cigna10q9-07.htm

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

[x] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2007

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

for the transition period from _____ to _____

Commission file number 1-08323

CIGNA Corporation
(Exact name of registrant as specified in its charter)

Delaware
06-1059331
(State or other jurisdiction
(I.R.S. Employer
of incorporation or organization)
Identification No.)
 
Two Liberty Place, 1601 Chestnut Street
Philadelphia, Pennsylvania 19192
(Address of principal executive offices)      (Zip Code)

Registrant's telephone number, including area code (215) 761-1000

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x   No _

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):

Large Accelerated Filer x
Accelerated Filer __
Non-Accelerated Filer __

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes _   No x

           As of October 26, 2007, 279,163,023 shares of the issuer's common stock were outstanding.
 
 

 


CIGNA CORPORATION

INDEX


   
Page No.
PART I.
FINANCIAL INFORMATION
 
 
 
Item 1.   Consolidated Financial Statements
 
 
 
 
 
 
 
 
Item 2.   Management's Discussion and Analysis of Financial Condition and Results of Operations
 
 
Item 3.   Quantitative and Qualitative Disclosures About Market Risk
 
 
Item 4.   Controls and Procedures
     
PART II.
 
OTHER INFORMATION
 
 
Item 1.   Legal Proceedings
 
 
Item 1A. Risk Factors
 
 
Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds
 
 
Item 6.   Exhibits
 
SIGNATURE
 
EXHIBIT INDEX

As used herein, the Company refers to one or more of CIGNA Corporation and its consolidated subsidiaries.
 
 

 
                       
Consolidated Statements of Income
                       
   
Three Months Ended
   
Nine Months Ended
 
   
September 30,   
   
September 30,   
 
(In millions, except per share amounts)
 
2007
   
2006
   
2007
   
2006
 
Revenues
                       
Premiums and fees
  $
3,744
    $
3,433
    $
11,209
    $
10,070
 
Net investment income
   
281
     
296
     
840
     
924
 
Other revenues
   
361
     
360
     
1,082
     
1,150
 
Realized investment gains
   
27
     
48
     
37
     
198
 
   Total revenues
   
4,413
     
4,137
     
13,168
     
12,342
 
Benefits and Expenses
                               
Health Care medical claims expense
   
1,659
     
1,595
     
5,107
     
4,536
 
Other benefit expenses
   
837
     
743
     
2,507
     
2,356
 
Other operating expenses
   
1,415
     
1,353
     
4,311
     
4,068
 
   Total benefits and expenses
   
3,911
     
3,691
     
11,925
     
10,960
 
Income from Continuing Operations
                               
   before Income Taxes
   
502
     
446
     
1,243
     
1,382
 
Income taxes (benefits):
                               
Current
   
125
     
158
     
420
     
477
 
Deferred
   
14
      (14 )     (34 )     (22 )
   Total taxes
   
139
     
144
     
386
     
455
 
Income from Continuing Operations
   
363
     
302
     
857
     
927
 
Income (loss) from Discontinued Operations, Net of Taxes
   
2
      (4 )     (5 )     (4 )
Net Income
  $
365
    $
298
    $
852
    $
923
 
Earnings Per Share - Basic:
                               
   Income from continuing operations
  $
1.30
    $
0.94
    $
3.01
    $
2.71
 
   Income (loss) from discontinued operations
   
-
      (0.01 )     (0.02 )     (0.01 )
Net income
  $
1.30
    $
0.93
    $
2.99
    $
2.70
 
Earnings Per Share - Diluted:
                               
   Income from continuing operations
  $
1.28
    $
0.93
    $
2.95
    $
2.67
 
   Income (loss) from discontinued operations
   
-
      (0.01 )     (0.01 )     (0.01 )
Net income
  $
1.28
    $
0.92
    $
2.94
    $
2.66
 
Dividends Declared Per Share
  $
0.010
    $
0.008
    $
0.028
    $
0.025
 
                                 
The accompanying Notes to the Consolidated Financial Statements are an integral part of these statements.         
       
 
 
1

                       
Consolidated Balance Sheets
                       
(In millions, except per share amounts)
   
  As of
September 30, 
     
 As of
December 31, 
         
2007
         
2006
 
Assets
                       
Investments:
                       
   Fixed maturities, at fair value (amortized cost, $11,655; $11,202)
        $
12,234
          $
11,955
 
   Equity securities, at fair value (cost, $112; $112)
         
122
           
131
 
   Mortgage loans
         
3,292
           
3,988
 
   Policy loans
         
1,449
           
1,405
 
   Real estate
         
48
           
117
 
   Other long-term investments
         
527
           
418
 
   Short-term investments
         
21
           
89
 
      Total investments
         
17,693
           
18,103
 
Cash and cash equivalents
         
1,421
           
1,392
 
Accrued investment income
         
230
           
223
 
Premiums, accounts and notes receivable
         
1,603
           
1,459
 
Reinsurance recoverables
         
7,446
           
8,045
 
Deferred policy acquisition costs
         
787
           
707
 
Property and equipment
         
601
           
632
 
Deferred income taxes, net
         
942
           
926
 
Goodwill
         
1,774
           
1,736
 
Other assets, including other intangibles
         
524
           
611
 
Separate account assets
         
6,779
           
8,565
 
   Total assets
        $
39,800
          $
42,399
 
Liabilities
                           
Contractholder deposit funds
        $
8,754
          $
9,164
 
Future policy benefits
         
8,092
           
8,245
 
Unpaid claims and claim expenses
         
4,164
           
4,271
 
Health Care medical claims payable
         
1,011
           
960
 
Unearned premiums and fees
         
487
           
499
 
   Total insurance and contractholder liabilities
         
22,508
           
23,139
 
Accounts payable, accrued expenses and other liabilities
         
4,468
           
4,602
 
Short-term debt
         
-
           
382
 
Long-term debt
         
1,793
           
1,294
 
Nonrecourse obligations
         
16
           
87
 
Separate account liabilities
         
6,779
           
8,565
 
   Total liabilities
         
35,564
           
38,069
 
Contingencies — Note 15
                           
Shareholders’ Equity
                           
Common stock (par value per share, $0.25; shares issued, 351; 160)
         
