Please stand by. We're about to begin. Good day, welcome to the Unum Group second quarter 2016 earnings conference call. Today's conference is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to the senior vice president investor relations, Mr. Tom White. Please go ahead, sir.
Great. Thank you, Gwen. Good morning, everyone, welcome to the second quarter 2016 earnings conference call for Unum. Our remarks today will include forward-looking statements, which are statements that are not of current or historical fact. As a result, actual results might differ materially from results suggested by these forward-looking statements. Information concerning factors that could cause results to differ appears in our filings with the SEC and are also located in the sections titled Cautionary Statement regarding Forward-Looking Statements and Risk Factors in our annual report on Form 10-K for the fiscal year ended December 31, 2015, and our subsequently filed quarterly reports on Form 10-Q. Our SEC filings can be found in the Investors section of our website.
I remind you that the statements in today's call speak only as of the date they are made, we undertake no obligation to publicly update or revise any forward-looking statements. A presentation of the most directly comparable GAAP measures and reconciliations of any non-GAAP financial measures included in today's presentation can be found in our statistical supplement on our website, also in the Investors section. Participating in this morning's conference call are Unum's President and CEO, Rick McKenney, our CFO, Jack McGarry, as well as the CEOs of our core business segments, Mike Simonds for Unum US, Peter O'Donnell for Unum UK, and Tim Arnold for Colonial Life. Now I'll turn the call over to Rick for his opening comments.
Thank you, Tom, good morning, everyone. Our second quarter results were excellent, with operating income per share of $0.99. This is an increase of 11% over last year. Together with our strong first quarter results, operating income per share grew 9% in the first half. Our operating trends have been very strong across the company, with solid levels of premium growth in Unum US, Unum UK, and Colonial Life, coupled with stable benefits experience and favorable expense management trends. I am particularly pleased that we are achieving these strong results despite what has been a difficult business environment with historically low interest rates. The reason that we can deliver these consistent to improving results is because we have a sound strategy and business plan in place.
It is one that resonates well with our customers in the employee benefits marketplace, both on our existing group solutions as well as the growing voluntary space. It's our execution of this strategy that is generating these strong financial outcomes. I'll discuss this in more detail in a moment, first I want to provide a few highlights on the second quarter. First, the premium growth we are generating in our core operations remains very healthy at approximately 5% in each of our business lines. For the second quarter, premium income growth in Unum US was driven by strong persistency trends and our sales trends over the past several quarters. Total sales increased slightly in the second quarter with very strong performance in the voluntary and supplemental lines, offsetting a small decline in our employee benefits lines where markets remain competitive.
Unum UK premium growth benefited from the National Dental Plan acquisition from last year, as well as growth in the group income protection line. Finally, premium growth at Colonial Life was driven by the excellent sales trends we have seen over the past few years, which continued again this quarter, with growth in new sales of 13%, bringing first half sales growth to just under 15%. Next, I'm very pleased that we have maintained strong profit margins in our core business segments while building this positive momentum and premium growth over the past several quarters. This shows the discipline we're bringing to our markets and how we price, underwrite, and manage customer relationships in order to maintain a balance between producing top-line growth and maintaining industry-leading profit margins. These strong operating results drive a very strong level of statutory earnings and capital, which provides us substantial financial flexibility.
Our first half statutory operating earnings have been outstanding, increasing 29% year-over-year to $400 million, or just over. This enables us to continually generate free cash flow, which we have used to create shareholder value through steady, consistent share repurchases and annual dividend increases. At the same time, we're able to capitalize on attractive acquisition opportunities such as National Dental Plan in the U.K. and Starmount Life Insurance Company, which is also in the dental market, and we are able to capitalize them when they are available. In summary, it's been a very strong first half of 2016 for the company. This performance is a result of our steadfast focus on disciplined execution of our business plan. This is reflected in many facets of our business.
Starting with our customers, it includes how we underwrite and price business, how we manage claims to help people return to work, how we administer and enroll business, and how we manage customer relationships. Operationally, we also continue to focus on disciplined expense management, which is evident in the favorable expense trends we have delivered in many of our business segments, which is also net of the investment we are making in our businesses through such things as customer-facing technologies. When you combine this disciplined execution with our market positioning and growing footprint, we see a continuation of good, profitable growth. Finally, I can't say enough about our people who are responsible for this performance day in and day out. We're committed to developing our talent, building our bench strength, and ensuring our people continue to drive the change necessary to remain a leader in the employee benefits marketplace.
With those highlights on an excellent second quarter, I'll ask Jack to cover our results in greater detail. Jack?
Thank you, Rick, and good morning, everyone. I'll provide an overview of our second quarter results. Now I want to provide a more in-depth view of the trends we saw in the quarter. First, I want to highlight the composition of our after-tax operating income per share growth of 11.2%, which was well-balanced between after-tax operating income growth and capital management. Our operating income grew 5.9% over the year-ago quarter. This quarter was one of the strongest and best-balanced quarters we've seen. In addition, the benefit from our share repurchase activity reduced our average shares outstanding by 4.8% compared to the year-ago share count. A key driver of our success this quarter was the performance of Unum US. Second quarter operating income was very strong at $227.2 million, an increase of 12% from the year-ago quarter. Premium income growth continued its positive trend, increasing 5.1% over the year-ago quarter.
