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The Travelers Companies 10-K 2005 Documents found in this filing:
Table of ContentsIndex to Financial StatementsUNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-K
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 2004
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 001-10898
The St. Paul Travelers Companies, Inc. (Exact name of registrant as specified in its charter)
385 Washington Street, St. Paul, MN 55102 (Address of principal executive offices) (Zip Code) (651) 310-7911 (Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Securities registered pursuant to Section 12(g) of the Act: None
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No ¨
As of June 30, 2004, the aggregate market value of the registrant’s voting and non-voting common equity held by non-affiliates was $27,051,384,688.
As of March 8, 2005, 673,464,057 shares of the registrant’s common stock (without par value) were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant’s Proxy Statement relating to the 2005 Annual Meeting of Shareholders are incorporated by reference into Part III of this report.
Table of ContentsIndex to Financial StatementsThe St. Paul Travelers Companies, Inc.
Annual Report on Form 10-K
For Fiscal Year Ended December 31, 2004
TABLE OF CONTENTS
Table of ContentsIndex to Financial StatementsPAR T I
The St. Paul Travelers Companies, Inc. (together with its consolidated subsidiaries, the Company) is a holding company principally engaged, through its subsidiaries, in providing a wide range of commercial and personal property and casualty insurance products and services to businesses, government units, associations and individuals. It also has a presence in the asset management industry through its 79% majority ownership of Nuveen Investments, Inc. (Nuveen Investments). The Company, known as The St. Paul Companies, Inc. (SPC) prior to its merger with Travelers Property Casualty Corp. (TPC), is incorporated as a general business corporation under the laws of the state of Minnesota and is one of the oldest insurance organizations in the United States, dating back to 1853. The principal executive offices of the Company are located at 385 Washington Street, St. Paul, Minnesota 55102, and the telephone number is (651) 310-7911.
On April 1, 2004, TPC merged with a subsidiary of SPC, as a result of which TPC became a wholly-owned subsidiary of SPC, and SPC changed its name to The St. Paul Travelers Companies, Inc. For accounting purposes, this transaction was accounted for as a reverse acquisition with TPC treated as the accounting acquirer. Accordingly, this transaction was accounted for as a purchase business combination, using TPC’s historical financial information and applying fair value estimates to the acquired assets, liabilities and commitments of SPC as of April 1, 2004. Beginning on April 1, 2004, the results of operations and financial condition of SPC were consolidated with TPC’s results of operations and financial condition. Accordingly, all financial information presented herein for the twelve months ended December 31, 2004 reflects the accounts of TPC for the three months ended March 31, 2004 and the consolidated accounts of SPC and TPC for the nine months ended December 31, 2004. The financial information presented herein for the prior year periods reflects the accounts of TPC. In connection with the merger, each issued and outstanding share of TPC class A and class B common stock (including the associated preferred stock purchase rights) was exchanged for 0.4334 of a share of the Company’s common stock. All share and per share amounts for all prior periods have been restated to reflect the exchange of TPC’s common stock, par value $0.01 per share, for the Company’s common stock without designated par value, except with regard to share information related to the TPC initial public offering in 2002.
TPC is a Connecticut corporation that was formed in 1979 and, prior to its March 2002 initial public offering of class A common stock (IPO), was an indirect wholly-owned subsidiary of Citigroup Inc. (together with its consolidated subsidiaries, Citigroup). TPC was reorganized in connection with its IPO in March 2002. Pursuant to the reorganization, which was completed on March 19, 2002, TPC’s consolidated financial statements were adjusted to exclude the accounts of certain formerly wholly-owned TPC subsidiaries, principally The Travelers Insurance Company and its subsidiaries (being the former U.S. life insurance operations of TPC), certain other wholly-owned non-insurance subsidiaries of TPC and substantially all of TPC’s assets and certain liabilities not related to the property casualty insurance business.
In the IPO, on March 21, 2002, TPC issued 231 million shares* of its class A common stock, representing approximately 23% of TPC’s common equity. After the IPO, Citigroup Inc. beneficially owned all of the 500 million shares* of TPC’s outstanding class B common stock, each share of which was entitled to seven votes, and 269 million shares* of TPC’s class A common stock, each share of which was entitled to one vote, representing at the time 94% of the combined voting power of all classes of TPC’s voting securities and 77% of the equity interest in TPC. On August 20, 2002, Citigroup made a tax-free distribution to its stockholders (the Citigroup Distribution), of a portion of its ownership interest in TPC, which, together with the shares issued in the IPO, represented more than 90% of TPC’s common equity and more than 90% of the combined voting power of TPC’s outstanding voting securities. Citigroup received a private letter ruling from the Internal Revenue Service that the Citigroup Distribution was tax-free to Citigroup, its stockholders and TPC. As part of the ruling
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Table of ContentsIndex to Financial Statementsprocess, Citigroup agreed to vote the shares it continued to hold of TPC following the Citigroup Distribution pro rata with the shares held by the public and to divest the remaining shares it holds within five years following the Citigroup Distribution. After the merger, this undertaking also applies to shares of Company common stock.
At December 31, 2004, Citigroup held for its own account 6.50% of the Company’s outstanding common stock. At December 31, 2003 and 2002, Citigroup held for its own account 9.87% and 9.95%, respectively, of TPC’s common equity and 9.87% and 9.98%, respectively, of the combined voting power of TPC’s outstanding voting securities.
The following discussion of the Company’s business is organized as follows: (i) a description of each of the Company’s four business segments (Commercial, Specialty, Personal, collectively comprising the Company’s property-casualty insurance operations, and Asset Management) and related services; (ii) a description of Interest Expense and Other; and (iii) certain other information.
PROPERTY-CASUALTY INSURANCE OPERATIONS
COMMERCIAL
The Commercial segment offers a broad array of property and casualty insurance and insurance-related services to its clients. Commercial is organized into three marketing and underwriting groups, each of which focuses on a particular client base:
Commercial also includes the Special Liability Group (which manages the Company’s asbestos and environmental liabilities); the reinsurance, health care, and certain international runoff operations; and policies written by the Company’s subsidiary Gulf Insurance Company (Gulf), which was placed into runoff during the second quarter of the year. These operations are collectively referred to as Commercial Other.
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Table of ContentsIndex to Financial StatementsSelected Market and Product Information
The following table sets forth Commercial net written premiums by market and product line for the periods indicated. For a description of the product lines and markets referred to in the table, see “—Principal Markets and Methods of Distribution” and “—Product Lines,” respectively.
Many National Accounts customers require insurance-related services in addition to or in lieu of pure risk coverage, primarily for workers’ compensation and, to a lesser extent, general liability and commercial automobile exposures. These types of services include risk management services, such as claims administration, loss control and risk management information services, and are generally offered in connection with large deductible or self-insured programs. These services generate fee income rather than net written premiums.
Principal Markets and Methods of Distribution
The Commercial segment distributes its products through approximately 6,200 independent agencies and brokers located throughout the United States that are serviced by approximately 100 field offices and three customer service centers. In recent years, the Commercial segment, particularly in its Select Accounts operation, has made significant investments in enhanced technology utilizing internet-based applications to provide real-time interface capabilities with its independent agencies and brokers. Commercial builds relationships with well-established, independent insurance agencies and brokers. In selecting new independent agencies and brokers to distribute its products, Commercial considers each agency’s or broker’s profitability, financial stability, staff experience and strategic fit with its operating and marketing plans. Once an agency or broker is appointed, Commercial carefully monitors its performance.
Commercial Accounts sells a broad range of property and casualty insurance products through a large network of independent agents and brokers. Commercial Accounts’ casualty products primarily target mid-sized businesses with 75 to 1,000 employees, while its property products target large, mid-sized and small businesses. The Company offers a full line of products to its Commercial Accounts customers with an emphasis on guaranteed cost programs.
A key objective of Commercial Accounts is continued focus on first party product lines of business, which cover risks of loss to property of the insured. Beyond the traditional middle market network, dedicated
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Table of ContentsIndex to Financial Statementsunderwriting units exist to complement the middle market or specifically respond to the unique or unusual business client insurance needs. These units are as follows:
Select Accounts is a leading provider of property casualty products to small businesses. It generally serves firms with one to 75 employees and generally less complex exposures. Products offered by Select Accounts are guaranteed cost policies, often a packaged product covering property and liability exposures. Products are sold through independent agents and brokers, who are often the same agents and brokers that sell the Company’s Commercial Accounts, Specialty and Personal products. In addition to the traditional small commercial agency network, Select Accounts has a dedicated servicing unit that serves unique customer needs, including small national programs, architects and engineers, and emerging distribution markets.
Select Accounts offers its independent agents a system for small businesses that helps them connect all aspects of sales and service through a comprehensive service platform. Components of the platform include agency automation capabilities and state-of-the-art service centers that function as an extension of an agency’s customer service operations, both of which are highly utilized by agencies. More than 89% of Select Accounts’ eligible business volume is processed by agencies using its automated issuance systems, which allow agents to quote and issue policies from agency offices. Approximately 3,600 agencies have chosen to take advantage of Select Accounts’ service centers, which offer agencies a wide range of services, including coverage and billing inquiries, policy changes, the assistance of licensed service professionals and extended hours of operations.
National Accounts sells a variety of casualty products and services to large companies. National Accounts clients generally select loss-sensitive products in connection with a large deductible or self-insured program and, to a lesser extent, a retrospectively rated or a guaranteed cost insurance policy. Through a network of field offices, the Company’s underwriting specialists work closely with national and regional brokers to tailor insurance programs to meet clients’ needs. Workers’ compensation accounted for approximately 76% of sales to National Accounts customers during 2004, based on direct written premiums and fees. National Accounts generated $446 million of fee income in 2004, excluding residual market business discussed below.
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Table of ContentsIndex to Financial StatementsNational Accounts also includes the Company’s commercial residual market business. The Company’s commercial residual market business sells claims and policy management services to workers’ compensation and automobile assigned risk plans and to self-insurance pools throughout the United States. The Company services approximately 35% of the total workers’ compensation assigned risk market. The Company is one of only two servicing carriers that operate nationally. Assigned risk plan contracts generated approximately $212 million in fee income in 2004.
Commercial Other includes the Special Liability Group (which manages the Company’s asbestos and environmental liabilities); the reinsurance, health care, and certain international runoff operations; and Gulf, which was placed into runoff during the second quarter of 2004. Certain business previously written by Gulf is now being written in Commercial Accounts and in the Company’s Specialty segment. Gulf provided specialty coverages including management and professional liability, excess and surplus lines, environmental, umbrella and fidelity. Gulf also provided insurance products specifically designed for financial institutions, the entertainment industry and sports organizations.
Pricing and Underwriting
Pricing levels for Commercial property and casualty insurance products are generally developed based upon the frequency and severity of estimated losses, the expenses of producing business and managing claims, and a reasonable allowance for profit. Commercial has a disciplined approach to underwriting and risk management that emphasizes a profit-orientation rather than premium volume or market share.
Commercial has developed an underwriting and pricing methodology that incorporates underwriting, claims, engineering, actuarial and product development disciplines for particular industries. This approach is designed to maintain high quality underwriting and pricing discipline. It utilizes proprietary data gathered and analyzed with respect to its Commercial business over many years. The underwriters and engineers use this information to assess and evaluate risks prior to quotation. This information provides specialized knowledge about specific industry segments. This methodology enables Commercial to streamline its risk selection process and develop pricing parameters that will not compromise Commercial’s underwriting integrity.
For smaller businesses, Select Accounts uses a process based on industry classifications to allow agents and field underwriting representatives to make underwriting and pricing decisions within predetermined classifications, because underwriting criteria and pricing tend to be more standardized for these smaller exposures.
A significant portion of Commercial business is written with large deductible insurance policies. Under some workers’ compensation insurance contracts with deductible features, the Company is obligated to pay the claimant the full amount of the claim. The Company is subsequently reimbursed by the contractholder for the deductible amount, and is subject to credit risk until such reimbursement is made. At December 31, 2004, contractholder receivables and payables on unpaid losses associated with large deductible policies were each approximately $4.21 billion. Retrospectively rated policies are also used for workers’ compensation coverage. Although the retrospectively rated feature of the policy substantially reduces insurance risk for the Company, it does introduce credit risk to the Company. Receivables on unpaid losses from holders of retrospectively rated policies totaled approximately $267 million at December 31, 2004. Significant collateral, primarily letters of credit and, to a lesser extent cash collateral and surety bonds, is generally requested for large deductible plans and/or retrospectively rated policies that provide for deferred collection of deductible recoveries and/or ultimate premiums. The amount of collateral requested is predicated upon the creditworthiness of the customer and the nature of the insured risks. Commercial continually monitors the credit exposure on individual accounts and the adequacy of collateral.
The Company continually monitors its exposure to natural and manmade peril catastrophic losses and attempts to mitigate such exposure. The Company uses sophisticated computer modeling techniques to analyze
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Table of ContentsIndex to Financial Statementsunderwriting risks of business in hurricane-prone, earthquake-prone and target risk areas. The Company relies upon this analysis to make underwriting decisions designed to manage its exposure on catastrophe-exposed business. See “—Reinsurance.”
Product Lines
Commercial Multi-Peril provides a combination of property and liability coverage. Property insurance covers damages such as those caused by fire, wind, hail, water, theft and vandalism, and protects businesses from financial loss due to business interruption resulting from a covered loss. Liability coverage insures businesses against third parties from accidents occurring on their premises or arising out of their operations, such as injuries sustained from products sold.
Workers’ Compensation provides coverage for employers for specified benefits payable under state or federal law for workplace injuries to employees. There are typically four types of benefits payable under workers’ compensation policies: medical benefits, disability benefits, death benefits and vocational rehabilitation benefits. The Company emphasizes managed care cost containment strategies, which involve employers, employees and care providers in a cooperative effort that focuses on the injured employee’s early return to work, cost-effective quality care, and customer service in this market. The Company offers the following three types of workers’ compensation products:
Commercial Automobile provides coverage for businesses against losses incurred from personal bodily injury, bodily injury to third parties, property damage to an insured’s vehicle, and property damage to other vehicles and other property resulting from the ownership, maintenance or use of automobiles and trucks in a business.
Property provides coverage for loss or damage to buildings, inventory and equipment from natural disasters, including hurricanes, windstorms, earthquakes, hail, and severe winter weather. Also covered are manmade events such as theft, vandalism, fires, explosions, terrorism and financial loss due to business interruption resulting from covered property damage. For additional information on terrorism coverages, see “—Terrorism Risk Insurance Act of 2002.” Property also includes specialized equipment insurance, which provides coverage for loss or damage resulting from the mechanical breakdown of boilers and machinery, and ocean and inland marine, which provides coverage for goods in transit and unique, one-of-a-kind exposures.