88
           
40
 
Additional paid-in capital
         
2,465
           
2,451
 
Net unrealized appreciation, fixed maturities
  $
114
            $
187
         
Net unrealized appreciation, equity securities
   
7
             
22
         
Net unrealized depreciation, derivatives
    (26 )             (15 )        
Net translation of foreign currencies
   
56
             
33
         
Postretirement benefits liability adjustment
    (327 )             (396 )        
   Accumulated other comprehensive loss
            (176 )             (169 )
Retained earnings
           
6,865
             
6,177
 
Less treasury stock, at cost
            (5,006 )             (4,169 )
   Total shareholders’ equity
           
4,236
             
4,330
 
   Total liabilities and shareholders’ equity
          $
39,800
            $
42,399
 
Shareholders’ Equity Per Share
          $
15.17
            $
14.63
 
                                 
The accompanying Notes to the Consolidated Financial Statements are an integral part of these statements.
                 
 
2

 
                       
Consolidated Statements of Comprehensive Income and Changes in Shareholders’ Equity           
 
(In millions, except per share amounts)
                       
Three Months Ended September 30,
 
2007
   
2006
 
   
Compre-
   
Share-
   
Compre-
   
Share-
 
   
hensive
   
holders’
   
hensive
   
holders’
 
   
Income
   
Equity
   
Income
   
Equity
 
Common Stock, September 30
        $
88
          $
40
 
Additional Paid-In Capital, July 1
         
2,460
           
2,428
 
Effect of issuance of stock for employee benefit plans
         
5
           
12
 
Additional Paid-In Capital, September 30
         
2,465
           
2,440
 
Accumulated Other Comprehensive Loss, July 1
          (257 )           (682 )
Net unrealized appreciation, fixed maturities
  $
51
     
51
    $
152
     
152
 
Net unrealized appreciation (depreciation), equity securities
    (3 )     (3 )    
4
     
4
 
 Net unrealized appreciation on securities
   
48
             
156
         
Net unrealized appreciation (depreciation), derivatives
    (1 )     (1 )    
10
     
10
 
Net translation of foreign currencies
   
18
     
18
     
13
     
13
 
Postretirement benefits liability adjustment
   
16
     
16
     
-
     
-
 
 Other comprehensive income
   
81
             
179
         
Accumulated Other Comprehensive Loss, September 30
            (176 )             (503 )
Retained Earnings, July 1
           
6,513
             
5,686
 
Net income
   
365
     
365
     
298
     
298
 
Effects of issuance of stock for employee benefit plans
            (10 )             (7 )
Common dividends declared
            (3 )             (3 )
Retained Earnings, September 30
           
6,865
             
5,974
 
Treasury Stock, July 1
            (4,795 )             (2,778 )
Repurchase of common stock
            (236 )             (931 )
Other, primarily issuance of treasury stock for employee
                               
   benefit plans
           
25
             
15
 
Treasury Stock, September 30
            (5,006 )             (3,694 )
Total Comprehensive Income and Shareholders’ Equity
  $
446
    $
4,236
    $
477
    $
4,257
 
                                 
The accompanying Notes to the Consolidated Financial Statements are an integral part of these statements.             
     
 
 
3

 
                       
Consolidated Statements of Comprehensive Income and Changes in Shareholders’ Equity           
 
(In millions, except per share amounts)
                       
Nine Months Ended September 30,
 
2007
   
2006
 
   
Compre-
   
Share-
   
Compre-
   
Share-
 
   
hensive
   
holders’
   
hensive
   
holders’
 
   
Income
   
Equity
   
Income
   
Equity
 
Common Stock, January 1
        $
40
          $
40
 
Effect of issuance of stock for stock split
         
48
           
-
 
Common Stock, September 30
         
88
           
40
 
Additional Paid-In Capital, January 1
         
2,451
           
2,385
 
Effect of issuance of stock for employee benefit plans
         
62
           
55
 
Effect of issuance of stock for stock split
          (48 )          
-
 
Additional Paid-In Capital, September 30
         
2,465
           
2,440
 
Accumulated Other Comprehensive Loss, January 1
                           
   prior to implementation effect
          (169 )           (509 )
Implementation effect of SFAS No.155 (see Note 2)
          (12 )          
-
 
Accumulated Other Comprehensive Loss,
                           
   January 1 as adjusted
          (181 )           (509 )
Net unrealized depreciation, fixed maturities
  $ (73 )     (73 )   $ (10 )     (10 )
Net unrealized depreciation, equity securities
    (3 )     (3 )     (1 )     (1 )
 Net unrealized depreciation on securities
    (76 )             (11 )        
Net unrealized appreciation (depreciation), derivatives
    (11 )     (11 )    
1
     
1
 
Net translation of foreign currencies
   
23
     
23
     
25
     
25
 
Postretirement benefits liability adjustment
   
69
     
69
     
-
     
-
 
Minimum pension liability
   
-
     
-
      (9 )     (9 )
 Other comprehensive income
   
5
             
6
         
Accumulated Other Comprehensive Loss, September 30
            (176 )             (503 )
Retained Earnings, January 1 prior to
                               
    implementation effects
           
6,177
             
5,162
 
Implementation effect of SFAS No. 155 (see Note 2)
           
12
             
-
 
Implementation effect of FIN 48 (see Note 2)
            (29 )            
-
 
Retained Earnings, January 1 as adjusted
           
6,160
             
5,162
 
Net income
   
852
     
852
     
923
     
923
 
Effects of issuance of stock for employee benefit plans
            (139 )             (102 )
Common dividends declared
            (8 )             (9 )
Retained Earnings, September 30
           
6,865
             
5,974
 
Treasury Stock, January 1
            (4,169 )             (1,718 )
Repurchase of common stock
            (1,158 )             (2,226 )
Other, primarily issuance of treasury stock for employee
                               
   benefit plans
           
321
             
250
 
Treasury Stock, September 30
            (5,006 )             (3,694 )
Total Comprehensive Income and Shareholders’ Equity
  $
857
    $
4,236
    $
929
    $
4,257
 
                                 
The accompanying Notes to the Consolidated Financial Statements are an integral part of these statements.               
 