The benefit ratio for Unum US segment improved to 69.1% in the second quarter compared to 71.2% in the year-ago quarter. In addition, our focus on disciplined expense management also contributed to operating results with the other expense ratio declining to 20.9% in the quarter compared to 21.9% in the year-ago quarter. The profitability of our Unum US segment remains very strong, with an operating ROE of 15.1% for the second quarter of 2016. Within the Unum US segment, operating income in our group disability business was $74.4 million in the second quarter of 2016, an increase of 21.6% over last year. Premium income increased 5% over the year-ago quarter, pressure on net investment income continues, driven primarily by lower portfolio yields.
The benefit ratio was quite positive at 80.0% for the second quarter compared to 83.4% in the year-ago quarter, as we continue to see lower new claims incidents and favorable claim recovery trends in our group long-term disability line, along with shorter claim duration periods in our group short-term disability line. Group Life and AD&D operating income improved to $56.9 million for the second quarter, an increase of 8.4% from the year-ago quarter. Premium income grew 3.9% over the year-ago quarter, with the benefit ratio improved to 71.5% for the second quarter compared to 73.1% in the year-ago quarter, aided by favorable group life waiver of premium benefits. Operating income in the supplemental and voluntary lines was also very strong at $95.9 million in the second quarter of 2016, an increase of 7.6% over the year-ago quarter.
Premium income growth trends remain favorable, increasing 6.7% in the quarter compared to last year. From a benefits perspective, overall results remain in line with our expectations, with favorable trends in the voluntary benefits line offset by mildly elevated benefit ratios in the individual disability line. Looking at Unum UK, operating income was GBP 25.7 million for the second quarter, an increase of 2.8% over the year-ago quarter. Premium income increased 5.7% over the year-ago quarter, driven by the acquisition of NDP and the growth of the group disability line. The benefit ratio was 70.1% for the second quarter, a slight improvement relative to the 70.7% in the year-ago quarter as favorable risk experience in the disability line offset some unfavorable experience in the life line. Overall profitability of the Unum UK segment remains quite strong, with an operating ROE of 20.9% for the second quarter.
It's too early to tell what the long-term impact of Brexit will have on our Unum UK operations. The lower exchange rate will impact our results immediately in the third quarter. We do not expect to see much, if any, impact to our risk results. However, if employment trends and wage inflation slow down in the U.K. and interest rates remain under pressure, we could see some negative impact to our premium growth and investment income trends. We believe that the fundamental need for protection products in the U.K. has not changed as a result of the Brexit vote, but we will be monitoring very closely for any impacts in our markets over the next several quarters. Colonial Life continued to generate strong, steady results with operating income of $77.9 million in the second quarter of 2016 compared to $77.6 million in the year-ago quarter.
Premium income increased 4.6% and the benefit ratio was 51.1% for the second quarter compared to 50.4% for the year-ago quarter, due primarily to less favorable mortality experience in the life product line. Colonial Life continues to generate excellent margins with an operating ROE of 17.4% for the quarter. In the second quarter, we completed our DAC reviews for both our Unum US and Colonial Life businesses with minimal impacts on second quarter results. Finally, for the closed block, operating income was $32.6 million in the second quarter of 2016 compared to the exceptionally strong $36.6 million reported in the year-ago quarter. In the individual disability line, we saw very favorable underlying experience.
The increase in the interest-adjusted loss ratio to 84.3% in the second quarter from 83.6% in the year-ago quarter includes a reduction in the reserve discount rate to recognize the impact on future portfolio yields from the high level of bond calls and bond tenders during the second quarter of 2016. Excluding this reduction in the discount rate, the interest-adjusted loss ratio would have been slightly below 80%, one of our most favorable results in years. For the long-term care line, the interest-adjusted loss ratio was 92.6% for the second quarter, compared to the unusually favorable 83.4% in the year-ago quarter. This swing in results demonstrates the volatility that this block is subject to on a quarterly basis and the importance of taking a longer-term view of the performance, which shows an interest-adjusted loss ratio since our 4Q 2014 reserve review of 88.6%.
The results in long-term this quarter were driven by an increase in new claim incidents and severity brought on in part, we believe, by the rate increase notifications that we delivered to policyholders recently. We expect that this is likely to continue in the near term and is consistent with the claim activity behavior we've experienced in the past following rate increase notifications to policyholders. As before, we expect these higher claim levels to remediate once we are through the rate increase notifications. I'm pleased that we continue to make good progress on achieving rate increases in our in-force long-term care business. In addition to making good progress with state regulators, we're also seeing strong take-up of the landing spot option. The landing spot has the same positive impact on reserves as rate increases, but also has the added benefit of de-risking the portfolio.
Since future claims will be smaller under the landing spot, the reserves will be somewhat less sensitive to future changes in reserve assumptions. I'll move now to the growth trends we experienced across our business this quarter. Starting with Unum US, total sales increased 1.4% for the second quarter compared to a year-ago. We continue to see competitive market conditions, particularly in the core market segment, where we continue to increase our rates to offset interest rate pressures. In total for LTD, STD, and group life, we saw an overall decline in sales of 3.4%, with core market sales down 9.9%, while large case sales increased 12.8%, reflecting continued success in our ongoing efforts to increase penetration within existing customers. The momentum in our supplemental and voluntary segments remain very encouraging. Our individual disability sales increased 12.3% compared to a year-ago quarter, driven by strong growth to existing customers.