General Liability provides coverage for liability exposures including bodily injury and property damage arising from products sold and general business operations. Specialized liability policies may also include coverage for directors’ and officers’ liability arising in their official capacities, employment practices liability insurance, fiduciary liability for trustees and sponsors of pension, health and welfare, and other employee benefit plans, errors and omissions insurance for employees, agents, professionals and others arising from acts or failures to act under specified circumstances, as well as umbrella and excess insurance. Errors and omissions insurance for professionals (such as lawyers, accountants, doctors and other health care providers) is sometimes also known as professional liability insurance.
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Table of ContentsIndex to Financial StatementsGeographic Distribution
The following table shows the distribution of Commercials’ direct written premiums for the states that accounted for the majority of premium volume for the year ended December 31, 2004:
SPECIALTY
The Specialty segment was created upon the merger of TPC and SPC. It combined SPC’s specialty operations with TPC’s Bond and Construction operations, which were included in TPC’s Commercial segment prior to the merger. The Specialty segment provides a full range of standard and specialized insurance coverages and services through dedicated underwriting, claims handling and risk management groups. In many of its businesses, Specialty competes through the use of proprietary rates and policy forms. The segment comprises two primary groups: Domestic Specialty and International Specialty.
Domestic Specialty includes the following marketing and underwriting organizations, each of which possesses customer expertise and offers products and services to address its respective customers’ specific needs:
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Table of ContentsIndex to Financial StatementsSpecialty also includes several other underwriting groups that provide unique combinations of insurance coverage, risk management, claims handling and other services for a targeted client’s needs. Included in “Other Domestic Specialties” are the following business units:
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Table of ContentsIndex to Financial Statements
International Specialty includes coverages marketed and underwritten to several specialty customer groups within the United Kingdom, Canada and the Republic of Ireland, the Company’s participation in Lloyd’s, and the Global Underwriting business group.
Specialty’s International Operations are located in the United Kingdom, Canada and the Republic of Ireland, where it offers specialized insurance and risk management services to several specialty customer groups, including those in the technology, public services, and financial and professional services industry sectors. The Company’s international operations primarily underwrite employers’ liability (similar to workers’ compensation coverage in the United States), public and product liability (the equivalent of general liability), professional indemnity (similar to directors and officers or errors and omissions coverage), motor (similar to automobile coverage in the United States) and property.
The Global Underwriting business group underwrites “home-foreign” business, representing coverage for a U.S. organization’s property-liability exposures in a foreign country, and “reverse-flow” business, which involves coverage of a foreign organization’s property or liability exposures located in the United States, as part of a global program.
At Lloyd’s, Specialty underwrites four principal lines of business—aviation, marine, global property and personal lines—through Syndicate 5000, for which the Company provides 100% of the capital. During the second half of 2004, the Company made a decision to exit certain portions of the personal lines business. In early 2005, the Company sold the right to renew this business as well as the operating companies that supported it.
Select Market and Product Information
The following table sets forth Specialty net written premiums by market and product line for the periods indicated. For a description of the product lines and markets referred to in the table, see “—Principal Markets and Methods of Distribution” and “—Product Lines,” respectively.
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Table of ContentsIndex to Financial StatementsPrincipal Markets and Methods of Distribution
Specialty distributes the majority of its specialty commercial products through the same base of approximately 6,200 independent agencies and brokers that distribute the Commercial segment’s products. These brokers and independent agencies are located throughout the United States and are serviced by three customer service centers. In recent years, Specialty has made significant investments in enhanced technology utilizing internet-based applications to provide real-time interface capabilities with its independent agencies and brokers. Specialty builds relationships with well-established, independent insurance agencies and brokers. In selecting new independent agencies and brokers to distribute its products, Specialty considers each agency’s or broker’s profitability, financial stability, staff experience and strategic fit with its operating and marketing plans. Once an agency or broker is appointed, Specialty carefully monitors its performance.
Specialty also distributes property and casualty products through selected wholesalers using surplus lines paper, both on a brokerage and managing general underwriting basis. Wholesalers are used because they serve certain markets that are not typically served by our appointed retail agents. The wholesale surplus lines market allows for more flexibility to write certain classes of business due to the absence of rate and form regulation for surplus lines business. In working with wholesalers on a brokerage basis, Specialty underwrites the business and sets the premium level. In working with wholesalers on a managing general underwriting (MGU) basis, the MGUs produce and underwrite business that conforms to Specialty’s underwriting guidelines that have been specifically designed for each facility.
Specialty distributes its specialty products internationally through brokers in the domestic markets of each of the three countries in which it operates, the United Kingdom, Canada and the Republic of Ireland. Specialty also writes business at Lloyd’s, where its products are distributed through Lloyd’s accredited brokers and, by virtue of Lloyd’s worldwide licenses, Specialty has access to international markets across the world.
Pricing and Underwriting
Pricing levels for Specialty property and casualty insurance products are generally developed based upon the frequency and severity of estimated losses, the expenses of producing business and managing claims, and a reasonable allowance for profit. Specialty has a disciplined approach to underwriting and risk management that emphasizes profit orientation rather than premium volume or market share.
Specialty has developed an underwriting and pricing methodology that incorporates dedicated underwriting, claims, engineering, actuarial and product development disciplines for particular industries. This approach is designed to maintain high quality underwriting and pricing discipline, based on an in-depth knowledge of the specific industry. The underwriters and engineers use proprietary data gathered and analyzed over many years to assess and evaluate risks prior to quotation, and then use the more than 4,000 proprietary forms to tailor insurance coverage to target markets. This methodology enables Specialty to streamline its risk selection process and develop pricing parameters that will not compromise its underwriting integrity.
A portion of Specialty business is written with large deductible insurance policies. Under some workers’ compensation insurance contracts with deductible features, Specialty is obligated to pay the claimant the full amount of the claim. Specialty is subsequently reimbursed by the contractholder for the deductible amount and is subject to credit risk until such reimbursement is made. At December 31, 2004, contractholder receivables and payables on unpaid losses associated with large deductible policies were each approximately $1.41 billion. Significant collateral, primarily letters of credit and, to a lesser extent surety bonds and cash collateral, is generally requested for large deductible plans that provide for deferred collection of deductibles. The amount of collateral requested is predicated upon the creditworthiness of the customer and the nature of the insured risks. Specialty continually monitors the credit exposure and the adequacy of collateral.
Product Lines
General Liability provides coverage for liability exposures including bodily injury and property damage arising from products sold and general business operations. Specialized liability policies may also include
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Table of ContentsIndex to Financial Statementscoverage for directors’ and officers’ liability arising in their official capacities, employment practices liability insurance, fiduciary liability for trustees and sponsors of pension, health and welfare, and other employee benefit plans, errors and omissions insurance for employees, agents, professionals and others arising from acts or failures to act under specified circumstances, as well as umbrella and excess insurance. Errors and omissions insurance for professionals (such as lawyers, accountants, doctors and other health care providers) is sometimes also known as professional liability insurance.
Fidelity and Surety provides fidelity insurance coverage, which protects an insured for loss due to embezzlement or misappropriation of funds by an employee, and surety, which is a three-party agreement whereby the insurer agrees to pay a third party or make complete an obligation in response to the default, acts or omissions of an insured. Surety is generally provided for construction performance, legal matters such as appeals, trustees in bankruptcy and probate and other performance bonds. This product line includes surety business written in the Company’s St. Paul Guarantee (Canada) and Afianzadora Insurgentes (Mexico) subsidiaries.
Workers’ Compensation provides coverage for employers for specified benefits payable under state or federal law for workplace injuries to employees. There are typically four types of benefits payable under workers’ compensation policies: medical benefits, disability benefits, death benefits and vocational rehabilitation benefits. The Company emphasizes managed care cost containment strategies, which involve employers, employees and care providers in a cooperative effort that focuses on the injured employee’s early return to work, cost-effective, quality care and customer service in this market.
Commercial Automobile provides coverage for businesses against losses incurred from personal bodily injury, bodily injury to third parties, property damage to an insured’s vehicle, and property damage to other vehicles and other property resulting from the ownership, maintenance or use of automobiles and trucks in a business.
Property provides coverage for loss or damage to buildings, inventory and equipment from natural disasters, including hurricanes, windstorms, earthquakes, hail, and severe winter weather. Also covered are manmade events such as theft, vandalism, fires, explosions, terrorism and financial loss due to business interruption resulting from covered property damage. For additional information on terrorism coverages, see “Reinsurance—Terrorism Risk Insurance Act of 2002.” Property also includes specialized equipment insurance, which provides coverage for loss or damage resulting from the mechanical breakdown of boilers and machinery, and ocean and inland marine insurance, which provides coverage for goods in transit, and unique one-of-a-kind exposures.
Commercial Multi-Peril provides a combination of property and liability coverage. Property insurance covers damages such as those caused by fire, wind, hail, water, theft and vandalism, and protects businesses from financial loss due to business interruption resulting from a covered loss. Liability coverage insures businesses against third parties from accidents occurring on their premises or arising out of their operations, such as injuries sustained from products sold.
International provides coverage through non-U.S. insurance markets, predominantly through operations in the United Kingdom, Canada, the Republic of Ireland and at Lloyd’s. The coverage provided in those markets includes employers’ liability (similar to workers’ compensation coverage in the United States), public and product liability (the equivalent of general liability), professional indemnity (similar to directors and officers or errors and omissions coverages), motor (similar to automobile coverage in the United States) and property. While the covered hazard may be similar to those in the U.S. market, the different legal environments can make the product risks and coverage terms potentially very different from those in the United States. International does not include surety business written in the Company’s St. Paul Guarantee and Afianzadora Insurgentes subsidiaries.
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Table of ContentsIndex to Financial StatementsGeographic Distribution
The following table shows the distribution of Specialty’s direct written premiums for the states that accounted for the majority of Domestic Specialty premium volume for the year ended December 31, 2004:
PERSONAL
Personal writes virtually all types of property and casualty insurance covering personal risks. These products are distributed through independent agents, sponsoring organizations such as employee and affinity groups, and joint marketing arrangements with other insurers.
Selected Product and Distribution Channel Information
The following table sets forth net written premiums for Personal by product line for the periods indicated. For a description of the product lines referred to in the accompanying table, see “—Product Lines.” In addition, see “—Principal Markets and Methods of Distribution” for a discussion of distribution channels for Personal’s product lines.
Principal Markets and Methods of Distribution
Personal products are distributed primarily through approximately 7,500 independent agencies located throughout the United States, supported by personnel in ten marketing regions, three single state companies and six business service centers. In selecting new independent agencies to distribute its products, Personal considers each agency’s profitability, financial stability, staff experience and strategic fit with Personal’s operating and marketing plans. Once an agency is appointed, Personal carefully monitors its performance. While the principal markets for Personal’s insurance products are in states along the East Coast, in the South and Texas, Personal is expanding its geographical presence across the United States.
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Table of ContentsIndex to Financial StatementsPersonal operates single state companies in Massachusetts, New Jersey and Florida with products marketed primarily through independent agents. These states represented approximately 20% of Personal direct written premiums in 2004. The companies were established to manage complex markets in Massachusetts and New Jersey and property catastrophe exposure in Florida. Each company has dedicated resources in underwriting, claim, finance, legal and service functions.
Personal uses a consistent operating model with agents outside of the single state companies (see discussion above). The model provides technological alternatives to agents to maximize their ease of doing business. Personal agents quote and issue approximately 97% of Personal’s policies directly from their agencies by leveraging either their own agency management system or using Personal’s proprietary quote and issuance systems which allows agents to rate, quote and issue policies on line. All of these quote and issue platforms interface with the Personal’s underwriting and rating systems, which edit transactions for compliance with Personal’s underwriting and pricing programs. Business processed by agents on these platforms is subjected to consultative review by Personal’s in-house underwriters. In the past year, Personal continued to increase use of Internet-based proprietary systems, and agents have transitioned approximately 96% of Personal’s new business to these platforms. Personal also provides a download capability that refreshes the individual agency system databases of approximately 4,100 agents each day with updated policy information.
Personal continues to develop functionality to provide its agents with a comprehensive array of online service capabilities packaged together in an easy-to-use agency service portal, including customer service, marketing and claim functionality. Agencies can also choose to shift the ongoing core service responsibility for Personal’s customers to one of the Company’s four Customer Care Centers, where the Company functions as an extension of an agency’s servicing operation by providing a comprehensive array of direct customer service needs, including response to billing and coverage inquiries, and policy changes. Approximately 1,100 agents take advantage of this service alternative.
Personal also markets through additional distribution channels, including sponsoring organizations such as employers and consumer associations, and joint marketing arrangements with other insurers. Personal handles the sales and service for these programs either through a sponsoring independent agent or through two of the Company’s call center locations. The Company is one of the leading providers of personal lines products to members of affinity groups. A number of well-known corporations endorse the Company’s product offerings to their employees primarily through a payroll deduction payment process. The Company has significant relationships with the majority of the American Automobile Association (AAA) clubs in the United States and other affinity groups that endorse Personal’s tailored offerings to their members. Since 1995, the Company has had a marketing agreement with GEICO to receive referrals for homeowners business. This agreement has added profitable business and helped to geographically diversify the homeowners line of business.
Pricing and Underwriting
Pricing levels for Personal property and casualty insurance products are generally developed based upon the frequency and severity of incurred losses and loss adjustment expense, the expenses of producing business and a reasonable allowance for profit and contingencies. The Company has a disciplined approach to underwriting and risk management that places emphasis on underwriting profit rather than market share.
Personal has developed a product management methodology that integrates the disciplines of underwriting, claim, actuarial and product development. This approach is designed to maintain high quality underwriting discipline and pricing segmentation. Proprietary data is analyzed with respect to Personal’s business over many years. Personal uses a variety of proprietary and vendor produced risk differentiation models to facilitate its pricing segmentation. Personal’s product managers establish strict underwriting guidelines integrated with its filed pricing and rating plans, which enable Personal to streamline its risk selection and pricing processes.
Pricing for personal automobile insurance is driven by changes in the frequency of claims and by inflation in the cost of automobile repairs, medical care and litigation of liability claims. As a result, the profitability of the
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Table of ContentsIndex to Financial Statementsbusiness is largely dependent on promptly identifying and rectifying disparities between premium levels and projected claim costs, and obtaining approval from state regulatory authorities when necessary for filed rate changes.