 
 
4

 
           
Consolidated Statements of Cash Flows
           
(In millions)
 
Nine Months Ended September 30,
 
   
2007
   
2006
 
Cash Flows from Operating Activities
           
Net income
  $
852
    $
923
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
       Loss from discontinued operations
   
5
     
4
 
       Insurance liabilities
   
17
      (283 )
       Reinsurance recoverables
   
59
     
81
 
       Deferred policy acquisition costs
    (79 )     (45 )
       Premiums, accounts and notes receivable
    (120 )    
98
 
       Other assets
    (125 )     (17 )
       Accounts payable, accrued expenses and other liabilities
   
76
      (236 )
   Current income taxes
   
54
     
214
 
       Deferred income taxes
    (34 )     (22 )
       Realized investment gains
    (37 )     (198 )
       Depreciation and amortization
   
147
     
155
 
       Gains on sales of businesses (excluding discontinued operations)
    (36 )     (48 )
       Mortgage loans originated and held for sale
    (5 )     (315 )
       Proceeds from sales of mortgage loans held for sale
   
1
     
99
 
       Other, net
    (9 )     (30 )
          Net cash provided by operating activities
   
766
     
380
 
Cash Flows from Investing Activities
               
Proceeds from investments sold:
               
       Fixed maturities
   
657
     
2,591
 
       Equity securities
   
25
     
18
 
       Mortgage loans
   
1,219
     
363
 
       Other (primarily short-term and other long-term investments)
   
166
     
1,133
 
Investment maturities and repayments:
               
       Fixed maturities
   
662
     
677
 
       Mortgage loans
   
96
     
291
 
Investments purchased:
               
       Fixed maturities
    (1,711 )     (2,172 )
       Equity securities
    (13 )     (42 )
       Mortgage loans
    (608 )     (908 )
       Other (primarily short-term and other long-term investments)
    (311 )     (515 )
Property and equipment sales
   
74
     
1
 
Property and equipment purchases
    (183 )     (94 )
Cash provided by investing activities of discontinued operations
   
65
     
32
 
Other acquisitions/dispositions, net cash used
    (40 )     (18 )
Conversion of single premium annuity business
   
-
      (45 )
Other, net
    (5 )    
-
 
          Net cash provided by investing activities
   
93
     
1,312
 
Cash Flows from Financing Activities
               
Deposits and interest credited to contractholder deposit funds
   
370
     
396
 
Withdrawals and benefit payments from contractholder deposit funds
    (397 )     (512 )
Change in cash overdraft position
   
36
     
12
 
Net proceeds on issuance of long-term debt
   
498
     
-
 
Repayment of long-term debt
    (378 )     (100 )
Repurchase of common stock
    (1,185 )     (2,181 )
Issuance of common stock
   
231
     
197
 
Common dividends paid
    (8 )     (9 )
          Net cash used in financing activities
    (833 )     (2,197 )
Effect of foreign currency rate changes on cash and cash equivalents
   
3
     
4
 
Net increase (decrease) in cash and cash equivalents
   
29
      (501 )
Cash and cash equivalents, beginning of period
   
1,392
     
1,709
 
Cash and cash equivalents, end of period
  $
1,421
    $
1,208
 
Supplemental Disclosure of Cash Information:
               
     Income taxes paid, net of refunds
  $
327
    $
232
 
     Interest paid
  $
83
    $
72
 
                 
The accompanying Notes to the Consolidated Financial Statements are an integral part of these statements.   
         
 
5


 
CIGNA CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 – BASIS OF PRESENTATION

The consolidated financial statements include the accounts of CIGNA Corporation, its significant subsidiaries, and variable interest entities of which CIGNA is the primary beneficiary, which are referred to collectively as “the Company.”  Intercompany transactions and accounts have been eliminated in consolidation.  These consolidated financial statements were prepared in conformity with accounting principles generally accepted in the United States of America (GAAP).

The interim consolidated financial statements are unaudited but include all adjustments (including normal recurring adjustments) necessary, in the opinion of management, for a fair statement of financial position and results of operations for the periods reported.  The interim consolidated financial statements and notes should be read in conjunction with the Consolidated Financial Statements and Notes in the Company’s Annual Report to Shareholders and Form 10-K for the year ended December 31, 2006.

The preparation of interim consolidated financial statements necessarily relies heavily on estimates.  This and certain other factors, such as the seasonal nature of portions of the health care and related benefits business as well as competitive and other market conditions, call for caution in estimating full year results based on interim results of operations.

All weighted average shares, per share amounts and references to stock compensation for all periods presented have been adjusted to reflect the three-for-one stock split effective June 4, 2007 (see Note 4).  Par value and treasury stock were not affected by the stock split and, as a result, the Company reclassified $48 million from additional paid-in capital to common stock to reflect the issuance of approximately 191 million in additional shares at par value.  

Beginning in 2007, the Company reports the results of the run-off retirement business in Other Operations.  Prior periods have been restated to conform to this presentation.

