Horace Mann Educators (HMN) 10-Q2023 Q1 Quarterly report

We have reviewed the consolidated balance sheet of Horace Mann Educators Corporation and subsidiaries (the Company) as of March 31, 2023, the related consolidated statements of operations, comprehensive income (loss), and changes in shareholders' equity for the three-month periods ended March 31, 2023 and 2022, the related consolidated statements of cash flows for the three-month periods ended March 31, 2023 and 2022, and the related notes (collectively, the consolidated interim financial information). Based on our reviews, we are not aware of any material modifications that should be made to the consolidated interim financial information for it to be in conformity with U.S. generally accepted accounting principles.

This consolidated interim financial information is the responsibility of the Company’s management. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our reviews in accordance with the standards of the PCAOB. A review of consolidated interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the PCAOB, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

 

All intercompany transactions and balances between HMEC and its subsidiaries and affiliates have been eliminated.

The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosure of contingent assets and liabilities at the reporting date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from these estimates.

The most significant critical accounting estimates include valuation of hard-to-value fixed maturity securities, evaluation of credit loss impairments for fixed maturity securities, evaluation of goodwill and intangible assets for impairment, valuation of annuity and life deferred policy acquisition costs, valuation of liabilities for property and casualty unpaid claims and claim expense reserves, valuation of liabilities for group benefits unpaid claims and claim expense reserves, valuation of future policy benefit reserves and policyholders' account balances and valuation of long-duration insurance contracts under the new accounting guidance in ASU 2018-12.

In August 2018, the FASB issued ASU 2018-12, Financial Services – Insurance (Topic 944): Targeted Improvements to the Accounting for Long-Duration Contracts, as clarified and amended by (i) ASU 2019-09, Financial Services - Insurance (Topic 944): Effective Date, and (ii) ASU 2020-11, Financial Services - Insurance (Topic 944): Effective Date and Early Application (collectively referred to herein as ASU 2018-12). ASU 2018-12 changed existing recognition, measurement, presentation, and disclosure requirements for long-duration contracts. ASU 2018-12 includes: (1) a requirement to review and, if there is a change, update cash flow assumptions used to measure the liability for future policy benefits (LFPB) at least annually, and to update the discount rate assumption quarterly, (2) a requirement to account for market risk benefits (MRBs) at fair value, (3) simplified amortization for deferred policy acquisition costs (DAC), and (4) enhanced financial statement presentation and disclosures. ASU 2018-12 became effective for the Company for interim and annual periods beginning after December 15, 2022.

The Company adopted ASU 2018-12 for LFPB and DAC on a modified retrospective basis such that those balances were adjusted to conform to ASU 2018-12 on January 1, 2021. The Company adopted ASU 2018-12 for MRBs on a full retrospective basis, using hindsight where necessary. For variable annuities, actuarial assumptions (mortality, lapse, and premium payment patterns) used to measure MRBs were unobservable for years prior to 2006 and thus, hindsight was used to determine relevant assumptions for transition purposes. The factors used in applying hindsight included internal experience studies, the historical economic environment, actual performance of the business, and relevant industry information.

The following table summarizes the balance of and changes in LFPB on January 1, 2021 due to adoption of ASU 2018-12. The impact of shifts between deferred profit liabilities (DPL) and LFPB for limited-payment products are presented as offsetting line items in the effect of net premiums exceeding gross premiums and the effect of decrease/increase of DPL.

The following table summarizes the balance of and changes in DAC on January 1, 2021 due to adoption of ASU 2018-12:

The following table summarizes the balance of and changes in the net liability position of MRBs on January 1, 2021 due to adoption of ASU 2018-12:

The following table presents the effect of the after-tax transition adjustments on consolidated shareholders' equity due to adoption of ASU 2018:

For LFPB, the net transition adjustment is related to the difference in the discount rate used pre-transition and the discount rate at January 1, 2021. At transition, the Company had several instances, at the cohort level, where net premiums exceeded gross premiums which were recorded as an adjustment to retained earnings. For DAC, the Company removed shadow adjustments previously recorded in accumulated other comprehensive income (loss) (i.e., AOCI) for the impact of net unrealized investment gains (losses) that were included in the pre-ASU 2018-12 expected gross profits amortization calculation as of the transition date.