Pricing in the homeowners business is also driven by changes in the frequency of claims and by inflation in the cost of building supplies, labor and household possessions. Most homeowners policies offer, but do not require, automatic increases in coverage to reflect growth in replacement costs and property values. In addition to the normal risks associated with any multiple peril coverage, the profitability and pricing of homeowners insurance is affected by the incidence of natural disasters, particularly hurricanes, winter storms, wind and hail, water damage, earthquakes and tornadoes. In order to reduce the Company’s exposure to catastrophe losses, Personal has limited the writing of new homeowners business and selectively non-renewed existing homeowners business in some markets. In addition, underwriting standards have been tightened, price increases have been implemented in some catastrophe-prone areas, and deductibles have been put in place in hurricane and wind and hail prone areas. Personal uses computer-modeling techniques to assess its level of exposure to loss in hurricane and earthquake catastrophe-prone areas. Changes to methods of marketing and underwriting in some jurisdictions are subject to state-imposed restrictions, which can make it more difficult for an insurer to significantly reduce catastrophe exposures.
Insurers writing personal lines property casualty policies may be unable to increase prices until some time after the costs associated with coverage have increased, primarily because of state insurance rate regulation. The pace at which an insurer can change rates in response to increased costs depends, in part, on whether the applicable state law requires prior approval of rate increases or notification to the regulator either before or after a rate change is imposed. In states with prior approval laws, rates must be approved by the regulator before being used by the insurer. In states having “file-and-use” laws, the insurer must file rate changes with the regulator, but does not need to wait for approval before using the new rates. A “use-and-file” law requires an insurer to file rates within a period of time after the insurer begins using the new rate. Approximately one-half of the states require prior approval of most rate changes.
Independent agents either submit applications to the Company’s service centers for underwriting review, quote, and issuance or they utilize one of its automated quote and issue systems. Automated transactions are edited by the Company’s systems and issued if they conform to established guidelines. Exceptions are reviewed by underwriters in the Company’s business centers or by agency managers. Audits are conducted by business center underwriters and agency managers, on a systematic sampling basis, across all of the Company’s independent agency generated business. Each agent is assigned to a specific employee or team of employees responsible for working with the agent on business plan development, marketing, and overall growth and profitability. The Company uses agency level management information to analyze and understand results and to identify problems and opportunities.
The Personal products sold through additional marketing channels are underwritten by the Company’s employees. Underwriters work with the Company management on business plan development, marketing, and overall growth and profitability. Channel-specific production and claim information is used to analyze results and identify problems and opportunities.
Product Lines
The primary coverages in Personal are personal automobile and homeowners insurance sold to individuals. Personal had approximately 6.1 million policies in force at December 31, 2004.
Personal Automobile provides coverage for liability to others for both bodily injury and property damage and for physical damage to an insured’s own vehicle from collision and various other perils. In addition, many states require policies to provide first-party personal injury protection, frequently referred to as no-fault coverage.
Homeowners and Other provides protection against losses to dwellings and contents from a wide variety of perils, as well as coverage for liability arising from ownership or occupancy. The Company writes
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Table of ContentsIndex to Financial Statementshomeowners insurance for dwellings, condominiums and rental property contents. The Company also writes coverage for personal watercraft, personal articles such as jewelry, and umbrella liability protection.
Geographic Distribution
The following table shows the distribution of Personal’s direct written premiums for the states that accounted for the majority of premium volume for the year ended December 31, 2004:
ASSET MANAGEMENT
Nuveen Investments, Inc. is the Company’s asset management subsidiary. The Company held a 79% interest in Nuveen Investments at December 31, 2004.
Nuveen Investments’ core businesses are asset management and related research, as well as the development, marketing and distribution of investment products and services for the affluent, high-net-worth and institutional market segments. Nuveen Investments distributes its investment products and services, including individually managed accounts, closed-end exchange-traded funds and mutual funds, to the affluent and high-net-worth market segments through unaffiliated intermediary firms including broker/dealers, commercial banks, affiliates of insurance providers, financial planners, accountants, consultants and investment advisors. Nuveen Investments also provides managed account services to several institutional market segments and channels. Nuveen Investments markets its capabilities under four distinct brands: Rittenhouse (“blue-chip” growth-style equities); NWQ (value-style equities); Nuveen (fixed-income investments); and Symphony (an institutional manager of market-neutral alternative investment portfolios). Nuveen Investments is listed on the New York Stock Exchange, trading under the symbol “JNC.”
Nuveen Investments’ primary business activities generate three principal sources of revenue: (1) advisory fees earned on assets under management, including exchange-traded funds, separately managed accounts and mutual funds; (2) underwriting and distribution revenues earned upon the sale of certain investment products; and (3) performance fees earned on certain institutional accounts based on the performance of such accounts. Advisory fees accounted for 93% of Nuveen Investments’ total revenues in 2004.
Operations of Nuveen Investments are organized around its principal advisory subsidiaries, which are registered investment advisors under the Investment Advisers Act of 1940. Certain of these advisory subsidiaries
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Table of ContentsIndex to Financial Statementsmanage the mutual funds and exchange-traded funds of Nuveen Investments, and others provide investment services for individual and institutional managed accounts. Additionally, Nuveen Investments, LLC, a registered broker and dealer in securities under the Securities Exchange Act of 1934, as amended, provides investment product distribution and related services for the Company’s managed funds, and, through March 2002, sponsored and distributed the Company’s defined portfolios (unit investment trusts).
At December 31, 2004, Nuveen Investments’ assets under management totaled $115.45 billion, consisting of $50.21 billion of exchange-traded funds, $36.98 billion of retail managed accounts, $15.58 billion of institutional managed accounts and $12.68 billion of mutual funds.
On January 31, 2005, the Company announced its intention to explore alternatives for divestiture of ownership of its 79% share of Nuveen Investments. The proposed divestiture reflects the Company’s strategic decision to focus on its property-casualty business. The Company anticipates a sale within twelve months.
On March 3, 2005, Nuveen Investments filed a Registration Statement on Form S-3 in conjunction with the Company’s intention to explore its strategic alternatives with respect to its equity interest in Nuveen Investments, including a public offering or a sale to a third party.
CLAIMS MANAGEMENT
The Company’s claims management strategy and its execution are critical to operating results and business retention. Claim payout and expense represent a substantial portion of every premium dollar the Company earns. The Company’s claims management strategy is based on four core tenets:
Claim Services employs a diverse group of professionals, including claim adjusters, appraisers, attorneys, investigators, system specialists and training, management and support personnel. Approved external service providers, such as independent adjusters and appraisers, investigators and attorneys, are available for use as appropriate.
Field claim management teams located in 72 offices in 45 states are organized to maintain focus on the specific claim characteristics unique to the businesses within the Commercial, Personal and Specialty segments. Claim teams with specialized skills, resources, and workflows are matched to the unique exposures of those businesses with local claim management dedicated to achieving optimal results within each segment. The Company’s home office operations provide additional support in the form of workflow design, quality management, information technology, advanced management information and data analysis, training, financial reporting and control, and human resources strategy. In addition to the field teams, claim staff is dedicated to each of Personal’s single state companies in Florida, Massachusetts and New Jersey. This structure permits the Company to maintain the economies of scale of a larger, established company while retaining the agility to respond promptly to the needs of customers, brokers, agents and underwriters.
An integral part of the Company’s strategy to benefit customers and shareholders is its continuing leadership in the fight against insurance fraud.
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Table of ContentsIndex to Financial StatementsClaim Services uses advanced technology, management information, and data analysis to assist the Company in reviewing its claim practices and results to evaluate and improve its performance. The Company’s claim management strategy is focused on segmentation of claims and appropriate technical specialization to drive effective claim resolution. The Company continually monitors its investment in claim resources to maintain an effective focus on claim outcomes. In recent years, the Company has invested significant additional resources in its Personal claim handling operations and expanded its “catastrophe response team”. The Company has embarked upon a series of process re-engineering pilots, in both auto and property. To the extent that those pilots show favorable results, the Company would anticipate rolling them out more broadly in 2005. The Company’s proven catastrophe response strategy and its catastrophe claim handling teams were instrumental in its response to a variety of weather-related losses that impacted the insurance industry in 2004, including Hurricanes Charley, Frances, Ivan and Jeanne, an unprecedented series of significant storms that struck the southeastern United States in the third quarter.
The Company is a leading user of digital and wireless technology and browser-based claim processes. For example, TravGlassSM, the Company’s Internet-based claims application, includes a network of pre-approved and customer or agent selected glass repair providers and enables the Company to effectively and efficiently meet its customers’ automobile glass repair needs.
Another strategic advantage is TravCompSM, a workers’ compensation claim resolution and medical management program that assists adjusters in the prompt investigation and effective management of workers’ compensation claims. Innovative medical and claims management technologies permit nurse, medical and claims professionals to share appropriate vital information that supports prompt investigation, effective return to work and claim resolution strategies. These technologies, together with effective matching of professional skills and authority to specific claim issues, have resulted in more efficient management of workers’ compensation claims with lower medical, wage replacement costs and loss adjustment expenses.
REINSURANCE
The Company reinsures a portion of the risks it underwrites in order to control its exposure to losses and protect capital resources. The Company cedes to reinsurers a portion of these risks and pays premiums based upon the risk and exposure of the policies subject to such reinsurance. Ceded reinsurance involves credit risk, except with regard to mandatory pools, and is generally subject to aggregate loss limits. Although the reinsurer is liable to the Company to the extent of the reinsurance ceded, the Company remains liable as the direct insurer on all risks reinsured. Reinsurance recoverables are reported after reductions for known insolvencies and after allowances for uncollectible amounts. The Company also holds collateral, including trust agreements, escrow funds and letters of credit, under certain reinsurance agreements. The Company monitors the financial condition of reinsurers on an ongoing basis and reviews its reinsurance arrangements periodically. Reinsurers are selected based on their financial condition, business practices and the price of their product offerings. For additional information concerning reinsurance, see note 8 of notes to the Company’s consolidated financial statements.
The Company utilizes a variety of reinsurance agreements to control its exposure to large property and casualty losses, including:
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Table of ContentsIndex to Financial StatementsThe following presents the Company’s top five reinsurers, except Lloyd’s, which is discussed in more detail below, by reinsurance recoverables at December 31, 2004 (in millions):
As of December 31, 2004, the Company had reinsurance recoverables from syndicates at Lloyd’s of $738 million. In 1996, Lloyd’s restructured its operations with respect to claims for years prior to 1993 and reinsured these into Equitas Limited, which is currently unrated. Approximately $90 million of the Company’s Lloyd’s reinsurance recoverables at December 31, 2004 relates to Equitas liabilities. The remaining recoverables of $648 million are from the continuing market of Lloyd’s, which is rated A (3rd highest of 16 ratings) by A.M. Best. During the first quarter of 2004, TPC entered into an agreement to settle all current and future reinsurance claims against certain underwriters at Lloyd’s reinsured by Equitas. Under terms of this settlement, the Company received $245 million, resolving approximately $255 million of TPC’s net claim balances from Equitas. Virtually all of the $90 million reinsurance recoverables relating to Equitas remaining at December 31, 2004 relate to SPC.
At December 31, 2004, the Company had $19.05 billion in reinsurance recoverables. Of this amount, $2.50 billion is for mandatory pools and associations that relate primarily to workers’ compensation service business and have the obligation of the participating insurance companies on a joint and several basis supporting these cessions. An additional $3.94 billion of this amount is attributable to structured settlements relating primarily to personal injury claims, for which the Company has purchased annuities and remains contingently liable in the event of any defaults by the companies issuing the annuities. Of the remaining $12.61 billion ceded to reinsurers at December 31, 2004, $1.50 billion is attributable to asbestos and environmental claims, and the remainder principally reflects reinsurance in support of ongoing and runoff business. At December 31, 2004, $2.8 billion of reinsurance recoverables were collateralized by letters of credit, trust agreements and escrow funds. Also at December 31, 2004, the Company had an allowance for estimated uncollectible reinsurance recoverables of $751 million.
For a description of reinsurance related litigation, see Item 3, “Legal Proceedings.”
Current Net Retention Policy
The descriptions below relate to the Company’s reinsurance arrangements in effect at January 1, 2005. Most property and casualty reinsurance agreements have terrorism sublimits or exclusions. The Company does not purchase treaty reinsurance for losses arising from workers’ compensation policies. For third party liability, including automobile no-fault, the reinsurance agreement used by Commercial and Specialty limits the net retention to a maximum of $8 million per insured, per occurrence. For third party liability, including but not limited to professional liability, directors’ and officers’ liability, and employment practices liability, the reinsurance agreements used by Specialty generally limit the net retentions from $4 million to $16 million per policy. For third party liability, National Accounts limits its exposure by utilizing facultative reinsurance. Reinsurance is also used to limit the net retained amount per risk to $15 million for Commercial and Specialty property. For surety protection, the Company generally retains up to $24.5 million probable maximum loss (PML) per principal but may retain higher amounts based on the type of obligation, credit quality and other credit risk factors. Personal retains the first $5 million of umbrella policies and purchases facultative reinsurance for limits over $5 million. For personal property insurance, there is a $6 million maximum retention per risk. The Company also utilizes facultative reinsurance to provide additional limits capacity or to reduce retentions on an individual risk basis. The Company may also retain amounts greater than those described herein based upon the individual characteristics of the risk.
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Table of ContentsIndex to Financial StatementsCatastrophe Reinsurance
The Company utilizes a reinsurance agreement with nonaffiliated reinsurers to control its exposure to losses resulting from one occurrence. For the accumulation of net property losses arising out of one occurrence, the General Catastrophe agreement covers 60% of total losses between $750 million and $2 billion. This agreement excludes nuclear, chemical and biochemical losses for domestic terrorism and all terrorism losses as defined by the Terrorism Risk Insurance Act of 2002. This agreement covers all of the Company’s business except that business underwritten in the United Kingdom and Republic of Ireland, and through the Company’s Lloyd’s operations, where separate catastrophe coverage is purchased locally and generally results in significantly lower net loss exposure levels than in the General Catastrophe agreement. The Company conducts an ongoing review of its risk and catastrophe coverages and makes changes it deems appropriate.