In the voluntary benefits product line, total sales increased 14%, with a good balance between core market and large case sales. Persistency for Unum US is at very healthy levels. For the employee benefits lines combined, persistency was 89.6%. This is important to us as we look to move price increases into our in-force block to offset the impact of low interest rates and reduce discount rate assumptions that have been implemented in recent years. Our sales force does an excellent job of managing this balance of placing rate increases with maintaining our in-force business, which is essential to our ability to grow while protecting the strong profit margins we have in our employee benefits block. Likewise, voluntary benefits persistency of 76.7% was favorable to the prior year results, as was individual disability persistency at 91.3%.
Sales in Unum UK continue to rebound, increasing 19.4% in local currency, with favorable trends in the core market for group long-term disability and group life overall, along with the benefit of the NDP acquisition. Persistency was favorable at 85.5%, helping to drive premium income growth of 5.7% this quarter. Finally, sales trends at Colonial Life remain very strong, increasing 13.3% for the second quarter and 14.5% for the first half of the year. Growth continues to be well-balanced between the commercial market sector and the public sector and between sales to existing customers and sales to new accounts. Persistency for Colonial Life was slightly lower across all product lines in the quarter, but remains in line with our expectations. As a result, premium growth is showing steady momentum, increasing 4.6% in the second quarter compared to the year-ago quarter.
Overall, we remain very pleased with the growth trends we see across our core business segments and, as Rick highlighted earlier, the profit margins that we've been able to sustain. Looking now at investment results, new money yields remained under pressure in the second quarter. However, I'm pleased that we were able, again, to exceed the new money yield assumption we have for our long-term care portfolio. We have exceeded our target of investing cash flows at 5% rate for every quarter since the 4Q 2014 reserve review. We remain well-positioned with our Unum US long-term disability business from an interest rate perspective, as our interest reserve margin remains very healthy. It's a great benefit to us as we navigate the dip in interest rates that resulted from the Brexit referendum.
It's too early to make a decision today on any future changes to the LTD discount rate for new claim incurrals. We remain satisfied with our margin at this time and a well-tested improvement ability to deliver the offsetting rate increases into the market should an adjustment be needed. The overall credit quality of our investment portfolio remains in very good shape. I'd like to highlight the further rebound in the net unrealized gain position of our energy holdings to $433 million at the end of the second quarter, compared to a gain of $19 million a quarter ago. It's impressive that the gross unrealized loss on energy holdings has declined to $89.5 million at the end of the second quarter, compared to $297.4 million at the end of the first quarter.
Energy holdings in a loss position were trading at over 90% of book value at the end of the second quarter. I believe this validates the investment decisions and credit evaluation process we followed for the past several years, not just for our energy holdings, but for our management of the overall investment portfolio. Moving to capital management, it was another active quarter as we repurchased $100 million of our shares, consistent with our repurchase activity in recent quarters. Our holding company liquidity position remains very healthy at approximately $600 million as of quarter end, roughly twice the level we target for holding company cash coverage needs for one year. This cash position is net of the $350 million we are holding for the debt maturity on September 30th, subsidiary contributions in the acquisition of Starmount Life Insurance Company.
As a reminder, we issued $600 million in senior debt back in early May, in part to refinance this maturing debt. Our risk-based capital ratio for our traditional U.S. life insurance companies remained at approximately 390%, well within our target range of 375%-400% for this year. Statutory after-tax operating earnings were outstanding at $228.4 million for the second quarter of 2016 compared to $161.2 million in the year-ago quarter, an increase of 42%. This is one of the best statutory quarters on record, reflecting the favorable risk experience across our primary business lines. For the first half of 2016, statutory after-tax operating earnings totaled $412.5 million, an increase of 29% over last year. Our outlook for growth and after-tax operating income per share for 2016 is unchanged, with an expected growth rate of 3%-6%.
We now expect to be at the higher end of that range as our first half after-tax operating earnings per share growth has been a very healthy 9%. While we're not building that rate of growth into our expectations for the second half of the year, we remain very encouraged by our first half trends. To wrap up my comments, I'm very pleased with our first half results. In fact, I'd say they've been remarkable given the environment. We have executed very well on many parts of our strategy, including delivering rate increases and exceeding new money yield targets for long-term care, generating strong persistency and growth in our core business segments, and maintaining pricing discipline and delivering on renewals to help achieve strong profit margins.
Given this progress, we enter the second half of the year highly confident in our ability to continue to create value in this difficult environment. I'll turn the call back to Rick.
Great. Thank you, Jack. As we go to your questions, I'll conclude by reiterating how pleased we are with the second quarter and first half results. We continue to see good premium growth, stable benefits experience, the benefit of disciplined expense management, and strong capital generation. I'm very encouraged by these trends as I believe they will continue to serve us well. We'll now move to your questions, I'll ask Gwen to begin the Q&A session. Gwen?
Thank you. If you do have a question at this time, please press star 1 on your touchtone phone. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Once again, that is star 1 if you do have a question, we'll take our first question from Ryan Krueger with KBW.
Hey, thanks. Good morning. First question, was the uptick in long-term care claims that you mentioned you expected to continue while you're implementing the rate increases, is that something that you anticipated and modeled into your reserve assumptions?
Great, Ryan. Let me turn that first question over to Jack. Jack?
Yeah. We didn't model it into the reserve assumptions because it's such a small blip. It's only going to go on for a few quarters. Within the spectrum of $7 billion-$8 billion of reserves, it wasn't worth putting in there.
Okay. You view it as something that's kind of a one-off, you're not changing your-
It's something-
I think, Ryan, I think it's incorporated.
Yeah.