Discontinued operations.  Summarized financial data for discontinued operations primarily represents:

·  
a tax benefit recognized in the third quarter of 2007 associated with the disposition of Lovelace Health Systems, Inc. in 2003 as discussed in Note 12;
·  
an impairment loss recorded in the second quarter of 2007 associated with the sale of the Chilean insurance operations as discussed in Note 3;
·  
realized gains on the disposition of certain directly-owned real estate investments during the nine months ended September 30, 2007 and the third quarter of 2006 as discussed in Note 9; and
·  
an impairment loss recorded in the third quarter of 2006 associated with the probable sale of the Brazilian life insurance operations as discussed in Note 3.
 
             
   
Three Months
   
Nine Months
 
   
Ended   
   
Ended   
 
   
September 30,
   
September 30,
 
(In millions)
 
2007
   
2006
   
2007
   
2006
 
                         
Income before income taxes
  $
-
    $
19
    $
25
    $
19
 
Income (taxes) benefits
   
2
      (7 )     (7 )     (7 )
Income from operations
   
2
     
12
     
18
     
12
 
Impairment losses, net of tax
   
-
      (16 )     (23 )     (16 )
Income (loss) from discontinued
                         
   operations, net of tax
  $
2
    $ (4 )   $ (5 )   $ (4 )
 
Unless otherwise indicated, amounts in these Notes exclude the effects of discontinued operations.

Variable interest entities.  During the first and second quarters of 2007, certain real estate joint ventures and the remaining entity that issues investment products liquidated their primary assets and liabilities.  As a result, as of September 30, 2007, the Company consolidated $5 million in assets and $5 million in liabilities as the primary beneficiary of one real estate joint venture and no longer consolidates any assets or liabilities related to collateralized loan obligations (CLO).  As of December 31, 2006, the Company consolidated $57 million in assets and $47 million in liabilities related to real estate joint ventures, and $55 million
 
 
6

in assets and $26 million in liabilities related to CLO’s.

NOTE 2 – RECENT ACCOUNTING PRONOUNCEMENTS

Uncertain tax positions.  Effective January 1, 2007, the Company implemented Financial Accounting Standards Board (FASB) Interpretation No. (FIN) 48, "Accounting for Uncertainty in Income Taxes." This interpretation provides guidance for recognizing and measuring uncertain tax positions that are "more likely than not" to result in a benefit if challenged by the Internal Revenue Service (IRS).  The guidance clarifies that the amount of tax benefit recognized should be measured using management's best estimate based on the most favorable expected benefit with greater than fifty percent likelihood of being realized.  The interpretation also requires that interest expense and penalties be recognized for any reserved portion of an uncertain tax position beginning when the effect of that position is reported to tax authorities. The cumulative effect of implementing the interpretation for unrecognized tax benefits decreased opening retained earnings by $29 million.  See Note 12 for additional information.

Certain financial instruments.   Effective January 1, 2007, the Company implemented Statement of Financial Accounting Standards (SFAS) No. 155, "Accounting for Certain Hybrid Financial Instruments," an amendment of FASB Statements No. 133 and 140. This standard clarifies when certain financial instruments and features of financial instruments must be treated as derivatives and reported on the balance sheet at fair value with changes in fair value reported in net income. At adoption, the Company elected to fair value certain existing investments in preferred stock and debt securities with call or conversion features (hybrid securities) and future changes in the fair value of these investments will be reported in net income. As a result, the Company reclassified $12 million after-tax of unrealized appreciation from the opening balance of accumulated other comprehensive loss to retained earnings with no net change to total shareholders' equity. In addition, this standard may affect future income recognition for certain future financial instruments if the fair value election is used or if additional derivatives are identified because any changes in their fair values will be recognized in net income each period. See Note 9 for a review of instruments that the Company has elected to fair value.

Deferred acquisition costs.  Effective January 1, 2007, the Company implemented the American Institute of Certified Public Accountants’ (AICPA) Statement of Position (SOP) 05-1, "Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts."  The SOP requires that deferred acquisition costs be expensed in full when the original contract is substantially changed by election or amendment of an existing contract feature or by replacement with a new contract.  There were no material effects to the consolidated financial statements at implementation.  Although substantial contract changes are not expected to occur, the effect of this SOP in future periods may vary based on the nature and volume of any such contract changes.

Pension and other postretirement benefit plans.  In 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Benefits Plans," requiring that the overfunded or underfunded status of all defined benefit postretirement plans be measured as the difference between the fair value of plan assets and the benefit obligation and recognized in the balance sheet.  Changes in actuarial gains and losses and prior service costs are required to be recognized in accumulated other comprehensive income (loss), net of tax, each period.  The Company implemented this standard effective December 31, 2006.  Liabilities for pension benefits and other postretirement benefits are recorded in accounts payable, accrued expenses and other liabilities on the Company’s balance sheet.  The implementation of SFAS No. 158 did not impact the Company's pension expense, funding requirements or financial covenants.  See Note 8 for further information on pension and other postretirement benefit plans.
 
Fair value measurements. In 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," to expand disclosures about fair value measurements and to clarify how to measure fair value by focusing on the price that would be received when selling an asset or paid to transfer a liability (exit price).    Implementation is required in the first quarter of 2008 with any changes to the fair values of assets or liabilities to be reported generally in net income.  For fixed maturities and equity securities held for sale and derivatives that hedge future cash flows, changes in fair value will be reported in
 
7

accumulated other comprehensive income (loss) for the period.  Although the Company’s evaluation of these new requirements continues, estimates of the fair values of the assets and liabilities for reinsurance contracts covering guaranteed minimum income benefits under certain variable annuity contracts issued by other insurance companies, including related retrocessional contracts from third parties, will be impacted by these new requirements.
 