Terrorism Risk Insurance Act of 2002
On November 26, 2002, the Terrorism Risk Insurance Act of 2002 (the Terrorism Act) was enacted into Federal law and established the Terrorism Insurance Program (the Program), a temporary Federal program in the Department of the Treasury, that provides for a system of shared public and private compensation for insured losses resulting from acts of terrorism or war committed by or on behalf of a foreign interest. In order for a loss to be covered under the Program (subject losses), the loss must be the result of an event that is certified as an act of terrorism by the U.S. Secretary of Treasury. In the case of a war declared by Congress, only workers’ compensation losses are covered by the Terrorism Act. The Terrorism Act generally requires that all commercial property casualty insurers licensed in the United States participate in the Program. The Program terminates on December 31, 2005. Under the Program, a participating insurer is entitled to be reimbursed by the Federal Government for 90% of subject losses, after an insurer deductible, subject to an annual cap. In each case, the deductible percentage is applied to the insurer’s subject direct earned premiums from the calendar year immediately preceding the applicable year. The deductible under the Program was 7% for 2003, 10% for 2004 and is 15% for 2005. The Program also contains an annual cap that limits the amount of aggregate subject losses for all participating insurers to $100 billion. Once subject losses have reached the $100 billion aggregate during a program year, there is no additional reimbursement from the U.S. Treasury and an insurer that has met its deductible for the program year is not liable for any losses (or portion thereof) that exceed the $100 billion cap. The Company’s estimated deductible under this federal program is $2.51 billion for 2005. The Company had no terrorism-related losses in 2004 or 2003. If the Program is not renewed for periods after January 1, 2006, the benefits of the Program will not be available to the Company, and the Company will be subject to losses from acts of terrorism subject only to the terms and provisions of applicable policies.
Florida Reinsurance Fund
The Company also participates in the Florida Hurricane Catastrophe Fund (FHCF), which is a state-mandated catastrophe reinsurance fund that will provide reimbursement to insurers for a portion of their future catastrophic hurricane losses. FHCF is primarily funded by premiums from insurance companies that write residential property business in Florida and, if insufficient, assessments on insurance companies that write other property and casualty insurance, excluding workers’ compensation and medical malpractice. FHCF’s resources are limited to these contributions and to its borrowing capacity at the time of a significant catastrophe in Florida. In 2004, FHCF paid its obligations arising from the four hurricanes that made landfall in Florida from the cash on hand derived from premium payments. The Company believes that FHCF resources will be at the statutory required capacity in 2005. There can be no assurance that these resources will be sufficient to meet the obligations of FHCF.
The Company’s recovery of less than contracted amounts from FHCF could have a material adverse effect on the Company’s results of operations in the event of a significant catastrophe in Florida. However, the Company believes that it is not likely that its recovery of less than contracted amounts from FHCF would have a material adverse effect on its financial condition or liquidity.
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Table of ContentsIndex to Financial StatementsRESERVES
Claim and claim adjustment expense reserves (loss reserves) represent management’s estimate of ultimate unpaid costs of losses and loss adjustment expenses for claims that have been reported and claims that have been incurred but not yet reported.
Management continually refines its reserve estimates in a regular ongoing process that includes review of key assumptions, underlying variables and historical loss experience. The Company reflects adjustments to reserves in the results of operations in the periods in which the estimates are changed. In establishing reserves, the Company takes into account estimated recoveries for reinsurance, salvage and subrogation. The reserves are also reviewed regularly by a qualified actuary employed by the Company. For additional information on the process of estimating reserves and a discussion of underlying variables and risk factors, see “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Critical Accounting Estimates.”
The process of estimating loss reserves involves a high degree of judgment and requires the consideration of a number of variables. These variables (discussed by product line in the previously mentioned “Critical Accounting Estimates” section) are affected by both internal and external events, such as changes in claims handling procedures, inflation, judicial trends and legislative changes, among others. The impact of many of these items on ultimate costs of loss and loss adjustment expenses is difficult to estimate. Reserve estimation difficulties also differ significantly by product line due to differences in the underlying insurance contract (e.g., claims made versus occurrence), claim complexity, the volume of claims, the potential severity of individual claims, determining the occurrence date for a claim, and reporting lags (the time between the occurrence of the insured event and when it is actually reported to the insurer). Informed judgment is applied throughout the process.
The Company derives estimates for unreported claims and development on reported claims principally from actuarial analyses of historical patterns of loss development by accident year for each type of exposure and market segment. Similarly, the Company derives estimates of unpaid loss adjustment expenses principally from actuarial analyses of historical development patterns of the relationship of loss adjustment expenses to losses for each line of business and type of exposure. For a description of the Company’s reserving methods for asbestos and environmental claims, see “Item 7—Asbestos Claims and Litigation,” and “Environmental Claims and Litigation.”
Discounting
Included in the claims and claim adjustment expense reserves in the consolidated balance sheet are certain reserves discounted to the present value of estimated future payments. The liabilities for losses for some long-term disability payments under workers’ compensation insurance and workers’ compensation excess insurance, which totaled $2.06 billion and $1.33 billion at December 31, 2004 and 2003, respectively, have been discounted using rates of 3.5% to 5.0%. Reserves related to certain fixed and determinable asbestos-related settlements, where all payment amounts and their timing are known, were discounted using a range of interest rates from 2.3% to 5.5% and totaled $48 million and $445 million at December 31, 2004 and 2003, respectively. Reserves for certain assumed reinsurance coverage acquired in the merger, discounted using rates of 5.0% to 7.5%, were $116 million at December 31, 2004.
Other Factors
The table on page 22 sets forth the year-end reserves from 1994 through 2004 and the subsequent changes in those reserves, presented on a historical basis. The original estimates, cumulative amounts paid and reestimated reserves in the table for the years 1994 through 2003 have not been restated to reflect the acquisition of SPC in 2004. The table includes SPC reserves at December 31, 2004.
The original estimates, cumulative amounts paid and reestimated reserves in the table for the years 1994 to 2001 and 1994 to 1995 have also not been restated to reflect the acquisition of Northland and Commercial
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Table of ContentsIndex to Financial StatementsGuaranty Casualty and of Aetna’s property and casualty insurance subsidiaries, respectively. Beginning in 1996 and 2002, the table includes the reserve activity of Aetna’s property and casualty insurance subsidiaries, and Northland and Commercial Guaranty Casualty, respectively. The data in the table is presented in accordance with reporting requirements of the Securities and Exchange Commission (SEC). Care must be taken to avoid misinterpretation by those unfamiliar with this information or familiar with other data commonly reported by the insurance industry. The accompanying data is not accident year data, but rather a display of 1994 to 2004 year-end reserves and the subsequent changes in those reserves.
For instance, the “cumulative deficiency or redundancy” shown in the accompanying table for each year represents the aggregate amount by which original estimates of reserves as of that year end have changed in subsequent years. Accordingly, the cumulative deficiency for a year relates only to reserves at that year-end and those amounts are not additive. Expressed another way, if the original reserves at the end of 1994 included $4 million for a loss that is finally paid in 2004 for $5 million, the $1 million deficiency (the excess of the actual payment of $5 million over the original estimate of $4 million) would be included in the cumulative deficiencies in each of the years 1994 to 2003 shown in the accompanying table.
Various factors may distort the re-estimated reserves and cumulative deficiency or redundancy shown in the accompanying table. For example, a substantial portion of the cumulative deficiencies shown in the accompanying table arise from claims on policies written prior to the mid-1970s involving liability exposures such as asbestos and environmental claims. In the post-1984 period, the Company has developed more stringent underwriting standards and policy exclusions and has significantly contracted or terminated the writing of these risks. See “Item 7—Asbestos Claims and Litigation,” and “Environmental Claims and Litigation.” General conditions and trends that have affected the development of these liabilities in the past will not necessarily recur in the future.
Other factors that affect the data in the accompanying table include the discounting of certain reserves, as discussed above, and the use of retrospectively rated insurance policies. For example, workers’ compensation indemnity reserves (tabular reserves) are discounted to reflect the time value of money. Apparent deficiencies will continue to occur as the discount on these workers’ compensation reserves is accreted at the appropriate interest rates. Also, a portion of National Accounts business is underwritten with retrospectively rated insurance policies in which the ultimate loss experience is primarily borne by the insured. For this business, increases in loss experience result in an increase in reserves and an offsetting increase in amounts recoverable from insureds. Likewise, decreases in loss experience result in a decrease in reserves and an offsetting decrease in amounts recoverable from these insureds. The amounts recoverable on these retrospectively rated policies mitigate the impact of the cumulative deficiencies or redundancies on the Company’s earnings but are not reflected in the accompanying table.
Because of these and other factors, it is difficult to develop a meaningful extrapolation of estimated future redundancies or deficiencies in loss reserves from the data in the accompanying table.
The differences between the reserves for loss and loss adjustment expenses shown in the accompanying table, which is prepared in accordance with accounting principles generally accepted in the United States of America and those reported in the Company’s annual reports filed with insurance regulators, which are prepared in accordance with statutory accounting practices, were $(282) million, $26 million and $(12) million for 2004, 2003 and 2002, respectively. The increase in the difference from 2003 to 2004 was primarily driven by the impact of a reinsurance contract which the Company entered into in 2004 that provides coverage for prior accident years.
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Table of ContentsIndex to Financial StatementsAsbestos and Environmental Claims
Asbestos and environmental claims are segregated from other claims and are handled separately by the Company’s Special Liability Group, a separate unit staffed by dedicated legal, claim, finance and engineering professionals. For additional information on asbestos and environmental claims, see “Item 7—Management’s Discussion and Analysis of Financial Conditions and Results of Operations.”
INTERCOMPANY REINSURANCE
Most of the Company’s insurance subsidiaries are members of intercompany property and casualty reinsurance pooling arrangements. Pooling arrangements permit the participating companies to rely on the capacity of the entire pool’s capital and surplus rather than just on its own capital and surplus. Under such arrangements, the members share substantially all insurance business that is written, and allocate the combined premiums, losses and expenses. As of December 31, 2004, there were three intercompany pooling arrangements: the Travelers Property Casualty pool, the St. Paul Insurance Group pool, which was acquired in the merger, and the Northland Pool. Pools permit the participating companies to rely on the capacity of the entire pool’s capital and surplus rather than just on its own capital and surplus. Travelers Casualty and Surety Company of America (Travelers C&S of America), which is dedicated to the Bond business, does not participate in any of the pools. The Personal single state companies and Commercial Guaranty Casualty Insurance Company (see Ratings below) are also not included in any of the pools. In 2004, the former Gulf intercompany pooling arrangement was amended, thereby eliminating Gulf Insurance Company’s retrocession to the other former pool participants.
RATINGS
Ratings are an important factor in setting the Company’s competitive position in the insurance marketplace. The Company receives ratings from the following major rating agencies: A.M. Best Company (A.M. Best), Fitch Ratings (Fitch), Moody’s Investors Service (Moody’s) and Standard & Poor’s Corp. (S&P). Rating agencies typically issue two types of ratings: claims-paying (or financial strength) ratings which assess an insurer’s ability to meet its financial obligations to policyholders and debt ratings which assess a company’s prospects for repaying its debts and assist lenders in setting interest rates and terms for a company’s short and long term borrowing needs. The system and the number of rating categories can vary widely from rating agency to rating agency. Customers usually focus on claims-paying ratings, while creditors focus on debt ratings. Investors use both to evaluate a company’s overall financial strength. The ratings issued on the Company or its subsidiaries by any of these agencies are announced publicly and are available on the Company’s website and from the agencies.
The Company’s insurance operations could be negatively impacted by a downgrade in one or more of the Company’s financial strength ratings. If this were to occur, there could be a reduced demand for certain products in certain markets. Additionally, the Company’s ability to access the capital markets could be impacted and higher borrowing costs may be incurred.
In January 2004, A.M. Best placed the “A” financial strength rating of Gulf, a then majority-owned subsidiary of the Company, under review with developing implications, and S&P indicated that its A+ counterparty credit and financial strength ratings on members of the Gulf Insurance Group are remaining on CreditWatch with negative implications, pending the completion of a support arrangement between The Travelers Indemnity Company and Gulf.
Also in January 2004, A.M. Best downgraded the financial strength rating of the Northland Pool from A+ to A, removed the rating from under review and assigned a stable outlook.
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Table of ContentsIndex to Financial StatementsIn connection with the April 1, 2004 consummation of the merger of TPC and SPC, A.M. Best, Moody’s, S&P and Fitch announced the following rating actions with respect to the Company.
On June 29, 2004, A.M. Best announced the following ratings changes:
On July 23, 2004, A.M. Best, Moody’s, S&P and Fitch announced the following rating actions with respect to the Company.
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Table of ContentsIndex to Financial Statements
On September 15, 2004, S&P downgraded its counterparty and financial strength ratings of Afianzadora Insurgentes, S.A., a majority-owned subsidiary of United States Fidelity and Guaranty Company operating in Mexico, to BBB– from BBB+ in the global scale and to mxAA from mxAAA in the national scale. The short-term financial strength ratings were affirmed at mxA-1+ in the national scale. The ratings were removed from CreditWatch with an outlook of negative. At the same time, counterparty and financial strength ratings were withdrawn at the Company’s request.
On January 6, 2005, A.M. Best affirmed the financial strength rating of A of St. Paul Guarantee Insurance Company and withdrew the financial strength rating of A+ of Travelers Casualty and Surety Company of Canada (assigned an NR-5, not formerly followed rating). Both ratings were removed from under review with developing implications. St. Paul Guarantee Insurance Company was assigned a rating outlook of stable. These actions followed the January 1, 2005 completion of the amalgamation of St. Paul Guarantee Insurance Company and Travelers Casualty and Surety Company of Canada.
In connection with the Company’s January 31, 2005 announcement of fourth quarter 2004 earnings, A.M. Best, Moody’s, S&P and Fitch announced the following rating actions with respect to the company.
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Table of ContentsIndex to Financial Statements
The following table summarizes the current claims-paying and financial strength ratings of Travelers Property Casualty Insurance Pool, The St. Paul Insurance Group, Travelers C&S of America, Gulf Insurance Group, Northland Pool, Travelers Personal single state companies, Travelers Europe, Discover Reinsurance Company, Afianzadora Insurgentes, S.A. and St. Paul Guarantee Insurance Company by A.M. Best, Moody’s, S&P and Fitch as of March 8, 2005. The table also presents the position of each rating in the applicable agency’s rating scale.
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Table of ContentsIndex to Financial Statements
INVESTMENTS
Insurance company investments must comply with applicable laws and regulations which prescribe the kind, quality and concentration of investments. In general, these laws and regulations permit investments in federal, state and municipal obligations, corporate bonds, preferred and common equity securities, mortgage loans, real estate and certain other investments, subject to specified limits and certain other qualifications.
At December 31, 2004, the carrying value of the Company’s investment portfolio was $64.71 billion, of which 92% was invested in fixed maturity investments and short-term investments (of which 55% was invested in federal, state or municipal government obligations), 1% in mortgage loans and real estate, 1% in common stocks and other equity securities and 6% in other investments. The average duration of the fixed maturity portfolio, including short-term investments, was 4.1 years at December 31, 2004. Non-investment grade securities totaled approximately $1.78 billion, representing approximately 3% of the Company’s fixed maturity investment portfolio as of December 31, 2004.