Whether we specifically modeled the blip over the timeframe of LTC is probably too refined.
It's immaterial.
In the context of the broader, I would say it's included.
I would tell you, though, that we anticipated this in implementing the rate increases. It happened back in 2012 after the 2011-2012 rate increase. These rate increases are actually larger and more targeted than those were.
Okay, thanks. On group disability, the benefit ratio's kind of been in the low 80% range for the first half of the year. Is that a level you think is sustainable going forward?
Yeah, Ryan, we had great group disability results. Jack, and maybe Mike, comment on some of that.
Yeah. I mean, we're very encouraged by the trend. We're not necessarily declaring victory right now. We're continuing to actively manage that block with rate increases and price increases on new business. Again, it's been happening for a couple of quarters now. We're very encouraged by it. The fact of the matter is there's actions that we've taken over the past year and a half that would support that trend.
Thanks. Then just one quick clarification. I think, Jack, you mentioned a subsidiary contribution. Is that material, or what's that related to?
I don't think relative to our capital position, it's not terribly material. It's kind of the balancing of risk-based capital across our subs.
Okay. All right. Thank you.
Thanks, Ryan.
We'll go next to Suneet Kamath with UBS.
Thanks, and good morning. Just wanted to start with long-term care also. As you mentioned, since the charge, you've beaten your bogey of 5% every quarter. Your average loss ratio is 88.6%, that's right in the range of what you assumed, and you're not seeing the benefit of the rate increases yet. Although I think you expressed some confidence there. If I take all those things together, wouldn't that push out any kind of charge that you might have to take sort of towards the latter end of that typical 3-5-year timeframe that you've used in the past?
We're very encouraged by where our investments have been over the last six quarters. I've talked about we've exceeded the 5%. We've exceeded it by a healthy margin. It certainly gives us latitude in terms of when we may face a charge. The thing we haven't seen is the reversion to the norm as yet, so we're still holding on for that. I think it gives us some flexibility.
What does that mean, reversion to the norm in what?
Well, remember when we said we set the charge, we anticipated a 5% flat interest rate environment for four to five years, and then a reversion to the long-term average over the next five.
Okay. We're still in that first window.
We're still in that five-year period, and so we feel very good about where we are, and we do believe that the investment results we've managed to achieve to date do provide us some added cushion.
Okay. This may be a tough one for Rick, just, it seems like no matter how good your core results are, the focus is always on the long-term care business. I guess I'm just wondering, does it make sense for this company to be part of a larger organization where you just don't get that volatility from this business that is a non-core business but is still a sizable portion of your capital base?
That's a fair question, Suneet. I think that when we look at the company overall, we focus very much on our core operations and making sure that we just run great companies in terms of the ongoing. I think you see that quarter in, quarter out. You've certainly seen it over the last several years, and we're going to continue to focus on that. On the closed block, and more particularly on long-term care, it is a frustration to answer a lot of these questions. We think we do it very well. We're taking all the actions that we need to with regards to price increases, thinking about capital solutions, everything else. So I think we're executing where we want to on that block, it certainly does garner its fair share of questions.
Although a frustration, we're going to keep working the same way we've been working. To get to your broader question about the volatility and how that weaves into our position as a company overall, I think we've been clear over time that we want to look at what's in the best interest of our shareholders as well as all of our other constituencies. When we think about running our standalone company, that's how we think about it, because we have the wherewithal, the capital, and the opportunity to do so. That's where we focus first. As we think about other opportunities, if they came at us, we certainly would do the right thing from a governance perspective and entertain those.
We're still very focused on running those core operations to be the best business they can and taking all the actions necessary with regards to our closed block.
Got it. Appreciate that, Rick. Just lastly for Jack, any update on the closed block IDI? I know we talked about this last December in terms of some sort of capital relief solution. Just wondering, six months after, if there's any developments there.
There's nothing specific. We continue to work on it. It's a complicated thing given that we already have securitization behind the block. It's something we're continuing to actively pursue.
All right. Thanks, guys.
We'll go next to Randy Binner with FBR.
Hey, good morning. Thanks. Just a couple on the yield you've been able to earn against the long-term care. You mentioned it was over 5%. I was wondering if you could specify exactly what it was in the quarter. You mentioned you were very encouraged by the yield, that would be more bullish than the commentary we're getting from a lot of companies on yield. I'd be curious what kind of assets you're buying that are able to give you kind of good confidence around the risk-adjusted yield there.
You got to remember, in the long-term care business, we're a long-duration buyer. Our sweet spot is in the 30 year. The 30 year, you still have a reasonably steep yield curve. There's been a 70, 80 basis point pickup in the 30 year. There's also a credit curve. The credit spreads at the 30 year are significantly higher than credit spreads at the 10 year. The Barclays index over the past six quarters for a triple B 30-year issuance has been well above 5% historically. We also use some other risk classes, asset classes, whether it's private placements or other things to help boost that yield. Luckily, it's the fact that the longer end of the curve has maintained decent margins.
Just a couple follow-ups. What was it specifically in the quarter, just so we can track it better, the new money rate after that?
Yeah. We don't disclose our new money rates quarter by quarter.
It was well over 5%. Are the other asset classes, the alternatives you're looking at there, do they have a similar 30-year maturity, or would they be higher yield but shorter maturity than what you'd get with a 30 year? Okay, just one-
Price across the curve. I think one thing, Randy, I think you're isolating a small piece of investment, although very important to us and something we're focused on. You have to look at the overall construct of our portfolio as well. I think you won't see major shifts in our investment philosophy and how we run the portfolio, how we think about credit, how we incorporate private placements and other non-liquid assets in that mix. When you take all those things together, I think as Jack said it, we feel very good about how we've done it over the last 18 months. Even in the quarter, we invested a little bit early, as our investment team does. When they see the good yields out there, they capture them.
