did not have a material effect on our consolidated financial statements.