The assumptions used to estimate the fair value of these contracts will be determined using a market-based view of an exit price rather than using historical market data and actual experience to establish the Company’s future expectations.  These assumptions include market returns and volatilities of the underlying equity and bond mutual fund investments, interest rates, mortality, lapse and annuity election rates, retrocessional credit, and risk and profit charges. For many of these assumptions, there is limited or no observable market data so determining an exit price under SFAS No. 157 requires significant judgment. Based on current market conditions, changes in these assumptions are expected to have an adverse impact on the Run-off Reinsurance segment and the Company’s results of operations at implementation, which may be material. However, the impact on the Company’s financial condition at implementation is not expected to be material.  In addition, the Company’s results of operations related to this business are likely to be more volatile in future years as changes in the fair values of these assets and liabilities are recognized in net income each period.  The actual effect on the Company’s results of operations and financial condition will also depend on the market values of the underlying equity and bond mutual fund investments and interest rate levels at implementation.  The Company continues to evaluate these new requirements to determine whether their implementation will result in material changes to the fair value measurements of its assets and liabilities other than for reinsurance contracts covering guaranteed minimum income benefits under certain variable annuity contracts issued by other insurance companies, including related retrocessional contracts from third parties.
 
Fair value option.  In 2007, the FASB issued SFAS No. 159, "The Fair Value Option for Financial Assets and Financial Liabilities," which permits entities to choose fair value measurement of many financial instruments with subsequent changes in fair value to be reported in net income for the period. This choice is made for each individual financial instrument, is irrevocable and, after implementation, must be determined when the entity first commits to or recognizes the financial instrument.  Implementation is required in the first quarter of 2008 with any changes in the measurement of existing financial instruments to be reported as an adjustment to the opening balance of retained earnings.  The Company is presently evaluating these new requirements to determine whether the fair value election will be used for various financial assets and liabilities at implementation or for financial assets and liabilities acquired subsequently.
 
Investment company audit guide. In 2007, the AICPA issued SOP 07-1, "Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies" to explain when an entity should account for assets and liabilities at fair value with changes in fair value included in net income each period. The SOP also addresses when companies should retain this fair value accounting in their consolidated financial statements.  Although implementation is currently required as of January 1, 2008, the FASB has proposed an indefinite delay.  Changes in measurement for entities that are newly subject to fair value accounting will be reflected as an adjustment to the opening balance of retained earnings. Entities that should discontinue fair value accounting will be required to account for their investments under other applicable GAAP on a prospective basis. The Company is presently evaluating these new requirements to determine whether any changes to current accounting will result at implementation.
 
 
8

 
NOTE 3 – ACQUISITIONS AND DISPOSITIONS

The Company may from time to time acquire or dispose of assets, subsidiaries or lines of business.  Significant transactions are described below.

Sagamore Health Network Acquisition. Effective August 1, 2007, the Company acquired Sagamore Health Network, Inc.  Sagamore is a preferred provider rental network with claims re-pricing, medical management, and utilization management capabilities.  It provides access to a preferred provider network consisting of 9,400 primary care physicians, 26,600 specialists, 1,100 ancillary providers, and 210 hospitals.  Sagamore serves health claims payer organizations, self-insured employers and third-party administrators primarily in Indiana.  Sagamore writes no direct health coverage. The results of Sagamore are included in the accompanying consolidated financial statements from the date of the acquisition.

Star-HRG Acquisition.  On July 11, 2006, the Company acquired the operating assets of Star-HRG, a leading provider of low cost health plans and other employee benefits coverage for hourly and part-time workers and their families, for $156 million, including assumed liabilities.  The acquisition was accounted for as a purchase, and was financed through the issuance of a note payable to the seller for $151 million, of which $73 million was paid in 2006.  The results of Star-HRG are included in the accompanying consolidated financial statements from the date of the acquisition.

Sale of the Chilean Insurance Operations.  On August 10, 2007, the Company completed the sale of its Chilean insurance operations, which was classified as a discontinued operation in the second quarter of 2007.  The Company recognized an impairment loss in the second quarter of 2007 for this business of $23 million after-tax primarily relating to the write-off of unrecoverable tax assets and foreign currency translation losses.  As of December 31, 2006, the assets and liabilities of the Chilean insurance operations, which were held for sale, were reported in other assets and accounts payable, accrued expenses and other liabilities.

Sale of the Brazilian Life Insurance Operations.  During 2006, the Company entered into negotiations to sell its Brazilian life insurance business and classified this business as discontinued operations.  The Company recognized in the third quarter of 2006 an impairment loss with respect to this business of $16 million after-tax, primarily related to the write-off of unrecoverable foreign tax credits and foreign currency translation losses. The sale, which is subject to regulatory approvals, is expected to close by the end of 2007.

NOTE 4 – EARNINGS PER SHARE

On April 25, 2007, the Company's Board of Directors approved a three-for-one stock split (in the form of a stock dividend) of the Company's common shares.  The stock split was effective on June 4, 2007 for shareholders of record as of the close of business on May 21, 2007.  All weighted average shares, per share amounts and references to stock compensation data for all periods presented have been adjusted to reflect the effect of the stock split.
 