All those things come into play. We're not going to get into dissecting every investment we put behind a particular line of business, particularly or not in any particular quarter. I think those comments are good. The interest rate environment is challenging, we've mentioned that. Our team continues to outperform, and we'll keep you up to date every quarter on how we did.
Yeah. All right, great. Thanks.
We'll take our next question from Humphrey Lee with Dowling & Partners.
Good morning. Thank you for taking my questions. Jack, in your prepared remarks, you talk about the competitive landscape for the traditional line seems to be picking up a little bit. Can you go into a little detail in terms of what you're seeing in the traditional lines, then also if you can comment on the voluntary business as well, that would be helpful.
Yeah, Humphrey, I'll actually look for Mike to respond to that.
Thanks, and good morning, Humphrey. You would have heard us start talking about the new client acquisition pricing market in the group lines probably about three quarters ago. We started to see it get a little bit more aggressive, certainly we've seen this cycle many times before. We are not going to chase market share using price as a lever. So we have seen some pressure on new client sales. We can't really control the competitive pricing environment, so we stay very focused on what we can control, which is first and foremost to take care of our clients. Rick and Jack mentioned it before, but persistency is over 90%. Sales into these relationships were actually up 10% in the quarter and helped to drive an overall increase in sales. You put that together with persistency, and you've got really nice earned premium growth.
A big part of what we're bringing into those client relationships, as you highlighted, is the voluntary line of business, 14% growth in the quarter. Really over the last several years, it's been a consistent growth story for voluntary as more and more the employee is the decision maker. We see that in the Unum-branded business. We also see that in the really strong results coming out of Colonial Life.
You mentioned in terms of the aggressive pricing, is it a factor of you guys raising prices for the interest rate or people actually lowering their pricing to get share?
Yeah, Humphrey, I'll give you the wholly unsatisfactory answer of a little bit of both. We have put low to mid single digit increases, particularly on the long-term disability, but on the other group lines as well, into our new business pricing every six months or so over the last two years. That's been gradual, and our sales and client management teams have done a great job in taking that into the market. We would certainly then anticipate, given low rates, that the competitive environment would need to follow suit. We haven't seen that happen. In fact, we've seen a few carriers come back a bit more aggressively into the market and try to recapture some share they've lost over the last few years. The combination of the two, I think, is what's putting some pressure on new client sales.
Again, the aggregate, when you put it together, is actually consistent top-line growth, which we're pleased about.
Okay, got it. Then another question on long-term care. Florida recently announced they're going to do another public hearing for long-term care rate increase, seems to be following Pennsylvania's footstep. Do you expect more of these kind of hearings from regulators as they try to strike a balance between protecting consumers and keeping the LTC business viable? How does these kind of hearings affect some of your rate increase decision going forward?
In general, these hearings have been positive for rate increases. I know Pennsylvania held the hearing. They approved the rate increase shortly thereafter. There was a successful hearing in Massachusetts. Maine actually held a hearing, was one of the first. We're happy to attend those hearings. We're really engaged in them. We have a very good story about where our block is, the reasons we're pursuing rate increases, the justification for them. I think the fact that we're not trying to restore original pricing profitability into the block, that we're pursuing a sustainability strategy resonates well. The landing spot option that gives people an option to maintain their current premium level while continuing to maintain extremely valuable benefits resonates well. We're encouraged by the hearings, we think it's a catalyst for action.
Okay. Thank you.
Thanks, Humphrey.
We'll go next to Seth Weiss with Bank of America.
Hey, Seth.
Hi, good morning, and thanks for taking the question. Jack, I wanted to follow up on the commentary on the LTD discount rate. You mentioned in your prepared remarks you remain satisfied with the margin at this time. Can you just remind us where that is at this point?
Yeah. We haven't typically disclosed that margin, but it's in the upper end of that 60 to 90 range.
Okay, great. You mentioned it's too early to make a decision. Typically, when do you think about making those decisions? Is it kind of going into that December outlook call? Is that when we should think about perhaps an update on that?
Yeah. We do our reserve review. We start it in the third quarter, and it culminates in the fourth quarter, so that would be typical.
Maybe actually, Seth, it's helpful to step back too. The discount rate's a fair discussion, Mike, maybe you want to talk a little bit about how the block is performing overall, inclusive of anything we may look at on that front.
Yeah. Thanks, Rick. I appreciate it. Seth, thanks for the question. I think we look at the discount rate on new claims incurred for LTD, we look at it in the context of the overall health of the business as well. We continue to see good, strong, and favorable paid incidence trends, both in terms of count and severity. Very importantly, the recovery experience, our benefits team, the clinical in-voc resources, we continue to invest there and to good effect. Recovery trends have been very good as well. There is no crystal ball. It is a risk-taking business. As we look forward, we feel very good about those fundamentals, and that even if we need to make an adjustment on that new claim incurred discount rate, that it wouldn't have a material impact on the earnings trajectory for that group disability business.
Okay. I just want to make sure I'm interpreting that correctly. Is that similar to saying that as underlying experience and underwriting is improving, you're willing to maybe move a little bit lower in that range to the upper part of that range in terms of the margin on the discount rate?