The following table sets forth information regarding the Company’s investments. It reflects the average amount of investments, net investment income earned and the yield thereon. See note 6 of notes to the Company’s consolidated financial statements for information regarding the Company’s investment portfolio.
DERIVATIVES
See note 16 of notes to the Company’s consolidated financial statements for a discussion of the policies and transactions related to the Company’s derivative financial instruments.
COMPETITION
The property and casualty insurance industry is highly competitive in the areas of price, service, product offerings, agent relationships and method of distribution, i.e., use of independent agents, exclusive agents and/or salaried employees. According to A.M. Best, there are approximately 950 property casualty organizations in the United States, comprising approximately 2,400 property casualty companies. Of those organizations, the top 150 accounted for approximately 92% of the consolidated industry’s total net written premiums in 2003. Several property and casualty insurers writing commercial lines of business, including the Company, offer products for alternative forms of risk protection in addition to traditional insurance products. These products, including large deductible programs and various forms of self-insurance that utilize captive insurance companies and risk retention groups, have been instituted in reaction to the escalating cost of insurance caused in part by increased costs from workers’ compensation cases and jury awards in third-party liability cases.
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Table of ContentsIndex to Financial StatementsCommercial. The insurance industry is represented in the commercial lines marketplace by many insurance companies of varying size as well as other entities offering risk alternatives such as self-insured retentions or captive programs. Market competition works within the insurance regulatory framework to set the price charged for insurance products and the level of service provided. Growth is driven by a company’s ability to provide insurance and services at a price that is reasonable and acceptable to the customer. In addition, the marketplace is affected by available capacity of the insurance industry as measured by policyholders’ surplus and the availability of reinsurance. Surplus expands and contracts primarily in conjunction with profit levels generated by the industry. Growth in premium and service business is also measured by a company’s ability to retain existing customers and to attract new customers. Additionally, many large commercial customers self-insure their risks or utilize large deductibles on purchased insurance.
Commercial Accounts business has historically been written through independent agents and brokers, although some companies use direct writing. Competitors in this market are primarily national property casualty insurance companies willing to write most classes of business using traditional products and pricing and, to a lesser extent, regional insurance companies and companies that have developed niche programs for specific industry segments. Companies compete on price, product offerings, response time in policy issuance and claim and loss prevention services. Additionally, improved efficiency through automation and response time to customer needs are key to success in this market. The Commercial segment also utilizes dedicated units to tailor insurance programs to unique insurance needs. These units are national property, transportation, boiler and machinery, inland marine, agribusiness, excess and surplus and national programs.
Select Accounts business is typically written through independent agents and, to a lesser extent, regional brokers. Both national and regional property casualty insurance companies compete in the Select Accounts market which generally comprises lower hazard, “main street” business customers. Risks are underwritten and priced using standard industry practices and a combination of proprietary and standard industry product offerings. Competition in this market is primarily based on price, product offerings and response time in policy services. The Commercial segment has established a strong marketing relationship with its distribution network and has provided it with defined underwriting policies, a broad array of products, competitive prices and one of the most efficient automated environments in the industry. In addition, the Company has established centralized service centers to help agents perform many service functions, in return for a fee. Commercial’s overall service platform is one of the strongest in the small business commercial market.
National Accounts business is typically written through national brokers and, to a lesser extent, regional brokers. Insurance companies compete in this market based on price, product offerings, claim and loss prevention services, managed care cost containment and risk management information systems. National Accounts also offers a large nationwide network of localized claim service centers which provide greater flexibility in claims adjusting and allows Commercial to more quickly respond to the needs of its customers. Commercial’s residual market business also competes for state contracts to provide claims and policy management services. These contracts, which generally have three-year terms, are selected by state agencies through a bid process based on the quality of service and price. Commercial services approximately 35% of the total workers’ compensation assigned risk market, making the Company one of the largest servicing insurers in the industry.
The market in which Gulf competed included small to mid-size niche companies that target specific lines of insurance and larger, multi-line companies that focus on various segments of the specialty accounts market. Prior to being placed in runoff in 2004, Gulf’s business was generally written through retail and wholesale agents and brokers throughout the United States.
Specialty. The competitive landscape in which the Specialty segment operates is affected by many of the same factors described previously for the Commercial segment. The Company’s domestic and international insurance subsidiaries compete with other stock companies, mutual companies, alternative risk sharing groups and other underwriting organizations. Competitors in this market are primarily national property-liability insurance companies willing to write most classes of business using traditional products and pricing and, to a
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Table of ContentsIndex to Financial Statementslesser extent, regional insurance companies and companies that have developed niche programs for specific industry segments. In addition, many large commercial customers self-insure their risks or utilize large deductibles on purchased insurance.
Bond underwrites and markets its products to national, mid-sized and small businesses and organizations as well as individuals, and distributes them through both national and wholesale brokers, and retail agents and regional brokers. Bond competes in the highly competitive surety and executive liability marketplaces. Both national and regional property casualty insurance companies compete with Bond. Bond’s reputation for timely and consistent decision-making, a nationwide network of local underwriting, claims and industry experts and strong producer and customer relationships as well as its ability to offer its customers a full range of products, enable it to compete effectively. Bond’s ability to cross-sell its products to customers of the Commercial and Personal segments provides further competitive advantages for the Company.
Construction business has historically been written through independent agents and brokers. Competitors in this industry include both national property casualty insurance companies and regional insurance companies. Companies compete on price, coverage offerings, claim and loss prevention services, managed care cost containment and risk management information systems. Construction offers a nationwide network of localized, dedicated claim service professionals that provide greater flexibility in claims adjusting and allows Construction to more quickly respond to the needs of its customers. In addition, dedicated risk control professionals work directly with customers in the evaluation, design and implementation of safety programs to better control risk and exposure to loss.
Financial and Professional Services business is typically written through national brokers, regional brokers, and independent agents. Insurance companies compete on price and product offerings. The Company has developed a strong reputation in this complex, dynamic market segment and has an advantage over many of its competitors in offering a wide breadth of professional and general property and casualty coverages to its financial and professional customers.
There are several other domestic business groups in Specialty that compete in focused target markets. Each of these markets are different and require unique combinations of industry knowledge, proprietary coverage forms, specialized risk control and loss handling services, and partnerships with agents and brokers that also focus on these markets. In some cases the competition is national carriers with similarly dedicated underwriting and marketing groups. In other cases smaller regional companies tend to be the primary competition. In either case these businesses have regional structures that allow them to deliver personalized service and local knowledge to their customer base. Specialized agents and brokers supplement this strategy. In all of these businesses, the competitive strategy is market leadership attained through focused industry knowledge applied to insurance and risk needs.
International Specialty competes with numerous international and local country insurers in the United Kingdom, Canada and the Republic of Ireland. Companies compete on the basis of price, product offerings and the level of claim and risk management services provided. Specialty has developed expertise in various specialty markets in these countries similar to those served in the United States and provides both property and casualty coverage for these markets. This specialty focus is a particular competitive advantage in these countries where our competitors tend to be more product or line of business oriented. Products are generally distributed through a fairly small number of local country brokers and agents whose customer groups align with the Company’s specialty markets.
At Lloyd’s, International Specialty competes with other syndicates operating in the Lloyd’s market as well as international and domestic insurers in the various markets where International Specialty writes business worldwide. Syndicates are increasingly capitalized by corporate capital, much of which is provided by large international insurance enterprises. Competition is again based on price and product offerings. International Specialty has an exclusive focus on lines it believes it can underwrite effectively and profitably with an emphasis on short-tail insurance (versus reinsurance) lines. Specialty underwrites four major classes of business at Lloyd’s: Marine, Personal, Property and Aviation.
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Table of ContentsIndex to Financial StatementsPersonal. Personal lines insurance is written by hundreds of insurance companies of varying sizes. Although national companies write the majority of the business, Personal also faces competition from local or regional companies which often have a competitive advantage because of their knowledge of the local marketplace and their relationship with local agents. Personal believes that the principal competitive factors are price, service, perceived stability of the insurer and name recognition. Personal competes for business within each independent agency since these agencies also offer policies of competing companies. At the agency level, competition is primarily based on price and the level of service, including claims handling, as well as the level of automation and the development of long-term relationships with individual agents. Personal also competes with insurance companies that use exclusive agents or salaried employees to sell their products. In addition to its traditional independent agency distribution, Personal has broadened its distribution of products by marketing to sponsoring organizations, including employee and affinity groups, and through joint marketing arrangements with other insurers. Personal believes that its continued focus on expense management practices, underwriting and pricing segmentation, and claim settlement effectiveness strategies enable Personal to price its products competitively in all of its distribution channels.
Asset Management. Nuveen Investments is subject to substantial competition in all aspects of its business. The registered representatives that distribute Nuveen Investments’ investment products also distribute numerous competing products, often including products sponsored by the retail distribution firms where they are employed. There are relatively few barriers to entry for new investment management firms. Nuveen Investments’ managed account business is also subject to substantial competition from other investment management firms seeking to be approved as managers in the various “wrap-fee” programs. The sponsor firms have a limited number of approved managers at the highest and most attractive levels of their programs and closely monitor the investment performance and customer service aspects of such firms on an on-going basis as they evaluate which firms are eligible for continued participation in these programs. Nuveen Investments is also subject to competition in obtaining the commitment of underwriters to underwrite its exchange-traded fund offerings. To the extent the increased competition for underwriting and distribution causes higher distribution costs, Nuveen Investments’ net revenue and earnings will be reduced.
Investment products are sold to the public by broker/dealers, banks, insurance companies and others, and many competing investment product sponsors offer a broader array of investment products. Many of these institutions have substantially greater resources than Nuveen Investments. In addition, continuing consolidation in the financial services industry is altering the landscape in which Nuveen Investments’ distributors compete. The effect that continuing change in the brokerage and investment management industries will have on Nuveen Investments and its competitors cannot be predicted. Nuveen Investments competes with other providers of products primarily on the basis of the range of products offered, the investment performance of such products, quality of service, fees charged, the level and type of broker compensation, the manner in which such products are marketed and distributed, and the services provided to registered representatives and investors.
REGULATION
State Regulation
The Company’s insurance subsidiaries are subject to regulation in the various states and jurisdictions in which they transact business. The extent of regulation varies, but generally derives from statutes that delegate regulatory, supervisory and administrative authority to a department of insurance in each state. The regulation, supervision and administration relate, among other things, to standards of solvency that must be met and maintained, the licensing of insurers and their agents, the nature of and limitations on investments, premium rates, restrictions on the size of risks that may be insured under a single policy, reserves and provisions for unearned premiums, losses and other obligations, deposits of securities for the benefit of policyholders, approval of policy forms and the regulation of market conduct, including the use of credit information in underwriting as well as other underwriting and claims practices. In addition, many states have enacted variations of competitive
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Table of ContentsIndex to Financial Statementsrate-making laws, which allow insurers to set certain premium rates for certain classes of insurance without having to obtain the prior approval of the state insurance department. State insurance departments also conduct periodic examinations of the affairs of insurance companies and require the filing of annual and other reports relating to the financial condition of companies and other matters. At the present time, the Company’s insurance subsidiaries are collectively licensed to transact insurance business in all states, the District of Columbia, Guam, Puerto Rico, Bermuda, and the U.S. Virgin Islands, as well as Australia, Canada, New Zealand, the Philippines, the United Kingdom, the Republic of Ireland, South Africa and Central and South America.
As part of ongoing, industry-wide investigations, the Company and its affiliates have received subpoenas from several government agencies, including 14 states and the SEC. The areas of inquiry addressed to the Company include its relationship with brokers and agents, the Company’s involvement with “non-traditional insurance and reinsurance products,” lawyer liability insurance and branding requirements for salvage automobiles. The Company is cooperating fully with these subpoenas and requests for information.
Insurance Holding Company Statutes
As a holding company, the Company is not regulated as an insurance company. However, as the Company owns capital stock in insurance subsidiaries, it is subject to state insurance holding company statutes, as well as certain other laws, of each of the states of domicile of the Company’s insurance subsidiaries. All holding company statutes, as well as other laws, require disclosure and, in some instances, prior approval of material transactions between an insurance company and an affiliate. The holding company statutes as well as other laws also require, among other things, prior approval of an acquisition of control of a domestic insurer, some transactions between affiliates and the payment of extraordinary dividends or distributions.
Insurance Regulation Concerning Dividends
The Company’s principal insurance subsidiaries are domiciled in the states of Connecticut and Minnesota. The insurance holding company laws of both states applicable to the Company’s subsidiaries require notice to, and approval by, the state insurance commissioner for the declaration or payment of any dividend, that together with other distributions made within the preceding twelve months, exceeds the greater of 10% of the insurer’s surplus as of the preceding December 31, or the insurer’s net income for the twelve-month period ending the preceding December 31, in each case determined in accordance with statutory accounting practices. (In the case of Minnesota, net income excludes realized investment gains for purposes of the calculation of the 10% threshold.) This declaration or payment is further limited by adjusted unassigned surplus, as determined in accordance with statutory accounting practices.
The insurance holding company laws of other states in which the Company’s insurance subsidiaries are domiciled generally contain similar, although in some instances somewhat more restrictive, limitations on the payment of dividends.
Assessments for Guaranty Funds and Second-Injury Funds and Other Mandatory Pooling Arrangements
Virtually all states require insurers licensed to do business in their state to bear a portion of the loss suffered by some insureds as a result of the insolvency of other insurers. Depending upon state law, insurers can be assessed an amount that is generally equal to between 1% and 2% of premiums written for the relevant lines of insurance in that state each year to pay the claims of an insolvent insurer. Part of these payments is recoverable through premium rates, premium tax credits or policy surcharges. Significant increases in assessments could limit the ability of the Company’s insurance subsidiaries to recover such assessments through tax credits or other means. In addition, there have been some legislative efforts to limit or repeal the tax offset provisions, which efforts, to date, have been generally unsuccessful. These assessments are expected to increase in the future as a result of recent insolvencies.
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Table of ContentsIndex to Financial StatementsMany states have laws that established second-injury funds to provide compensation to injured employees for aggravation of a prior condition or injury. Insurers writing workers’ compensation in those states having second-injury funds are subject to the laws creating the funds, including the various funding mechanisms that those states have adopted to fund the second-injury funds. Several of the states having larger second-injury funds utilize a premium surcharge that effectively passes the cost of the fund to policyholders. Other states assess the insurer based on paid losses and allow the insurer to recoup the assessment through future premium rates.