 
9

Basic and diluted earnings per share were computed as follows:
                   
(Dollars in millions, except
       
Effect of
       
   per share amounts)
 
Basic
   
Dilution
   
Diluted
 
Three Months Ended September 30,
             
2007
                 
Income from continuing
                 
  operations
  $
363
     
-
    $
363
 
Shares (in thousands):
                       
Weighted average
   
279,883
     
-
     
279,883
 
Options and restricted stock grants
     
4,579
     
4,579
 
Total shares
   
279,883
     
4,579
     
284,462
 
EPS
  $
1.30
    $ (0.02 )   $
1.28
 
2006
                       
Income from continuing
                       
  operations
  $
302
     
-
    $
302
 
Shares (in thousands):
                       
Weighted average
   
319,743
     
-
     
319,743
 
Options and restricted stock grants
     
4,961
     
4,961
 
Total shares
   
319,743
     
4,961
     
324,704
 
EPS
  $
0.94
    $ (0.01 )   $
0.93
 
Nine Months Ended September 30,
                 
2007
                       
Income from continuing
                       
  operations
  $
857
     
-
    $
857
 
Shares (in thousands):
                       
Weighted average
   
284,917
     
-
     
284,917
 
Options and restricted stock grants
     
5,316
     
5,316
 
Total shares
   
284,917
     
5,316
     
290,233
 
EPS
  $
3.01
    $ (0.06 )   $
2.95
 
2006
                       
Income from continuing
                       
  operations
  $
927
     
-
    $
927
 
Shares (in thousands):
                       
Weighted average
   
341,789
     
-
     
341,789
 
Options and restricted stock grants
     
5,788
     
5,788
 
Total shares
   
341,789
     
5,788
     
347,577
 
EPS
  $
2.71
    $ (0.04 )   $
2.67
 

The following outstanding employee stock options were not included in the computation of diluted earnings per share because their effect would have increased diluted earnings per share (antidilutive) as their exercise price was greater than the average share price of the Company's common stock for the period.
     
 
Three Months
Nine Months
 
Ended 
Ended 
 
September 30,
September 30,
(In millions)
2007
2006
2007
2006
Antidilutive options
1.6
5.4
1.6
4.5
 
The Company held 71,788,175 shares of common stock in Treasury as of September 30, 2007, and 57,460,553 shares as of September 30, 2006.  Treasury shares were not affected by the stock split.

NOTE 5 – HEALTH CARE MEDICAL CLAIMS PAYABLE

Medical claims payable for the Health Care segment reflects estimates of the ultimate cost of claims that have been incurred but not yet reported, those which have been reported but not yet paid (reported claims in process) and other medical expense payable, which primarily comprises accruals for provider incentives and other amounts payable to providers. Incurred but not yet reported comprises the majority of the reserve balance as follows:
             
   
September 30,
   
December 31,
 
(In millions)
 
2007
   
2006
 
Incurred but not yet reported
  $
832
    $
820
 
Reported claims in process
   
133
     
95
 
Other medical expense payable
   
46
     
45
 
Medical claims payable
  $
1,011
    $
960
 
 
10

Activity in medical claims payable was as follows:
       
   
For the period ended
 
   
September 30,
   
December 31,
 
(In millions)
 
2007
   
2006
 
Balance at January 1,
  $
960
    $
1,165
 
Less: Reinsurance and other
         
   amounts recoverable
   
250
     
342
 
Balance at January 1, net
   
710
     
823
 
Incurred claims related to:
               
  Current year
   
5,189
     
6,284
 
  Prior years
    (82 )     (173 )
  Total incurred
   
5,107
     
6,111
 
Paid claims related to:
               
  Current year
   
4,471
     
5,615
 
  Prior years
   
582
     
609
 
  Total paid
   
5,053
     
6,224
 
Ending Balance, net
   
764
     
710
 
Add:  Reinsurance and other
               
   amounts recoverable
   
247
     
250
 
Ending Balance
  $
1,011
    $
960
 
 
Reinsurance and other amounts recoverable reflect amounts due from policyholders to cover incurred but not reported and pending claims for minimum premium products and certain administrative services only business where the right of offset does not exist.

For the nine months ended September 30, 2007, actual experience differed from the Company’s key assumptions, resulting in favorable incurred claims related to prior years’ medical claims payable of $82 million, or 1.3% of the current year incurred claims as reported for the year ended December 31, 2006. Actual completion factors resulted in a reduction in medical claims payable of $45 million, or 0.7% of the current year incurred claims as reported for the year ended December 31, 2006 for the insured book of business. Actual medical cost trend resulted in a reduction in medical claims payable of $37 million, or 0.6% of the current year incurred claims as reported for the year ended December 31, 2006 for the insured book of business. The favorable impact in 2007 relating to completion factor and medical cost trend variances is primarily due to the release of the provision for moderately adverse conditions, which is a component of the assumptions for both completion factors and medical cost trend, established for claims incurred related to 2006.  This release was substantially offset by the provision for moderately adverse conditions established for claims incurred related to 2007.

For the year ended December 31, 2006, actual experience differed from the Company's key assumptions, resulting in favorable incurred claims related to prior years’ medical claims payable of $173 million, or 2.6% of the current year incurred claims as reported for the year ended December 31, 2005. The favorable impact in 2006 is due to faster than expected completion factors and lower than expected medical cost trends, both of which included an assumption for moderately adverse experience.

For the year ended December 31, 2006, actual completion factors resulted in a reduction of the medical claims payable of $99 million or 1.5% of the current year incurred claims as reported for the year ended December 31, 2005 for the insured book of business. Completion factors in 2006 reflected better than expected time to process claims, driven by higher auto-adjudication rates, the impact of claim recoveries and more timely submissions of provider claims.  For the year ended December 31, 2006, actual medical cost trend resulted in a reduction of the medical claims payable of $74 million or 1.1% of the current year incurred claims as reported for the year ended December 31, 2005 for the insured book of business.  The better than expected medical cost trend in 2006 was driven by lower inpatient, outpatient and pharmacy service utilization and lower than expected unit cost trends.  The lower than expected unit cost trends reflected provider contracting initiatives and the mix of services provided.
 