No, I think more the thing, we've been continuing to place rate increases. We've had favorable underwriting results. I think more of what we're saying is, if you look at the trend we entered the year on, the experience that's emerged underlying that block would keep us on that same trend even after taking a discount rate charge.
I see. Thanks very much.
Sure thing.
We'll go next to Thomas Gallagher with Evercore ISI.
Hey, good morning. I wanted to start it off just on the long-term care claims side. The higher claims that you're seeing following the rate increases, I guess you've seen that before. The expectation here is that you expect it to be a temporary blip. My question related to it is, aren't you coming back though, and you've been coming back at least every couple of years on these rate increase filings? Shouldn't we expect if that's in fact the cause and effect here on higher claims when you file for rate increases, shouldn't we think about that as more of a recurring issue if you keep coming back for future rate increases?
Yeah. First of all, I don't think future rate increases is a forever thing. We've kept on kind of coming back because the interest rate environment has deteriorated. You get more recent experience, not only within Unum, but industry tables and things. This isn't a always get worse forever thing. I expect we'll get very close in the current filing to being where we need to be to support the sustainability of the business. There may be some rate increase filings in the future. Those would be predicated on changes in our view of what the future of long-term care will be. I don't see rate increases being a forever in our future thing. You do get a mild blip in rate increases when you do them. That's what we're seeing now, but we believe it's temporary.
We actually, I think, we are much more confident in where we are in long-term care and our ability to manage through, not only the short-term with our current reserve position, but manage through long-term care in general, than I think others are.
Jack, just related to that, are you then, in terms of the level, I don't know, maybe just a broad question, the level of rate that you're asking for, are you actually getting around what you're requesting? It sort of sounds like you are based on the way you responded to it, because I guess what I've heard from some others is that they might request 50% and they might get half of that, but then it's spread out over three years. Is my example still more the situation for you, or are you getting much closer to what you're requesting in terms of rate increase?
We're getting what we expect to get, which is less than we request. We didn't put what we requested into our reserve assumptions. We put our expectations. In some states you'll get 50%, in some states it'll be spread out over three years. In the scheme of things, that's not terribly material if it's spread out over three years, given the 40 years that the rest of it's going to run. It depends by state. In many states have approved the full rate increase. Other states have approved the full rate increase, but required it to be implemented over three years. We have good data on how different states react, and we've built that data into what we're assuming in our reserve assumptions.
Okay. That's helpful. As you think about, can you just remind us your process for this year, both timing. Is the actuarial review for long-term care, is that conducted in 3Q? As part of your process, do you factor forward interest rates? Do you look at the forward curve, or do you look at trailing? Because obviously forward rates matter a lot more than what you've accomplished in the last six quarter. Based on, I guess the claims you've gotten to date, how much does that factor in or is that less impactful? Is it really more of an interest rate issue at this point?
We do our reserve reviews, not only on long-term care but across the board. All of our reserve reviews in the company, we start those in the third quarter. They come to conclusion in the fourth quarter, so that we're confident in our year-end results. That would be the same timing for long-term care. In terms of what we look at going forward for the assumption underlying long-term care, we told you exactly what it was last time. It was 5% for four to five years in a reversion to the long-term mean thereafter. When we test, we'll come up with a reasonable assumption that we believe in and that it's audited by external auditors. It's not necessarily the forward curve, but it's a reasonable assumption.
My final question is, one of the things that surprised me a little bit was the increase in financial leverage. Pro forma, the debt pay down that you expect in 3Q, you're going to be at a 27% debt to cap. What surprised me a little bit is there haven't really been much in the way of extraordinary needs. You've done a few small acquisitions, but nothing too big. Why has the leverage gone up? It also sort of stands out when you had just had a great statutory earnings quarter where the cash generation looked pretty good. Why the increased financial leverage? Is there a need for cash more or what's happening?
First of all, we feel very comfortable with where we are at 27%. It's a comfortable place. We have great coverage ratios. We don't view 27% as being problematic. With that said, we did pre-fund the debt maturity in September. When we announced the Starmount acquisition, we talked about funding a portion of that and debt. When we looked at our capital plans and where our leverage would end up, it made sense to make that a little bit bigger. Debt issuance, given the rates at the time and where things were, and given what we thought our equity growth would be through 2017. We're very comfortable where we are. We expect it to come down over the ensuing few quarters, but there's nothing remarkable about it.
No issues with the rating agencies with the-
None whatsoever
the higher level. Sorry, last question, if I could sneak it in. Do you guys expect to contribute to the long-term care captive at all this year in terms of Fairwind or the N.Y. sub as well? If so, what size should we expect in terms of capital contributions?
Yeah. We would expect to contribute to the N.Y. sub. Our guidance on that has always been look at the levels that we've historically contributed at as guidance. We will keep the sub well capitalized. That's our commitment. We'll see how much capital that requires when we get to year-end.
How about the captive?
I just talked about the captive. Yeah.
Oh, that's a TBD?
Yeah, we'll see what it requires at year-end.
I think the key thing, Tom, is our capital plans remain very much intact, and so how things move around between different entities is kind of a moot point. We feel very good about our capital plans, where they are, how we've talked about them going all the way back to last year-end, and you'll see us execute on those.
All of those are built into our expectations, and the underlying free cash flow generation has actually exceeded our expectations.
Okay. Thanks, guys.
Thanks, Tom. Bye.
We'll go next to Michael Kovac with Goldman Sachs.