The Company’s insurance subsidiaries are also required to participate in various involuntary assigned risk pools, principally involving workers’ compensation and automobile insurance, which provide various insurance coverages to individuals or other entities that otherwise are unable to purchase that coverage in the voluntary market. Participation in these pools in most states is generally in proportion to voluntary writings of related lines of business in that state. In the event that a member of that pool becomes insolvent, the remaining members assume an additional pro rata share of the liabilities of the pool. The underwriting results of these pools traditionally have been unprofitable. Combined earned premiums related to such pools and assigned risks for the Company were $168 million, $160 million and $148 million in 2004, 2003 and 2002, respectively. The related combined underwriting losses for the Company were $71 million, $111 million and $39 million in 2004, 2003 and 2002, respectively.
Proposed legislation and regulatory changes have been introduced in the states from time to time that would modify some of the laws and regulations affecting the financial services industry, including the use of information. The potential impact of that legislation on the Company’s businesses cannot be predicted at this time.
Insurance Regulations Concerning Change of Control
Many state insurance regulatory laws intended primarily for the protection of policyholders contain provisions that require advance approval by state agencies of any change in control of an insurance company that is domiciled, or, in some cases, having substantial business that it is deemed to be commercially domiciled, in that state. The Company owns, directly or indirectly, all of the shares of stock of property and casualty insurance companies domiciled in the states of Arizona, California, Connecticut, Delaware, Florida, Illinois, Indiana, Iowa, Maryland, Massachusetts, Minnesota, Mississippi, New Jersey, New York, Texas and Wisconsin. “Control” is generally presumed to exist through the ownership of 10% (5% in the case of Florida) or more of the voting securities of a domestic insurance company or of any company that controls a domestic insurance company. Any purchaser of shares of common stock representing 10% (5% in the case of Florida) or more of the voting power of the Company’s capital stock will be presumed to have acquired control of the Company’s domestic insurance subsidiaries unless, following application by that purchaser in each insurance subsidiary’s state of domicile, the relevant insurance commissioner determines otherwise.
In addition to these filings, the laws of many states contain provisions requiring pre-notification to state agencies prior to any change in control of a non-domestic insurance company admitted to transact business in that state. While these pre-notification statutes do not authorize the state agency to disapprove the change of control, they do authorize issuance of cease and desist orders with respect to the non-domestic insurer if it is determined that some conditions, such as undue market concentration, would result from the acquisition.
Any transactions that would constitute a change in control of any of the Company’s insurer subsidiaries would generally require prior approval by the insurance departments of the states in which the Company’s insurance subsidiaries are domiciled or commercially domiciled and may require preacquisition notification in those states that have adopted preacquisition notification provisions and in which such insurance subsidiaries are admitted to transact business.
One of the Company’s insurance subsidiaries and the Company’s operations at Lloyd’s are domiciled in the United Kingdom. Insurers in the United Kingdom are subject to change of control restrictions in the Financial
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Table of ContentsIndex to Financial StatementsServices and Markets Act of 2000 including approval of the Financial Services Authority. Insurers in the Republic of Ireland are subject to regulation by the Irish Financial Services Regulatory Authority.
Some of the Company’s other insurance subsidiaries are domiciled in, or authorized to conduct insurance business in, Canada. Authorized insurers in Canada are subject to change of control restrictions in Section 407 of the Insurance Companies Act, including approval of the Office of the Superintendent of Financial Institutions.
These requirements may deter, delay or prevent transactions affecting the control of or the ownership of common stock, including transactions that could be advantageous to the Company’s shareholders.
Insurance Regulatory Information System
The National Association of Insurance Commissioners (NAIC) Insurance Regulatory Information System (IRIS) was developed to help state regulators identify companies that may require special attention. The IRIS system consists of a statistical phase and an analytical phase whereby financial examiners review annual statements and financial ratios. The statistical phase consists of twelve key financial ratios based on year-end data that are generated from the NAIC database annually, and each ratio has an established “usual range” of results. These ratios assist state insurance departments in executing their statutory mandate to oversee the financial condition of insurance companies.
A ratio result falling outside the usual range of IRIS ratios is not considered a failing result; rather, unusual values are viewed as part of the regulatory early monitoring system. Furthermore, in some years, it may not be unusual for financially sound companies to have several ratios with results outside the usual ranges. Generally, an insurance company will become subject to regulatory scrutiny if it falls outside the usual ranges of four or more of the ratios. As published by the NAIC, approximately 18.5% of the companies included in the IRIS system have reported results outside the usual range on four or more ratios in 2002.
In 2004, most of the Company’s insurance subsidiaries in the Travelers Property Casualty pool had results outside the usual range for the estimated current reserve deficiency to surplus ratio, with ratios ranging from 26% to 37% above the usual 25% or lower, due to the lags in the ratio’s ability to reflect changes in business volume and business mix. Also in 2004, the Gulf Insurance Company, St. Paul Fire and Marine Insurance Company, United States Fidelity and Guaranty Company, Discover Reinsurance Company and most of the St. Paul Fire and Marine pool members had unusual values in the one-year and two-year reserve development ratios above the usual values of 20% or lower, due to reserve strengthening actions that occurred in 2003 and 2004. Those one-year and two-year reserve development ratios for Gulf Insurance Company were 44% and 126%, for St. Paul Fire and Marine Insurance Company the ratios were 24% and 40%, for United States Fidelity and Guaranty Company the ratios were 78% and 29%, and for Discover Reinsurance Company the ratios were 64% and 151%. The one-year and two-year reserve development ratios for the St. Paul Fire and Marine pool members with unusual values ranged from 22% to 45% and 40% to 93% respectively. United States Fidelity and Guaranty Company, Discover Reinsurance Company and Gulf Insurance Company had two-year operating ratios of 159%, 108% and 149%, respectively, compared to the usual maximum of 100%, due to the 2004 reserve strengthening actions. United States Fidelity and Guaranty Company and Discover Reinsurance Company also had change in surplus ratios of 63% and 78%, respectively, compared to a usual maximum of 50%, due to 2004 capital contributions from their parent companies. Discover Reinsurance Company also had a surplus aid to surplus ratio of 17% compared to the usual maximum of 15%. Several of the Company’s insurance subsidiaries, including Gulf Insurance Company, had investment yield ratios below the usual minimum ratio of 4.5% due to lower yields on newer investments. This was especially true for those companies with predominately shorter term investments and investments in tax-exempt securities.
In 2003, most of the Company’s insurance subsidiaries in the Travelers Property Casualty pool had results outside the usual range for the two-year reserve development to surplus ratio and the estimated current reserve deficiency to surplus ratio ranging from 22% to 51%, which exceeded the usual range of 20% to 25% or lower, primarily because of the pretax statutory income statement charges for additions to asbestos reserves in 2002. In
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Table of ContentsIndex to Financial Statementsaddition, one of the Company’s principal insurance companies had one other ratio outside the usual range. The Travelers Indemnity Company had a liabilities to liquid assets ratio of 116%, which exceeded the usual maximum result of 105% due primarily to sizable subsidiary investments that are excluded from the calculation of liquid assets and the 2002 increase in asbestos reserves that are included in liabilities. Also in 2003, the insurance companies in the Gulf pool had results for the one-year and two-year reserve development to surplus ratios ranging from 75% to 112% and 88% to 120%, respectively, which exceeded the usual result of 20% or lower for both of these measures because of reserve additions related primarily to the residual value business coupled with increases in core business lines and the reserve for uncollectible reinsurance. The reserve additions also resulted in the Gulf pool companies having two-year overall operating ratios ranging from 128% to 134% which is in excess of the usual value of 100% or lower. In addition, the Gulf pool companies had an estimated current reserve deficiency to surplus ratio ranging from 163% to 268% which exceeded the usual result of 25% or lower also due to these reserve additions. The Gulf pool companies had investment yield ratios ranging from 2.7% to 3.4% which is below the normal minimum value of 4.5% reflecting a shortening of the duration of the fixed maturity portfolio and a decline in interest rates on new investments. Gulf Insurance Company had a liabilities to liquid assets ratio of 115% which exceeded the usual maximum result of 105% due primarily to increases in reinsurance recoverables, a sizeable investment in subsidiaries that are excluded from the calculation of liquid assets and the reserve additions noted above. Gulf Underwriters Insurance Company also had a gross written premiums to surplus ratio of 1065%, which exceeded the usual maximum value of 900% due to increases in premiums written on core specialty lines of business.
In 2002, most of the Company’s insurance subsidiaries in the Travelers Property Casualty pool had results outside the usual range for the one year reserve development to surplus ratio, the two year reserve development to surplus ratio and the estimated current reserve deficiency to surplus ratio ranging from 21% to 44%, which exceeded the usual range of 20% to 25% or lower, primarily because of the pretax statutory income statement charges for additions to asbestos reserves in 2002. In addition, three of the Company’s principal insurance companies had other ratios outside the usual range. The Travelers Indemnity Company and The Standard Fire Insurance Company had investment yield ratios of 3.8% and 4.2%, respectively, which were less than the usual results of 4.5% or higher, reflecting the decline in interest rates on new investments and lower dividends from subsidiary equity investments. The Travelers Indemnity Company and Travelers Casualty and Surety Company had liabilities to liquid assets ratios of 120% and 107%, respectively, which exceeded the usual result of 105% or lower due primarily to sizable subsidiary investments that are excluded from the calculation of liquid assets and an increase in asbestos reserves that are included in liabilities. The Travelers Casualty and Surety Company and the Standard Fire Insurance Company each had a change in surplus ratio of -12%, which exceeded the usual result of -10% due to a net loss resulting primarily from charges for additions to asbestos reserves in 2002. Also in 2002, the insurance companies in the Gulf pool had results for the two year reserve development to surplus ratio ranging from 32% to 44%, which exceeded the usual result of 20% or lower because of reserve additions related to a run-off product line. In addition, the Gulf pool companies had an estimated current reserve deficiency to surplus ratio ranging from 46% to 84%, which exceeded the usual result of 25% or lower and a change in net writings ratio ranging from 223% to 403%, which exceeded the usual result of 33% or lower primarily due to the effect of their removal from the Travelers Property Casualty pool and the reestablishment of the Gulf pool. Gulf Insurance Company and Gulf Underwriters Insurance Company had investment yield ratios of 4.3% and 3.9%, respectively, which were less than the usual result of 4.5% or higher reflecting a shortening of the duration of the portfolio and a decline in interest rates on new investments. Gulf Underwriters Insurance Company also had a gross written premiums to surplus ratio of 1235%, which exceeded the usual result of 900% or lower due to increases in premiums written on core specialty lines and the effect of the companies’ removal from the Travelers Property Casualty pool and the reestablishment of the Gulf pool.
In all of these instances in prior years, regulators have been satisfied upon follow-up that no regulatory action was required. It is possible that similar results could occur in the future. Management does not anticipate regulatory action as a result of the 2004 IRIS ratio results. No regulatory action has been taken by any state insurance department or the NAIC with respect to IRIS ratios of any of the Company’s insurance subsidiaries for the year ended December 31, 2003.
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Table of ContentsIndex to Financial StatementsRisk-Based Capital (RBC) Requirements
In order to enhance the regulation of insurer solvency, the NAIC has adopted a formula and model law to implement RBC requirements for most property and casualty insurance companies, which is designed to determine minimum capital requirements and to raise the level of protection that statutory surplus provides for policyholder obligations. The RBC formula for property and casualty insurance companies measures three major areas of risk facing property and casualty insurers:
Under laws adopted by individual states, insurers having total adjusted capital less than that required by the RBC calculation will be subject to varying degrees of regulatory action, depending on the level of capital inadequacy.
The RBC law provides for four levels of regulatory action. The extent of regulatory intervention and action increases as the level of surplus to RBC falls. The first level, the company action level as defined by the NAIC, requires an insurer to submit a plan of corrective actions to the regulator if surplus falls below 200% of the RBC amount. The regulatory action level, as defined by the NAIC, requires an insurer to submit a plan containing corrective actions and requires the relevant insurance commissioner to perform an examination or other analysis and issue a corrective order if surplus falls below 150% of the RBC amount. The authorized control level, as defined by the NAIC, authorizes the relevant insurance commissioner to take whatever regulatory actions considered necessary to protect the best interest of the policyholders and creditors of the insurer which may include the actions necessary to cause the insurer to be placed under regulatory control, i.e., rehabilitation or liquidation, if surplus falls below 100% of the RBC amount. The fourth action level is the mandatory control level as defined by the NAIC, which requires the relevant insurance commissioner to place the insurer under regulatory control if surplus falls below 70% of the RBC amount.
The formulas have not been designed to differentiate among adequately capitalized companies that operate with higher levels of capital. Therefore, it is inappropriate and ineffective to use the formulas to rate or to rank these companies. At December 31, 2004, all of the Company’s property and casualty insurance subsidiaries had total adjusted capital in excess of amounts requiring company or regulatory action at any prescribed RBC action level.
Asset Management Regulation
One of Nuveen Investments’ subsidiaries is registered as a broker/dealer under the Securities Exchange Act of 1934 and is subject to regulation by the SEC, NASD Regulation, Inc. and other federal and state agencies and self-regulatory organizations. The securities industry is one of the most highly regulated in the United States, and failure to comply with related laws and regulations can result in the revocation of broker/dealer licenses, the imposition of censures or fines, and the suspension or expulsion of a firm and/or its employees from the securities business.
Each of Nuveen Investments’ investment adviser subsidiaries is registered with the SEC under the Investment Advisers Act. Virtually all aspects of Nuveen Investments’ investment management business are subject to various federal and state laws and regulations. These laws and regulations are primarily intended to benefit the investment product holder and generally grant supervisory agencies and bodies broad administrative powers, including the power to limit or restrict Nuveen Investments from carrying on its investment management business in the event that it fails to comply with such laws and regulations. In such event, the possible sanctions
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Table of ContentsIndex to Financial Statementsthat may be imposed include the suspension of individual employees, limitations on Nuveen Investments’ engaging in the investment management business for specified periods of time, the revocation of its advisory subsidiaries’ registrations as investment advisers or other censures and fines.
Over the past 18 months, Nuveen Investments has responded to various industry wide information requests from the SEC and other governmental entities which have arisen in connection with widely publicized regulatory violations by industry participants. These information requests have addressed a number of subjects, including market timing, late trading, pricing of portfolio securities, selective disclosure of portfolio information, revenue sharing, and directed brokerage. Nuveen Investments has responded to these information requests and various follow up requests and made any recommended revisions to its policies and procedures. It is possible that the various regulatory violations that prompted these information requests could result in increased regulation of all asset managers, including Nuveen Investments. Such regulation could have an adverse effect on the profitability of Nuveen Investments.
OTHER INFORMATION
General Business Factors
In the opinion of the Company’s management, no material part of the business of the Company and its subsidiaries is dependent upon a single customer or group of customers, the loss of any one of which would have a materially adverse effect on the Company, and no one customer or group of affiliated customers accounts for as much as 10% of the Company’s consolidated revenues.