11

 
The corresponding impact of favorable prior year development on net income was $10 million for the nine months ended September 30, 2007 and $54 million for the year ended December 31, 2006, or 0.2% in 2007 and 0.8% in 2006 of the current year incurred claims as reported for the years ended December 31, 2006 and 2005, respectively.   The change in the amount of the incurred claims related to prior years in the medical claims payable liability does not directly correspond to an increase or decrease in the Company's net income recognized for the following reasons:

First, due to the nature of the Company's retrospectively experience-rated business, only adjustments to medical claims payable on accounts in deficit affect net income.  An increase or decrease to medical claims payable on accounts in deficit, in effect, accrue to the Company and directly impact net income.  An account is in deficit when the accumulated medical costs and administrative charges, including profit charges, exceed the accumulated premium received.  Adjustments to medical claims payable on accounts in surplus accrue directly to the policyholder with no impact on the Company’s net income.   An account is in surplus when the accumulated premium received exceeds the accumulated medical costs and administrative charges, including profit charges.

Second, the Company consistently recognizes the actuarial best estimate of the ultimate liability within a level of confidence, as required by actuarial standards of practice, which require that the liabilities be adequate under moderately adverse conditions.  As the Company establishes the liability for each incurral year, the Company ensures that its assumptions appropriately consider moderately adverse conditions. When a portion of the development related to the prior year incurred claims is offset by an increase deemed appropriate to address moderately adverse conditions for the current year incurred claims, the Company does not consider that offset amount as having any impact on net income.  

The determination of liabilities for Health Care medical claims payable requires the Company to make critical accounting estimates.  See Note 2(O) in the Company’s 2006 Annual Report to Shareholders for additional information.

NOTE 6 – GUARANTEED MINIMUM DEATH BENEFIT CONTRACTS

The Company’s reinsurance operations, which were discontinued in 2000 and are now an inactive business in run-off mode, reinsured a guaranteed minimum death benefit under certain variable annuities issued by other insurance companies.  These variable annuities are essentially investments in mutual funds combined with a death benefit.  The Company has equity and other market exposures as a result of this product.

The determination of liabilities for guaranteed minimum death benefits requires the Company to make critical accounting estimates.  The Company regularly evaluates the assumptions used in establishing reserves and changes its estimates if actual experience or other evidence suggests that earlier assumptions should be revised.  If actual experience differs from the assumptions (including lapse, partial surrender, mortality, interest rates and volatility) used in estimating these reserves, the resulting change could have a material adverse effect on the Company’s consolidated results of operations, and in certain situations, could have a material adverse effect on the Company’s financial condition.  The Company had future policy benefit reserves for guaranteed minimum death benefit contracts of $827 million as of September 30, 2007, and $862 million as of December 31, 2006.

The following list provides information about the Company’s reserving methodology and assumptions for guaranteed minimum death benefits as of September 30, 2007:

·  
The reserves represent estimates of the present value of net amounts expected to be paid, less the present value of net future premiums.   Included in net amounts expected to be paid is the excess of the guaranteed death benefits over the values of the contractholders’ accounts (based on underlying equity and bond mutual fund investments).
·  
The reserves include an estimate for partial surrenders that essentially lock in the death benefit for a particular policy based on annual election rates that vary from 0-17% depending on the net amount at risk for each policy and whether surrender charges apply.
·  
The mean investment performance assumption is 5% considering the Company’s program to reduce equity market exposures using futures
 
 
12

 
 
  contracts.  In addition, the results of futures contracts are reflected in the liability calculation as a component of investment returns.
·  
The volatility assumption is 15-30%, varying by equity fund type; 3-8%, varying by bond fund type; and 1% for money market funds.
·  
The discount rate is 5.75%.
·  
The mortality assumption is 70-75% of the 1994 Group Annuity Mortality table, with 1% annual improvement beginning January 1, 2000.
·  
The lapse rate assumption is 0-15%, depending on contract type, policy duration and the ratio of the net amount at risk to account value.

As of September 30, 2007, the aggregate fair value of the underlying mutual fund investments was $32.6 billion.  The death benefit coverage in force as of that date (representing the amount that the Company would have to pay if all of the approximately 790,000 contractholders had died on that date) was $4.0 billion.  The death benefit coverage in force represents the excess of the guaranteed benefit amount over the fair value of the underlying mutual fund investments.

The notional amount of futures contract positions held by the Company at September 30, 2007 was $585 million.  The Company recorded in other revenues pre-tax losses of $11 million for the third quarter and $46 million for the nine months ended September 30, 2007, compared with pre-tax losses of $32 million for the third quarter and $56 million for the nine months ended September 30, 2006 from futures contracts.  Expense offsets reflecting corresponding changes in liabilities for these guaranteed minimum death benefit contracts were included in benefits and expenses.

For further information and details on these contracts and the program adopted to reduce related equity market risk, refer to Note 7 of the Company’s 2006 Annual Report to Shareholders.

NOTE 7 – REINSURANCE

In the normal course of business, the Company’s insurance subsidiaries enter into agreements with other insurance companies to assume and cede reinsurance.  Reinsurance is ceded primarily to limit losses from large exposures and to permit recovery of a portion of direct losses.  Reinsurance does not relieve the originating insurer of liability. The Company evaluates the financial condition of its reinsurers and monitors its concentrations of credit risk.

Retirement benefits business.  The Company had a reinsurance recoverable of $2.1 billion as of September 30, 2007, and $2.5 billion as of December 31, 2006 from Prudential Retirement Insurance and Annuity Company resulting from the sale of the retirement benefits business, which was primarily in the form of a reinsurance arrangement.  The reinsurance recoverable is secured primarily by fixed maturities and mortgage loans held in a business trust established by the reinsurer.  This recoverable is reduced as the Company’s reinsured liabilities are paid or directly assumed by the reinsurer.

Individual life and annuity reinsurance. The Company had a reinsurance recoverable of $4.7 billion at September 30, 2007 and $4.8 billion at December 31, 2006, from The Lincoln National Life Insurance Company that resulted from the 1998 sale of the Company’s individual life insurance and annuity business through an indemnity reinsurance arrangement.