Great. Good morning. Thanks for taking the question. Could you help us think about maybe some of the potential knock-on effects in the U.K. from the Brexit? I know you mentioned clearly an FX headwind and potentially some premium and net investment income. As your team kind of works through the last month, in terms of what you're seeing from future sales and also thinking about as well, potential impact on the benefit ratio on the disability line in particular, if the U.K. does enter some sort of recession, thinking about that within the context of other GDP slowdowns that you've seen either in the U.S. block or in the U.K. historically.
Okay, Mike, well, it sounds like a full analysis of our U.K. business. I'd step back one thing and make sure that investors, analysts remember this is about 10% of our company. We very much like our U.K. business. It's a fantastic business, but relative to the enterprise, it is 10%. With that, maybe I'll turn it over to Peter to just give a quick overview of Brexit and how it's impacting us.
Thanks, Rick, and thanks, Michael, for the question. Just to take you back, we decided to vote for exit late June, the immediate impact was quite volatile. We saw equities drop, both for the FTSE 100 and the FTSE 250. They've pretty much come back now to where they were pre-Brexit. We did see the risk-free rate drop as well. That hasn't come back yet, obviously the thing you're seeing in our results is the exchange rate dropping to around about $1.32. I think one of the things that if it stays there, you will see is continued pressure because our average exchange rate we're using at the moment is right in the 1.40s. That would come down if it sticks at 1.32.
What I would say, it's an uncertain environment, it's moved from remainers, leavers to now we're waiters to see what's going to happen to the economy. Looking to the U.K., if you take our investment portfolio, Jack's talked about this already. We're very well-positioned, defensively positioned to financial stocks and feel very good about the investment portfolio and the robustness of that. If you take revenue, we have got exposure to particularly some of the big financial services firms. In talking to them, though, very few have definitive plans about what they're going to do yet. Again, they're more cautious, I would say, we saw a bit of that come through our premiums in the first half. Therefore, they're not investing in recruiting people.
Perhaps they're taking it, have more of an eye for cost control on their benefits plans, nothing material, I would say, yet coming through that would affect us. I'll answer your question on benefits. Actually, in the last recession, we didn't see a lot of impact on our benefit ratio. We saw something called presenteeism, people worried about their jobs and actually not going off ill. That was a bit of a countercyclical aspect for us. Our business model remains very robust, so we're pretty happy that we've got a good focus on the risks we raise and what the impacts of that might be. The area that is more difficult to call is the new money rates. As I said, the risk-free dropped. Clearly, the 10-year bond is below 1% for the U.K.
Again, like the U.S., we've got a proven track record of putting rate through. Clearly, that will probably dampen growth a bit because not all our competitors are as disciplined as Unum is, both in the U.S. and the U.K., but we'll have to see how that works out. Really, as we go through the next few months and the government begins to set out its position, we'll get a clearer picture and be able to update you on the impacts as that becomes more clear. I'd just finish that we've got a strong business model that's well-positioned to manage Brexit. That was all I was going to say, Rick.
That was great. Thanks, Peter.
Great. Very helpful. Are those changes, particularly the FX, and investment income impact in the forward EPS guidance that you gave for the second half of the year?
Jack?
We understood when we gave that guidance that that was an impact. Yes.
I'd say yes.
Yeah. Great. Thanks. One last one. In terms of sort of shifting gears to the U.S. as you think about growth, can you maybe give us a little bit more detail in terms of what is driving the large case market success that we've seen for the past couple of quarters? Is it mostly with current customers, or are you winning share with some new customers?
Yeah, great question. I appreciate it. You hit the nail on the head. It's almost entirely selling into those existing client relationships. We talked about an aggregate persistency rate of about 90%. We're actually a tick or two higher than that in our large employer market. These are long-term clients that we've been able to grow within quite effectively, cross-selling, re-enrolling, contract changes, and the like. We're encouraged about that. This is also selling season for the large employer market. Many of them make changes to their benefit plans with a January 1st effective date, and to be implemented, those decisions need to be happening now, and we feel like we're competing effectively by maintaining our discipline here through the new case sales season.
Are you seeing any Sorry, go ahead.
Go ahead.
Are you seeing any divergence in terms of the competitive landscape between the large case and maybe the core sort of middle to small case market?
Yeah, I'd say across the board, it's reasonably competitive. Where we feel it most acutely would be in the middle market. That's typically employers in the, say, 250 employees up to, say, 5,000. Typically, you've got competitors in the space that focus in the large case, but they will go down into the mid, and then you have small employer-focused carriers that will go elephant hunting, and that takes them up into the mid. Pretty much that can get a crowded space. When prices get a little bit soft, we find it's a difficult place to write business within our pricing parameters. Again, it's a
Much work to be done between now and the end of the year, and we feel like we've got a good value proposition to take into the market. That's where we probably felt it most acutely.
Thank you, Michael.
Thanks.
We'll take our next question from Yaron Kinar with Deutsche Bank.
Good morning, everybody. I have a couple of questions. First, I heard you talk about the claims impact from raising pricing in long-term care. Can you explain the relation between the two?
Yeah. It's been something we've seen, and it's kind of like waking a sleeping dog when they get the rate notice. It's not only the policyholder, but it's very often the caregivers or children of the policyholder. Oftentimes, an old person can go into an assisted living facility and not even realize that they have the coverage, even though they're still paying for it. That rate increase comes out as a reminder, and that reminder sparks people to apply for the benefits. You get some late applications with that, people who have been in a facility for a while, who are looking for back payments. That affects the loss ratio. It just becomes an increase.