Employees
At December 31, 2004, the Company had 29,200 full-time and 1,000 part-time employees. The Company believes that its employee relations are satisfactory. None of the Company’s employees are subject to collective bargaining agreements.
Source of Funds
For a discussion of the Company’s sources of funds and maturities of the long-term debt of the Company, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources,” and note 10 of notes to the Company’s consolidated financial statements.
Taxation
For a discussion of tax matters affecting the Company and its operations, see note 11 of notes to the Company’s consolidated financial statements.
Financial Information about Industry Segments
For financial information regarding industry segments of the Company, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and note 5 of notes to the Company’s consolidated financial statements.
Recent Transactions
For information regarding recent transactions of the Company, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and note 1 of notes to the Company’s consolidated financial statements.
Company Website and Availability of SEC Filings
The Company’s Internet website is www.stpaultravelers.com. Information on the Company’s website is not a part of this Form 10-K. The Company makes available free of charge on its website or provides a link to the Company’s Annual Report on Form 10-K, Quarterly Reports on Form 10-Q and Current Reports on Form 8-K, and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, that are filed with the SEC. To access these filings, go to the Company’s website, then click on “SEC Filings” under the “Investors” heading.
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Table of ContentsIndex to Financial StatementsGlossary of Selected Insurance Terms
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Table of ContentsIndex to Financial StatementsItem 2. PROPERTIES
The Company owns its corporate headquarters buildings located at 385 Washington Street and 130 West Sixth Street, St. Paul, Minnesota. These buildings are adjacent to one another and consist of approximately 1.1 million square feet of gross floor space. The Company also owns properties in Woodbury, Minnesota, where an administrative services building and off-site computer processing operations are located. The Woodbury properties are currently being marketed for sale.
The Company also owns six buildings in Hartford, Connecticut. The Company currently occupies approximately 1.7 million square feet of office space in these buildings. The Company also owns other real property, which includes office buildings in Fall River, Massachusetts, and in Irving, Texas, and a data center located in Norcross, Georgia. In addition, the Company leases 222 field and claim offices totaling approximately 4.9 million square feet throughout the United States under leases or subleases with third parties.
The Company owns a building in London, England, which houses a portion of its operations in the United Kingdom.
The Company, through its subsidiaries, owns an investment portfolio of income-producing properties and real estate funds. Included in this portfolio are four office buildings in which the Company holds a 50% ownership interest located in New York, New York, which collectively accounted for approximately 13% of the carrying value of the property portfolio at December 31, 2004.
In the opinion of the Company’s management, the Company’s properties are adequate and suitable for its business as presently conducted and are adequately maintained.
Item 3. LEGAL PROCEEDINGS
This section describes the major pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Company or its subsidiaries are a party or to which any of the Company’s property is subject.
Asbestos and Environmental-Related Proceedings
In the ordinary course of its insurance business, the Company receives claims for insurance arising under policies issued by the Company asserting alleged injuries and damages from asbestos and other hazardous waste and toxic substances which are the subject of related coverage litigation, including, among others, the litigation described below. The Company continues to be subject to aggressive asbestos-related litigation. The conditions surrounding the final resolution of these claims and the related litigation continue to change.
TPC is involved in three significant proceedings relating to ACandS, Inc. (ACandS), formerly a national distributor and installer of products containing asbestos, including ACandS’ bankruptcy proceedings. The proceedings involve disputes as to whether and to what extent any of ACandS’ potential liabilities for bodily injury asbestos claims are covered by insurance policies issued by TPC. These proceedings have resulted in decisions favorable to TPC, although those decisions are subject to appellate review. The status of the various proceedings is described below.
ACandS filed for bankruptcy in September 2002 (In re: ACandS, Inc., pending in the U.S. Bankruptcy Court for the District of Delaware). In its proposed plan of reorganization, ACandS sought to establish a trust to pay asbestos bodily injury claims against it and sought to assign to the trust its rights under the insurance policies issued by TPC. The proposed plan and disclosure statement filed by ACandS claimed that ACandS had settled the vast majority of asbestos-related bodily injury claims currently pending against it for approximately $2.80 billion. ACandS asserts that, based on a prior agreement between TPC and ACandS and ACandS’ interpretation of the July 31, 2003 arbitration panel ruling described below, TPC is liable for 45% of the $2.80 billion. On January 26, 2004, the bankruptcy court issued a decision rejecting confirmation of ACandS’ proposed plan of
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Table of ContentsIndex to Financial Statementsreorganization. The bankruptcy court found, consistent with TPC’s objections to ACandS’ proposed plan, that the proposed plan was not fundamentally fair, was not proposed in good faith and did not comply with Section 524(g) of the Bankruptcy Code. ACandS has filed a notice of appeal of the bankruptcy court’s decision and has filed objections to the bankruptcy court’s findings of fact and conclusions of law in the United States District Court. TPC has moved to dismiss the appeal and objections and has also filed an opposition to ACandS’ objections.
An arbitration was commenced in January 2001 to determine whether and to what extent ACandS’ financial obligations for bodily injury asbestos claims are subject to insurance policy aggregate limits. On July 31, 2003, the arbitration panel ruled in favor of TPC that asbestos bodily injury claims against ACandS are subject to the aggregate limits of the policies issued to ACandS, which have been exhausted. In October 2003, ACandS commenced a lawsuit seeking to vacate the arbitration award as beyond the panel’s scope of authority (ACandS, Inc. v. Travelers Casualty and Surety Co., U.S.D.Ct., E.D. Pa.). On September 16, 2004, the Court entered an order denying ACandS’ motion to vacate the arbitration award. On October 6, 2004, ACandS filed a notice of appeal. Briefing of the appeal is complete. Oral argument has not been scheduled.
In the other proceeding, a related case pending before the same court and commenced in September 2000 (ACandS v. Travelers Casualty and Surety Co., U.S.D. Ct., E.D. Pa.), ACandS sought a declaration of the extent to which the asbestos bodily injury claims against ACandS are subject to occurrence limits under insurance policies issued by TPC. TPC filed a motion to dismiss this action based upon the July 31, 2003 arbitration decision described above. The Court found the dispute was moot as a result of the arbitration panel’s decision. The Court, therefore, based on the arbitration panel’s decision, dismissed the case. On October 6, 2004, ACandS filed a notice of appeal. This appeal has been consolidated with the appeal referenced in the paragraph above. Briefing of the appeal is complete. Oral argument has not been scheduled.
While the Company cannot predict the outcome of the appeals of the various ACandS rulings or other legal actions, based on these rulings, the Company would not have any significant obligations remaining under any policies issued by TPC to ACandS.
In October 2001 and April 2002, two purported class action suits (Wise v. Travelers and Meninger v. Travelers), were filed against TPC and other insurers (not including SPC) in state court in West Virginia. These cases were subsequently consolidated into a single proceeding in Circuit Court of Kanawha County, West Virginia. Plaintiffs allege that the insurer defendants engaged in unfair trade practices by inappropriately handling and settling asbestos claims. The plaintiffs seek to reopen large numbers of settled asbestos claims and to impose liability for damages, including punitive damages, directly on insurers. Lawsuits similar to Wise were filed in Massachusetts and Hawaii (these suits are collectively referred to as the “Statutory and Hawaii Actions”). Also, in November 2001, plaintiffs in consolidated asbestos actions pending before a mass tort panel of judges in West Virginia state court moved to amend their complaint to name TPC as a defendant, alleging that TPC and other insurers breached alleged duties to certain users of asbestos products. In March 2002, the court granted the motion to amend. Plaintiffs seek damages, including punitive damages. Lawsuits seeking similar relief and raising allegations similar to those presented in the West Virginia amended complaint are also pending in Ohio and Texas state courts against TPC and SPC and in Louisiana state court against TPC (the claims asserted in these suits, together with the West Virginia suit, are collectively referred to as the “Common Law Claims”).
All of the actions against TPC described in the preceding paragraph, other than the Hawaii Actions, had been subject to a temporary restraining order entered by the federal bankruptcy court in New York that had previously presided over and approved the reorganization in bankruptcy of TPC’s former policyholder Johns- Manville. In August 2002, the bankruptcy court conducted a hearing on TPC’s motion for a preliminary injunction prohibiting further prosecution of the lawsuits pursuant to the reorganization plan and related orders. At the conclusion of this hearing, the court ordered the parties to mediation, appointed a mediator and continued the temporary restraining order. During 2003, the same bankruptcy court extended the existing injunction to apply to an additional set of cases filed in various state courts in Texas and Ohio as well as to the attorneys who
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Table of ContentsIndex to Financial Statementsare prosecuting these cases. The order also enjoined these attorneys and their respective law firms from commencing any further lawsuits against TPC based upon these allegations without the prior approval of the court. Notwithstanding the injunction, additional Common Law Claims were filed and served on TPC.
On November 19, 2003, the parties advised the bankruptcy court that a settlement of the Statutory and Hawaii Actions had been reached. This settlement includes a lump sum payment of up to $412 million by TPC, subject to a number of significant contingencies. After continued meetings with the mediator, the parties advised the bankruptcy court on May 25, 2004 that a settlement resolving substantially all pending and similar future Common Law Claims against TPC had also been reached. This settlement requires a payment of up to $90 million by TPC, subject to a number of significant contingencies. Each of these settlements is contingent upon, among other things, an order of the bankruptcy court clarifying that all of these claims, and similar future asbestos-related claims against TPC, are barred by prior orders entered by the bankruptcy court in connection with the original Johns-Manville bankruptcy proceedings.
On August 17, 2004, the bankruptcy court entered an order approving the settlements and clarifying its prior orders that all of the pending Statutory and Hawaii Actions and substantially all Common Law Claims pending against TPC are barred. The order also applies to similar direct action claims that may be filed in the future.
Five appeals were taken from the August 17, 2004 ruling. These appeals have been consolidated and are currently pending. The parties have completed briefing all of the issues and await a date for oral argument. The Company has no obligation to pay any of the settlement amounts unless and until the orders and relief become final and are not subject to any further appellate review. It is not possible to predict how appellate courts will rule on the pending appeals.
SPC, which is not covered by the bankruptcy court rulings or the settlements described above, has numerous defenses in all of the direct action cases asserting Common Law Claims that are pending against it. Many of these defenses have been raised in initial motions to dismiss filed by SPC and other insurers. There have been favorable rulings during 2003 and 2004 in Texas and during 2004 in Ohio on some of these motions filed by SPC and other insurers that dealt with statute of limitations and the validity of the alleged causes of actions. The plaintiffs in these actions have appealed these favorable rulings. SPC’s defenses include the fact that these novel theories have no basis in law; that they are directly at odds with the well established law pertaining to the insured/insurer relationship; that there is no generalized duty to warn as alleged by the plaintiffs; and that the applicable statute of limitations as to many of these claims has long since expired.
The Company is defending its asbestos and environmental-related litigation vigorously and believes that it has meritorious defenses; however, the outcome of these disputes is uncertain. In this regard, the Company employs dedicated specialists and aggressive resolution strategies to manage asbestos and environmental loss exposure, including settling litigation under appropriate circumstances. For a discussion of other information regarding the Company’s asbestos and environmental exposure, see “Item 7—Management’s Discussion and Analysis of Financial Condition and Results of Operations—Asbestos Claims and Litigation”, “—Environmental Claims and Litigation” and “—Uncertainty Regarding Adequacy of Asbestos and Environmental Reserves.”
Currently, it is not possible to predict legal outcomes and their impact on the future development of claims and litigation relating to asbestos and environmental claims. Any such development will be affected by future court decisions and interpretations, as well as changes in applicable legislation. Because of these uncertainties, additional liabilities may arise for amounts in excess of the current related reserves. In addition, the Company’s estimate of ultimate claims and claim adjustment expenses may change. These additional liabilities or increases in estimates, or a range of either, cannot now be reasonably estimated and could result in income statement charges that could be material to the Company’s results of operations and financial condition in future periods.
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Table of ContentsIndex to Financial StatementsShareholder Litigation and Related Proceedings
TPC and its board of directors were named as defendants in three putative class action lawsuits brought by shareholders alleging breach of fiduciary duty in connection with the merger of TPC and SPC and seeking injunctive relief as well as unspecified monetary damages. The actions were captioned Henzel, et al. v. Travelers Property Casualty Corp., et al. (Jud. Dist. of Waterbury, Ct. Nov. 17, 2003); Vozzolo v. Travelers Property Casualty Corp., et al. (Jud. Dist. of Waterbury, Ct. Nov. 17, 2003); and Farina v. Travelers Property Casualty Corp., et al. (Jud. Dist. of Waterbury, Ct. December 15, 2003). The Farina complaint also named SPC and its former subsidiary, Adams Acquisition Corp., as defendants, alleging that they aided and abetted the alleged breach of fiduciary duty. On March 18, 2004, TPC and SPC announced that all of these lawsuits had been settled, subject to court approval of the settlements. The settlement included a modification to the termination fee that could have been paid had the merger not been completed, additional disclosure in the proxy statement distributed in connection with the merger and a nominal amount for attorneys’ fees. Before court approval of the settlement, additional shareholder litigation was commenced, as described below. In light of that litigation, the parties are evaluating how to proceed.
Beginning in August 2004, following post-merger announcements by the Company, various shareholders of the Company commenced fourteen putative class action lawsuits against the Company and certain of its current and former officers and directors in the United States District Court for the District of Minnesota. Plaintiff shareholders allege that certain disclosures relating to the April 2004 merger between TPC and SPC contained false or misleading statements with respect to the value of SPC’s loss reserves in violation of federal securities laws. The complaints do not specify damages. These actions have been consolidated under the caption In re St. Paul Travelers Securities Litigation. Plaintiffs have not yet filed a consolidated class action complaint. An additional putative class action based on the same allegations was brought in New York State Supreme Court. This action was subsequently transferred to, and is currently pending in, the District of Minnesota.