For MRBs, the transition adjustment to AOCI relates to the cumulative effect of changes in the instrument-specific credit risk between contract issue date and transition date. The remaining difference between the fair value and carrying amount of MRBs at transition, excluding the amounts recorded in AOCI, was recorded as an adjustment to retained earnings as of the transition date.

While the requirements of ASU 2018-12 represent a significant change from legacy GAAP, the adoption of ASU 2018-12 did not impact cash flows on the Company’s policies, or the underlying economics of the Company’s business. The Company's insurance subsidiaries' risk-based capital amounts and ratios, and regulatory dividends are not impacted as the National Association of Insurance Commissioners (NAIC) rejected ASU 2018-12.

See Note 11 for summarization of the effects of adopting ASU 2018-12 on the Company's 2022 Consolidated Financial Statements.

The following significant accounting policy has been added to reflect the Company's adoption of ASU 2018-12 as described above.

LFPB, which is the present value of estimated future policy benefits to be paid to or on behalf of policyholders and certain related expenses less the present value of estimated future net premiums to be collected from policyholders, is accrued as premium revenue. The liability is estimated using current assumptions that include discount rate, mortality, lapses, and expenses. These current assumptions are based on judgments that consider the Company's historical experience, industry data, and other factors.

For traditional, limited-payment and supplemental health contracts, such contracts are grouped into cohorts by contract type and issue year. The liability is adjusted for differences between actual and expected experience. With the exception of the expense assumption, the Company reviews its historical and future cash flow assumptions at least annually and updates the net premium ratio used to calculate the liability each time the assumptions are changed. The Company has elected to use expense assumptions that are locked-in at contract inception and are not subsequently reviewed or updated. At least annually, the Company updates its estimate of cash flows expected over the entire life of a group of contracts using actual historical experience and current future cash flow assumptions. These updated cash flows are used to calculate the revised net premiums and net premium ratio, which are used to derive an updated LFPB as of the beginning of the current reporting period, discounted at the original contract issuance discount rate. This amount is then compared to the carrying amount of the liability as of that same date, before updating cash flow assumptions, to determine the current period change in liability estimate. This current period change in liability estimate is the liability remeasurement gain or loss. The impact of updated cash flow assumptions as well as the periodic liability remeasurement gain or loss is recognized as Benefits, claims and settlement expenses in the Consolidated Statements of Operations and Comprehensive Income (Loss). In subsequent periods, the revised net premiums are used to measure LFPB, subject to future revisions.

For traditional and limited-payment contracts, a standard discount rate is used to measure the liabilities that is equivalent to the yield from an A-rated bond. The discount rate assumption is updated quarterly and used to remeasure the liability at the reporting date, with the resulting change reflected in other comprehensive income. For liability cash flows that are projected beyond the duration of market-observable A- rated bond, the Company uses the last market-observable yield level, and uses linear interpolation to determine yield assumptions for durations that do not have market-observable yields.

For limited-payment products, gross premiums received in excess of net premiums are deferred at initial recognition as a DPL. Gross premiums are measured using assumptions consistent with those used in the measurement of LFPB, including discount rate, mortality, lapses, and expenses.

DPL is amortized and recognized as premium revenue in proportion to insurance in force for life insurance contracts and expected future benefit payments for annuity contracts. Interest is accreted on the balance of DPL using the discount rate determined at contract issuance. The Company reviews and updates its estimates of cash flows for DPL at the same time as the estimates of cash flows for the liability for future policy benefits. When cash flows are updated, the updated estimates are used to recalculate DPL at contract issuance. The recalculated DPL as of the beginning of the current reporting period is compared to the carrying amount of DPL as of the beginning of the current reporting period, and any difference is recognized as either a charge or credit to Net premiums and contract charges earned presented in the Consolidated Statements of Operations and Comprehensive Income (Loss).

DPL is recognized as a component of the Investment contract and future policy benefit reserves presented in the Consolidated Balance Sheets.

