Unum 2007 Annual Report Download - page 76

Management’s Discussion and Analysis of
Financial Condition and Results of Operations
74 Unum 2007 Annual Report
Our mortgage/asset-backed securities were approximately $4.0 billion and $3.8 billion on an amortized cost basis at December 31,
2007 and 2006, respectively. At December 31, 2007, the mortgage/asset-backed securities had an average life of 7.0 years, effective
duration of 5.7 years, and a weighted average credit rating of AAA. The mortgage/asset-backed securities are valued on a monthly basis
using valuations supplied by the brokerage firms that are dealers in these securities as well as independent pricing services. The primary
risk involved in investing in mortgage/asset-backed securities is the uncertainty of the timing of cash flows from the underlying loans
due to prepayment of principal with the possibility of reinvesting the funds in a lower interest rate environment. We use models which
incorporate economic variables and possible future interest rate scenarios to predict future prepayment rates.
We have not invested in mortgage-backed derivatives, such as interest-only, principal-only, or residuals, where market values can be
highly volatile relative to changes in interest rates. All of our mortgage-backed securities are fixed rate. The credit quality of our mortgage-
backed securities portfolio has not been negatively impacted by the recent issues in the market concerning subprime mortgage loans. The
change in value of our mortgage-backed securities portfolio has moved in line with that of prime agency-backed mortgage-backed securities.
As of December 31, 2007, our exposure to below-investment-grade fixed maturity securities was $2,023.8 million, approximately
5.3 percent of the fair value of invested assets excluding ceded policy loans, compared to 5.8 percent at the end of 2006. Below-investment-
grade bonds are inherently more risky than investment-grade bonds since the risk of default by the issuer, by definition and as exhibited
by bond rating, is higher. Also, the secondary market for certain below-investment-grade issues can be highly illiquid. Additional downgrades
may occur, but we do not anticipate any liquidity problem caused by our investments in below-investment-grade securities, nor do we
expect these investments to adversely affect our ability to hold our other investments to maturity.
We have a significant interest in, but are not the primary beneficiary of, a special purpose entity which is a collateralized bond obligation
asset trust (CBO) in which we hold interests in several of the tranches and for which we act as investment manager of the underlying high-yield
securities. This entity is a cash flow CBO and was fully funded at the time of issuance. Our potential losses in this CBO are limited to our investment
in the entity. Our investment in this entity is reported at fair value with fixed maturity securities in the consolidated balance sheets. The fair
value of this investment was derived from the fair value of the underlying assets. The fair value and amortized cost of this investment were
$12.0 million and $11.8 million, respectively, at December 31, 2007, and $18.8 million and $18.4 million, respectively, at December 31, 2006.
Mortgage Loans and Real Estate
Our mortgage loan portfolio was $1,068.9 million and $944.0 million on an amortized cost basis at December 31, 2007 and 2006, respectively.
We expect that we will continue to add investments in this category either through the secondary market or through loan originations.
We believe our mortgage loan portfolio is well diversified geographically and among property types. The incidence of problem mortgage
loans and foreclosure activity remains low, and we expect the level of delinquencies and problem loans to remain low in the future. We
had no impaired mortgage loans at December 31, 2007. Impaired mortgage loans totaled $2.8 million at December 31, 2006.
Real estate was $18.2 million and $17.9 million at December 31, 2007 and 2006, respectively. Investment real estate is carried at cost
less accumulated depreciation. Real estate acquired through foreclosure is valued at fair value at the date of foreclosure and may be classified
as investment real estate if it meets our investment criteria. If investment real estate is determined to be permanently impaired, the carrying
amount of the asset is reduced to fair value. Occasionally, investment real estate is reclassified to real estate held for sale when it no longer
meets our investment criteria. Real estate held for sale, which is valued net of a valuation allowance that reduces the carrying value to
the lower of cost or fair value less estimated cost to sell, was $8.9 million and $6.5 million at December 31, 2007 and 2006, respectively.
We use a comprehensive rating system to evaluate the investment and credit risk of each mortgage loan and to identify specific
properties for inspection and reevaluation. We establish an investment valuation allowance for mortgage loans based on a review of
individual loans and the overall loan portfolio, considering the value of the underlying collateral. Investment valuation allowances for real
estate held for sale are established based on a review of specific assets. If a decline in value of a mortgage loan or real estate investment
is considered to be other than temporary or if the asset is deemed permanently impaired, the investment is reduced to estimated net
realizable value, and the reduction is recognized as a realized investment loss. We monitor the risk associated with these invested asset
portfolios and regularly review and adjust the investment valuation allowance. We had no valuation allowance for mortgage loans at
December 31, 2007. The balance in the valuation allowance for mortgage loans was $0.5 million at December 31, 2006. The balance in
the valuation allowance for real estate was $7.6 million at December 31, 2007 and 2006.