Unicover and other run-off reinsurance.  The Company’s Run-off Reinsurance operations reinsured workers’ compensation and personal accident business in the United States and London markets. This included participation in a workers’ compensation reinsurance pool formerly managed by Unicover Managers, Inc.

The Company purchased extensive retrocessional reinsurance for the Unicover contracts (through the pool) and also purchased retrocessional coverage for its other workers compensation and personal accident assumed risks.  Although the Company is involved in a retrocessional enforcement arbitration, other disputes concerning the retrocessional contracts have been resolved.  See Note 15 “Litigation and Other Legal Matters” for more information regarding these disputes.
 
13

 
The Company’s payment obligations under these contracts are based on ceding companies’ claim payments relating to accidents and injuries.  These claim payments can in some cases extend many years into the future, and the amount of the ceding companies’ ultimate claims, and therefore the amount of the Company’s ultimate payment obligations and ultimate collection from retrocessionaires may not be known with certainty for some time.

The Company’s reserves for underlying reinsurance exposures assumed by the Company, as well as for amounts recoverable from retrocessionaires, are considered appropriate as of September 30, 2007, based on current information.  However, it is possible that future developments could have a material adverse effect on the Company’s consolidated results of operations and, in certain situations, could have a material adverse effect on the Company’s financial condition.  The Company bears the risk of loss if its payment obligations to cedents increase or if its retrocessionaires are unable to meet, or successfully challenge, their reinsurance obligations to the Company.

Other reinsurance.  The Company could have losses if reinsurers fail to indemnify the Company on other reinsurance arrangements, either because of reinsurer insolvencies or contract disputes.  However, management does not expect charges for other unrecoverable reinsurance to have a material adverse effect on the Company’s consolidated results of operations, liquidity or financial condition.

Effects of reinsurance.  In the Company’s consolidated income statements, premiums and fees were net of ceded premiums, and benefits and expenses were net of reinsurance recoveries, in the following amounts:
             
   
Three Months
   
Nine Months
 
   
Ended   
   
Ended   
 
   
September 30,
   
September 30,
 
(In millions)
 
2007
   
2006
   
2007
   
2006
 
Ceded premiums and fees
                       
Individual life insurance
                       
  and annuity business sold
  $
52
    $
59
    $
166
    $
187
 
Other
   
55
     
57
     
170
     
155
 
Total
  $
107
    $
116
    $
336
    $
342
 
Reinsurance recoveries
                               
Individual life insurance
                               
  and annuity business sold
  $
84
    $
85
    $
242
    $
238
 
Other
   
40
     
60
     
96
     
105
 
Total
  $
124
    $
145
    $
338
    $
343
 
                                 
 
NOTE 8 – PENSION AND OTHER POSTRETIREMENT BENEFIT PLANS

Pension and other postretirement benefits liability.

For the nine months ended September 30, 2007, the Company’s postretirement benefits liability adjustment decreased by $106 million pre-tax ($69 million after-tax) resulting in an increase to shareholders’ equity.  The decrease in the liability was primarily due to net amortization of actuarial losses, the annual update of census data, favorable medical claim experience, and lower than expected election rates in the Company’s postretirement medical plan.
 
Through the nine months ended September 30, 2006, the Company’s minimum pension liability increased by $13 million pre-tax ($9 million after-tax) resulting in a decrease to shareholders’ equity. This increase in the liability was primarily due to an update of plan census data.  
 
14

Pension benefits.  Components of net pension cost were as follows:
 
             
   
Three Months
   
Nine Months
 
   
Ended   
   
Ended   
 
   
September 30,
   
September 30,
 
(In millions)
 
2007
   
2006
   
2007
   
2006
 
Service cost
  $
18
    $
18
    $
55
    $
53
 
Interest cost
   
58
     
56
     
173
     
167
 
Expected return on plan assets
    (53 )     (52 )     (157 )     (156 )
Amortization of:
                               
  Net loss from past experience
   
30
     
38
     
89
     
114
 
  Prior service cost
   
-
     
-
      (1 )    
-
 
Net pension cost
  $
53
    $
60
    $
159
    $
178
 
 
The Company funds its qualified pension plans by at least the minimum amount required by the Employee Retirement Income Security Act of 1974, as amended (ERISA).
 
The Company does not expect to make, nor is required to make contributions to its primary qualified domestic pension plan in 2007.
 
Other postretirement benefits. Components of net other postretirement benefit cost were as follows:
 
             
   
Three Months
   
Nine Months
 
   
Ended   
   
Ended   
 
   
September 30,
   
September 30,
 
(In millions)
 
2007
   
2006
   
2007
   
2006
 
Service cost
  $
-
    $
1
    $
1
    $
2
 
Interest cost
   
6
     
7
     
18
     
19
 
Expected return on plan assets
   
-
     
-
      (1 )     (1 )
Amortization of:
                               
   Net gain from past experience
    (2 )     (1 )     (5 )     (2 )
   Prior service cost
    (4 )     (5 )     (12 )     (13 )
Net other postretirement
                               
   benefit cost
  $
-
    $
2
    $
1
    $
5
 
 
NOTE 9 – INVESTMENTS

Realized Investment Gains and Losses

The following realized gains and losses on investments exclude amounts required to adjust future policy benefits for certain annuities:
 
             
   
Three Months
   
Nine Months
 
   
Ended   
   
Ended   
 
   
September 30,
   
September 30,
 
(In millions)
 
2007
   
2006
   
2007
   
2006
 
Fixed maturities
  $ (9 )   $ (18 )   $ (17 )   $ (32 )
Equity securities
   
-
      (1 )    
11
      (6 )
Mortgage loans
   
7
      (1 )    
6
      (7 )
Real estate
   
1
     
-
     
1
     
-
 
Other investments,
                               
   including derivatives
 </