MRBs are contracts or contract features that both provide protection to the contract holder from other-than-nominal capital market risk and expose the Company to other-than-nominal capital market risk. MRBs include guaranteed minimum death benefits on variable annuity products. MRBs are measured at fair value using a non-option-based valuation model based on current net amounts at risk, market data, Company experience, and other factors. Changes in fair value of MRBs are recognized as a component of Benefits, claims and settlement expenses presented in the Consolidated Statements of Operations and Comprehensive Income (Loss) each period with the exception of the portion of the change in fair value due to a change in the instrument-specific credit risk, which is recognized in other comprehensive income.

MRBs are recognized as a component of Policyholders' account balances reserves presented in the Consolidated Balance Sheets.

DAC are costs that are incremental and directly related to the successful acquisition of new or renewal insurance contracts. Such costs include the incremental direct costs of contract acquisition, such as sales commissions; the portion of employees' total compensation and payroll-related fringe benefits related directly to time spent performing acquisition activities, such as underwriting, issuing, and processing policies for contracts that have actually been acquired; and other costs related directly to acquisition activities that would not have been incurred if the contract had not been acquired.

Contracts are grouped by contract type and issue year into cohorts consistent with the grouping used in estimating the associated liability. DAC is amortized on a constant level basis for the grouped contracts over the expected term of the related contracts to approximate straight-line amortization. For all life insurance products, the constant level basis used is face amount in force. For all deferred annuity products, the constant level basis used is the deposit amount in force. The constant level bases used for amortization are projected using mortality and lapse assumptions that are based on the Company's experience, industry data, and other factors and are consistent with those used for LFPB. If those projected assumptions change in future periods, they will be reflected in the cohort level amortization basis at that time. Unexpected terminations, due to mortality and lapse experience higher than expected, are recognized in the current period as a reduction of the capitalized balances.

Amortization of DAC is recognized as DAC amortization expense presented in the Consolidated Statements of Operations and Comprehensive Income (Loss). The DAC balance is reduced for actual experience in excess of expected experience. Changes in future estimates are recognized prospectively over the remaining expected contract term.

Deferred sales inducements (DSIs) are contract features that are intended to attract new customers or to persuade existing customers to keep their current policy. DSIs may be deferred if the Company can demonstrate that the deferred sales inducement amounts are both incremental to the amounts Company credits on similar contracts without sales inducements and the amounts are higher than the contract's expected ongoing crediting rates for periods after the inducement. Day-one bonuses and persistency bonuses generally meet the criteria to be deferred. DSIs are amortized using the same methodology and assumptions used to amortize DAC.

The components of net investment income for the following periods were as follows:

Net investment gains (losses) for the following periods were as follows:

The Company, from time to time, sells fixed maturity securities subsequent to the reporting date that were considered temporarily impaired at such reporting date. Such sales are due to issuer-specific events occurring subsequent to the reporting date that result in a change in the Company's intent to sell a fixed maturity security. The types of events that may result in a sale include significant changes in the economic facts and circumstances related to the invested asset, significant unforeseen changes in liquidity needs, or changes in the Company's investment strategy.

The breakdown of net investment gains (losses) by transaction type for the following periods were as follows:

The following table presents changes in the allowance for credit loss impairments on fixed maturity securities classified as available for sale for the category of other asset-backed securities (no other categories of fixed maturity securities have an allowance for credit loss impairments):

The Company's investment portfolio is comprised primarily of fixed maturity securities. Amortized cost, net, gross unrealized investment gains (losses) and fair values of all fixed maturity securities in the portfolio were as follows:

The following table presents the fair value and gross unrealized losses for fixed maturity securities in an unrealized loss position as of March 31, 2023 and December 31, 2022, respectively. The Company views the decrease in fair value of all of the fixed maturity securities with unrealized losses as of March 31, 2023 — which was driven largely by increasing interest rates, spread widening, financial market illiquidity and/or market volatility from the date of acquisition — as temporary. As of March 31, 2023, the Company has not made the decision to sell and it is not more likely than not the Company will be required to sell the fixed maturity securities with unrealized losses before an anticipated recovery in value. There has been a significant increase in interest rates since January 1, 2022 driven mostly by increases in U.S. Treasury rates, though credit spreads also widened. As of March 31, 2023, the 10-year U.S. Treasury yield increased 196 basis points since January 2022, rising from 1.51% as of January 1, 2022 to 3.47% as of March 31, 2023. Additionally, credit spreads widened during the same time period, with investment grade and high yield wider by 46 and 172 basis points, respectively. These upward movements in rates caused market yields in the Company's investment portfolios to rise sharply, with downward pressure on prices. As of March 31, 2023, investment grade and high yield total returns were down 12.8% and 8.0%, respectively, since January 1, 2022. As of March 31, 2023, the Bloomberg Barclays Index Yield-to-Worst for Investment Grade rose 2.84% since January 1, 2022, ending at 5.2%, while the High Yield Index rose 4.31% to 8.5% since January 1, 2022. The Company's investment portfolios generated sizable unrealized losses as a result of sharp increases in interest rates. Therefore, it was determined that the unrealized losses on the fixed maturity securities presented in the table below were not indicative of any credit loss impairments as of March 31, 2023.

With regards to fixed maturity securities that had gross unrealized losses more than 12 months, the number of positions by their respective credit ratings were as follows:

Fixed maturity securities with an investment grade rating represented 96.3% of the gross unrealized losses as of March 31, 2023. With respect to fixed maturity securities involving securitized financial assets, the underlying collateral cash flows were stress tested to determine there was no adverse change in the present value of cash flows below the net amortized cost basis.

The following table presents the distribution of the Company’s fixed maturity securities portfolio by estimated expected maturity. Estimated expected maturities differ from contractual maturities, reflecting assumptions regarding borrowers' utilization of the right to call or prepay obligations with or without call or prepayment penalties. For structured securities, estimated expected maturities consider broker-dealer survey prepayment assumptions and are verified for consistency with the interest rate and economic environments.

Proceeds received from sales of fixed maturity and equity securities, each determined using the specific identification method, and gross gains and gross losses realized as a result of those sales for each period were as follows:

The following table reconciles net unrealized investment gains (losses) on fixed maturity securities, net of tax, included in AOCI:

Investments in limited partnership interests are accounted for using the equity method of accounting (EMA) and include interests in commercial mortgage loan funds, private equity funds, infrastructure equity funds, real estate equity funds, infrastructure debt funds and other funds. Principal factors influencing carrying amount appreciation or depreciation include operating performance, comparable public company earnings multiples, capitalization rates and the economic environment. The Company recognizes an impairment loss for EMA limited partnership interests when evidence demonstrates that the loss is other than temporary. Evidence of a loss in value that is other than temporary may include the absence of an ability to recover the carrying amount of the investment or the inability of the investee to sustain a level of earnings that would justify the carrying amount of the investment. The carrying amounts of EMA limited partnership interests were as follows:

The Company's derivatives are subject to enforceable master netting arrangements. Collateral support agreements associated with each master netting arrangement provides that the Company will receive or pledge financial collateral in the event minimum thresholds have been reached. The Company’s reverse repurchase agreements are also subject to enforceable master netting arrangements but there was no offsetting in their presentation in the Company’s Consolidated Balance Sheets. Information regarding the Company's derivatives is contained in Part II - Item 8, Note 5 in the Company's Annual Report on Form 10-K for the year ended December 31, 2022. The following table presents instruments that were subject to a master netting arrangement for the Company.

The Company is required to disclose estimated fair values for certain financial and nonfinancial assets and liabilities. Fair values of the Company’s insurance contracts other than annuity contracts (which are investment contracts) and EMA limited partnership interests are not required to be disclosed. However, the estimated fair values of liabilities under all insurance contracts are taken into consideration in the Company’s overall management of interest rate risk through appropriate matching of investment maturities with amounts due under insurance contracts.

Information regarding the three-level fair value hierarchy presented below and the valuation methodologies utilized by the Company to estimate fair values at each reporting date is included in Part II - Item 8, Note 4 of the

Consolidated Financial Statements in the Company’s Annual Report on Form 10-K for the year ended December 31, 2022.

The following table presents the Company's fair value hierarchy for financial assets and financial liabilities measured and carried at fair value on a recurring basis. During the three months ended March 31, 2023 and 2022, there were no transfers between Level 1 and Level 2. As of March 31, 2023, Level 3 invested assets comprised 8.0% of the Company’s total investment portfolio at fair value.