We actually looked over the past couple of quarters at the incidence rate on people who've received the notification versus the incidence rates on people who will be receiving them but haven't received them yet. There's a 10%-15% difference between those two, with the ones being notified being 10%-15% higher. It impacts severity of claims as well because that landing spot notification is focused on people with inflation riders. They tend to have higher benefits. We've seen it in the past. It's going to last for a while as we work through those rate increases, we do believe it's something that will abate over time.
Okay. I guess, when speaking to others, I often hear them discuss shock lapse once the rate increases come in. In the grand scheme of things, are you seeing more of a favorable impact from shock lapse or more of a negative impact from kind of waking these sleeping dogs?
I think shock lapse is relative. If the lapse rate goes up 0.1% or 0.2%, it's big relative to the lapse rate, I'm not sure I'd call it a shock lapse. We really don't see a ton of lapses with rate increases, maybe a little blip. In particular, because the landing spot provides the option to maintain their current premium, we would expect to see even a less of a persistency impact from these rate increases.
Okay. One quick clarification if I can, with regards to the updated guidance. I think you talked about it in the prepared comments, is the move up to the top end of the prior guidance, is that pretty much predicated on better than expected results in the first half of the year? Or is there also some expectation that relative to how you had thought of the year developing when you gave the initial guidance, is there some expectation that the second half results will be better than initially expected?
Yeah. We've assumed that the second half of the results will be on plan.
Okay.
Which is very consistent with your consensus estimates.
Okay. Thank you very much.
Thanks, Yaron.
We'll take our next question from Eric Berg with RBC Capital Markets.
Morning, Eric.
Mr. Berg, your line is open.
Yep, I'm ready. Sorry, I was on mute. I was surprised to hear that in response to an earlier question, that in the last recession in the U.K., there had not been a material increase in claims experience, because that would be at odds with the U.S. experience. Did I sort of hear you and interpret Peter's response correctly? If I did, what was different back then that would explain this difference from U.S. experience?
Yeah. Eric, maybe I'll take that from a U.S. perspective first. We actually did not see the increased level of claims coming through some of the financial crisis. What we would've seen maybe is a higher level of submitted, but our paid claims were very stable through that period of time. I don't actually think there was a difference. I think the U.K.'s experience was actually quite similar to that which we saw in the U.S.
Okay. Secondly, finally, in the long-term care area, Jack, I think you mentioned in your prepared remarks that the decision by many customers, many policyholders, to accept this landing spot option would have implications for either the volatility of or the rate of build of reserves prospectively. Could you just go over that concept and maybe explain it a little bit further? Thank you.
Yeah. If you pay the rate increase, your benefits continue to grow at 5% compound annual rate. Those who pay the rate increase have a bigger bucket out there, and that additional premium pays for that benefit bucket. If you take the landing spot, they compound at 3%, the ultimate benefits that you pay down the road are significantly smaller than they would have been had you paid the premium. As you realize fluctuations, whether it's interest rate fluctuations or underlying experience fluctuations, they don't affect premiums. They affect the benefits much more severely. By having a smaller pool out there, you're less sensitive to interest rates or mortality fluctuations.
You also have lower premiums than would otherwise have been the case.
Yeah.
Right?
They're not as sensitive to those things, A, as the benefits are. If you're going to have higher incidents down the road, premiums don't react to that. Benefits do.
To be sure. All right then. Thank you.
It's a little like de-risking a pension plan.
Go ahead.
It's a little like de-risking a pension plan.
In general, have you said that you have been neutral towards, agnostic towards the landing? Does the landing spot leave you better off than if a customer does not elect the landing spot, neutral or worse off?
It's relatively neutral, but you do get that benefit of being less sensitive to future changes in assumptions.
Thank you.
Yep. Thanks, Eric.
We'll go next to Mark Hughes with SunTrust.
Yeah. Colonial sales have been quite strong. I wonder if you have any commentary on recruiting and sales force trends, what that might mean for second half sales.
Great. Thanks, Mark. We're happy to take that as our last question. Flip it over to Tim Arnold.
Yep. Mark, thanks for the question. We feel great about the results that we're delivering. To your point about recruiting, we're seeing a very nice uptick in recruiting and probably more importantly, very strong growth in our sales management team. Those new recruits who are coming on are getting a lot of attention, and the success rate for those new recruits is improving. We like the market environment a lot right now. The market dynamics are very favorable. Employers increasingly need the solutions that we offer. Certainly, working Americans need the solutions that we offer. Feel very good about our strategy. Terrific execution of that strategy, especially in field distribution growth, very disciplined activity levels, incredible capabilities, including what we believe to be unparalleled enrollment capabilities. We do a lot of core enrollments.
For every dollar of Colonial Life benefits that we enroll, we enroll $10 of other benefits, which helps us with creating a very strong value prop for small employers, especially. A tremendous breadth and depth of our products, capabilities, and services. Finally, just an outstanding leadership team and strong talent throughout the organization. We feel very good. We had a very strong second half of the year in 2015, so we're up against some big numbers, but we're optimistic.
Thank you.
Great. Thank you, Mark, for that last question. I'd like to thank all of you as well for taking the time to join us this morning. We look forward to seeing many of you at various investor conferences and meetings in the weeks ahead. Operator, this now completes our second quarter 2016 earnings call.
Thank you, everyone. That does conclude today's conference. We thank you for your participation.