In addition, five other actions against the Company and certain of its current and former officers and directors are pending in the United States District Court for the District of Minnesota. Two of these actions, Kahn v. The St. Paul Travelers Companies, Inc., et al. (Nov. 2, 2004) and Michael A. Bernstein Profit Sharing Plan v. The St. Paul Travelers Companies, Inc., et al. (Nov. 10, 2004), are putative class actions brought by certain shareholders of the Company against the Company and certain of its current and former officers and directors. In these two actions, plaintiff shareholders allege violations of federal securities laws in connection with the Company’s alleged failure to make disclosure relating to the practice of paying brokers commissions on a contingent basis. Two derivative actions have been brought against all current directors of the Company, naming the Company as a nominal defendant. In Rowe v. Fishman, et al. (Oct. 22, 2004), the plaintiff shareholder alleges state law claims, including breach of fiduciary duty, based on allegations similar to those alleged in In re St. Paul Travelers Securities Litigation described above. In Clark v. Fishman, et al. (Nov. 18, 2004), the plaintiff shareholder alleges state law claims, including breach of fiduciary duty, based on the Company’s alleged mismanagement of and failure to make disclosure relating to the practice of paying brokers commissions on a contingent basis. The derivative actions have been consolidated for pretrial proceedings as Rowe, et al. v. Fishman, et al. In the fifth of these actions, an alleged beneficiary of the Company’s 401(k) savings plan has commenced a putative class action in the District of Minnesota against the Company and certain of its current and former officers and directors captioned Spiziri v. The St. Paul Travelers Companies, Inc., et al. (Dec. 28, 2004). The plaintiff alleges violations of the Employee Retirement Income Security Act based on allegations similar to those alleged in In re St.Paul Travelers Securities Litigation.
The Company believes that these lawsuits have no merit and intends to defend vigorously; however, the Company is not able to provide any assurance that one or more of these proceedings will not be material to the Company’s results of operations in a future period. The Company is obligated to indemnify its officers and directors to the extent provided under Minnesota law. As part of that obligation, the Company will advance officers and directors attorneys’ fees and other expenses they incur in defending these lawsuits.
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Table of ContentsIndex to Financial StatementsOther Proceedings
In previous filings, the Company reported on a series of purported class actions and one multi-party action brought in various courts around the United States against certain of TPC’s subsidiaries, dozens of other insurers and the National Council on Compensation Insurance. The allegations in the actions were substantially similar, and generally alleged that the defendants conspired to collect excessive or improper premiums on loss-sensitive workers’ compensation insurance policies in violation of state insurance laws, antitrust laws, and state unfair trade practices laws. The plaintiffs in the actions do not specify damages. TPC has vigorously defended the actions, with all but a few of the actions having been dismissed to date. In addition, the plaintiffs’ attempts to obtain class certification have not been successful. Under the present circumstances, the Company does not believe its remaining exposure to be significant.
From time to time the Company is involved in proceedings addressing disputes with its reinsurers regarding the collection of amounts due under the Company’s reinsurance agreements. These proceedings may be initiated by the Company or the reinsurers and may involve the terms of the reinsurance agreements, the coverage of particular claims, exclusions under the agreements, as well as counterclaims for rescission of the agreements. One of these disputes is the action described in the following paragraph.
Gulf, a wholly-owned subsidiary of TPC, brought an action on May 22, 2003, as amended on May 12, 2004, in the Supreme Court of New York, County of New York (Gulf Insurance Company v. Transatlantic Reinsurance Company, et al.), against Transatlantic Reinsurance Company (Transatlantic), XL Reinsurance America, Inc. (XL), Odyssey America Reinsurance Corporation (Odyssey), Employers Reinsurance Company (Employers) and Gerling Global Reinsurance Corporation of America (Gerling), to recover amounts due under reinsurance contracts issued to Gulf and related to Gulf’s February 2003 settlement of a coverage dispute under a vehicle residual value protection insurance policy. The reinsurers have asserted counterclaims seeking rescission of the vehicle residual value reinsurance contracts issued to Gulf and unspecified damages for breach of contract. Separate actions filed by Transatlantic and Gerling have been consolidated with the original Gulf action for pre-trial purposes. On October 1, 2003, Gulf entered into a final settlement agreement with Employers, and all claims and counterclaims with respect to Employers have been dismissed.
On May 26, 2004, the Court denied Gulf’s motion to dismiss certain claims asserted by Transatlantic and a joint motion by Transatlantic, XL and Odyssey for summary judgment against Gulf. Discovery is currently proceeding in the matters. Gulf denies the reinsurers’ allegations, believes that it has a strong legal basis to collect the amounts due under the reinsurance contracts and intends to vigorously pursue the actions.
Based on the Company’s beliefs about its legal positions in its various reinsurance recovery proceedings, the Company does not expect any of these matters to have a material adverse effect on its results of operations in a future period.
As part of ongoing, industry-wide investigations, the Company and its affiliates have received subpoenas and written requests for information from government agencies. The areas of inquiry addressed to the Company include its relationship with brokers and agents, the Company’s involvement with “non-traditional insurance and reinsurance products,” lawyer liability insurance and branding requirements for salvage automobiles. The Company or its affiliates have received subpoenas or written requests for information from: (i) State of California Office of the Attorney General; (ii) State of California Department of Insurance; (iii) Licensing and Market Conduct Compliance Division, Financial Services Commission of Ontario, Canada; (iv) State of Connecticut Insurance Department; (v) State of Connecticut Office of the Attorney General; (vi) State of Delaware Department of Insurance; (vii) State of Florida Department of Financial Services; (viii) State of Florida Office of Insurance Regulation; (ix) State of Florida Department of Legal Affairs Office of the Attorney General; (x) State of Illinois Department of Financial and Professional Regulation; (xi) State of Iowa Insurance Division; (xii) State of Maryland Insurance Administration; (xiii) Commonwealth of Massachusetts Office of the Attorney General; (xiv) State of Minnesota Office of the Attorney General; (xv) State of New York Office of the Attorney General;
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Table of ContentsIndex to Financial Statements(xvi) State of New York Insurance Department; (xvii) State of North Carolina Department of Insurance; (xviii) State of Ohio Office of the Attorney General; (xix) Commonwealth of Pennsylvania Office of the Attorney General; (xx) State of Texas Department of Insurance; (xxi) State of West Virginia Office of Attorney General; and (xxii) the United States Securities and Exchange Commission. The Company is cooperating fully with these subpoenas and requests for information. In addition, the Company is currently undertaking its own review of the matters addressed by these subpoenas and requests for information. The Company is not able to predict the outcome of the various agencies’ investigations or the reviews being undertaken, or how these matters may affect the Company, if at all.
Four putative class action lawsuits have been brought against a number of insurance brokers and insurers, including the Company, by plaintiffs who allegedly purchased insurance products through one or more of the defendant brokers. The complaints are captioned Shell Vacations LLC v. Marsh & McLennan Companies, Inc. (N.D. Ill. Jan. 14, 2005), Redwood Oil Company v. Marsh & McLennan Companies, Inc. (N.D. Ill. Jan. 21, 2005); Boros v. Marsh & McLennan Companies, Inc. (N.D. Cal. Feb. 4, 2005) and Mulcahey v. Arthur J. Gallagher & Co. (D.N.J. February 23, 2005). Plaintiffs allege that various insurance brokers conspired with each other and with various insurers, including the Company, to allocate brokerage customers and rig bids for insurance products offered to those customers. The complaints include causes of action under the Sherman Act, the Racketeer Influenced and Corrupt Organizations Act, federal and state common law and the laws of the various states prohibiting antitrust violations and unfair and/or deceptive trade practices. Plaintiffs seek monetary damages, including punitive damages and trebled damages, permanent injunctive relief, restitution, including disgorgement of profits, interest and costs, including attorneys’ fees. The Company believes that these lawsuits have no merit and intends to defend vigorously.
In addition to those described above, the Company is involved in numerous lawsuits, not involving asbestos and environmental claims, arising mostly in the ordinary course of business operations either as a liability insurer defending third-party claims brought against policyholders or as an insurer defending coverage claims brought against it. While the ultimate resolution of these legal proceedings could be significant to the Company’s results of operations in a future quarter, in the opinion of the Company’s management it would not be likely to have a material adverse effect on the Company’s results of operations for a calendar year or on the Company’s financial condition or liquidity.
NONE.
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Table of ContentsIndex to Financial StatementsPART II
The Company’s common stock is traded on the New York Stock Exchange, where it is assigned the symbol “STA.” Prior to the merger of SPC and TPC, SPC’s common stock traded on the New York Stock Exchange under the symbol “SPC.” The number of holders of record, including individual owners, of the Company’s common stock was 101,243 as of March 8, 2005. This is not the actual number of beneficial owners of the Company’s common stock, as shares are held in “street name” by brokers and others on behalf of individual owners. The following table sets forth the amount of cash dividends declared per share and the high and low closing sales prices of the Company’s common stock for each quarter during the last two fiscal years. SPC historical data is presented in the table for all of 2003 and the first quarter of 2004, as SPC common stock was issued to effect the merger, and SPC, as renamed, was the continuing public company registrant following the merger.
Cash dividends paid per share were $1.16 in both 2004 and 2003. The Company paid a special cash dividend of $0.21 per share and a regular dividend $0.22 per share in the second quarter of 2004. The special dividend was declared by SPC prior to the closing of the merger and was designed to result in the holders of SPC’s common stock prior to the merger receiving aggregate dividends with record dates in 2004 of $1.16 per share, which was SPC’s indicated annual dividend rate prior to the merger. Future dividend decisions will be based on and affected by a number of factors, including the operating results and financial requirements of the Company and the impact of dividend restrictions. For information on dividends, including dividend restrictions included in certain long-term loan or credit agreements of the Company and its subsidiaries, as well as restrictions on the ability of certain of the Company’s subsidiaries to transfer funds to the Company in the form of cash dividends or otherwise, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.” Dividends will be paid by the Company only if declared by its Board of Directors out of funds legally available, and subject to any other restrictions that may be applicable to the Company.
ISSUER PURCHASES OF EQUITY SECURITIES
The table below sets forth information regarding repurchases by the Company of its common stock during the periods indicated.
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Table of ContentsIndex to Financial StatementsAll amounts in the table represent shares repurchased to cover payroll withholding taxes in connection with the vesting of restricted stock awards and exercises of stock options, and shares used to cover the exercise price of certain stock options that were exercised.
All data in the following table for the years 2000 through 2003 represent historical data for TPC. For accounting purposes, the merger of SPC and TPC was accounted for as a reverse acquisition with TPC treated as the accounting acquirer. Accordingly, this transaction was accounted for as a purchase business combination, using TPC’s historical financial information and applying fair value estimates to the acquired assets, liabilities and commitments of SPC as of April 1, 2004.
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Table of ContentsIndex to Financial Statements
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following is a discussion and analysis of the financial condition and results of operations of The St. Paul Travelers Companies, Inc. (together with its subsidiaries, the Company). On April 1, 2004, Travelers Property Casualty Corp. (TPC) merged with a subsidiary of The St. Paul Companies, Inc. (SPC), as a result of which TPC became a wholly-owned subsidiary of SPC, and SPC changed its name to The St. Paul Travelers Companies, Inc. In connection with the merger, each issued and outstanding share of TPC class A (including the associated preferred stock purchase rights) and class B par value $0.01 common stock was exchanged for 0.4334 of a share of the Company’s common stock without designated par value. Share and per share amounts for all periods presented have been restated to reflect the second quarter exchange of TPC common stock for the Company’s common stock in the merger. For accounting purposes, this transaction was accounted for as a reverse acquisition with TPC treated as the accounting acquirer. Accordingly, this transaction was accounted for as a purchase business combination, using TPC historical financial information and applying fair value estimates to the acquired assets, liabilities, and commitments of SPC as of April 1, 2004. Beginning on April 1, 2004, the results of operations and financial condition of SPC were consolidated with TPC’s. Accordingly, all financial information presented herein for the twelve months ended December 31, 2004 reflects the accounts of TPC for the three months ended March 31, 2004 and the consolidated accounts of SPC and TPC for the nine months ended December 31, 2004. The financial information presented herein for the prior year periods reflects the accounts of TPC.
For more information regarding the completion of the merger, including the calculation and allocation of the purchase price, refer to note 2 to the Company’s consolidated financial statements included in this report.
In 2002, TPC completed a corporate reorganization in connection with its initial public offering of common stock. For more information regarding that reorganization and stock offering, refer to note 3 to the Company’s consolidated financial statements included in this report.
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Table of ContentsIndex to Financial StatementsEXECUTIVE SUMMARY
As a result of the April 1, 2004 merger of TPC and SPC, total assets and liabilities increased by $42.99 billion and $34.23 billion, respectively, adding $8.76 billion to the Company’s shareholders’ equity.
2004 Consolidated Results of Operations
2004 Consolidated Financial Condition
CONSOLIDATED OVERVIEW
The Company provides a wide range of property and casualty insurance products and services to businesses, government units, associations and individuals, primarily in the United States and in selected international markets. Through its majority ownership of Nuveen Investments, Inc. (Nuveen Investments), it also has a presence in the asset management industry.
Consolidated Results of Operations
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Table of ContentsIndex to Financial StatementsThe Company’s discussions related to all items, other than net income (loss), are presented on a pretax basis, unless otherwise noted.
Net income in 2004 totaled $955 million, or $1.53 per share diluted, compared with net income of $1.70 billion, or $3.80 per share diluted, in 2003. The $741 million decline in net income in 2004 compared with 2003 was driven by $1.59 billion of after-tax net unfavorable prior-year reserve development ($2.39 billion pretax). That pretax net unfavorable prior year reserve development was primarily comprised of $928 million to strengthen asbestos reserves primarily as a result of the completion of the Company’s annual asbestos liability review in the fourth quarter, $290 million to strengthen environmental reserves, reserve adjustments related to the merger of $500 million for construction and $300 million for surety, $252 million related to a specific construction contractor, $113 million related to the commutation of agreements with a major reinsurer and other net reserving actions, the major components of which are described in more detail in the following segment discussions. Net unfavorable reserve development in the Commercial and Specialty segments more than offset additional income resulting from the merger and strong operating income generated by the Company’s Personal segment. In addition, after-tax catastrophe losses in 2004 of $511 million were $282 million higher than in 2003. The catastrophe losses in 2004 were primarily driven by four hurricanes that struck the southeastern United States in the third quarter.
The rate environment continued to moderate in 2004 due to more aggressive pricing in the marketplace. Customer retention levels remained stable throughout the Company’s insurance underwriting operations; however, new business volume in 2004 declined when compared with the combined new business volume of SPC and TPC in 2003. Net income in 2004 included net realized investment losses of $28 million, compared with net realized investment gains of $21 million in 2003.
Net income of $1.70 billion in 2003 was a significant improvement over the net loss of $27 million in 2002. Results in 2003 reflected a favorable, but moderating, rate environment in excess of loss cost trends and a decline in unfavorable prior year reserve development. Those factors were partially offset by a $174 million increase in after-tax catastrophe losses in 2003. Net unfavorable prior year reserve development in 2003 was $309 million, including $339 million of charges related to reserve strengthening in the Company’s subsidiary Gulf Insurance Company (Gulf). In 2002, the $1.49 billion of net unfavorable prior year reserve development was driven by $1.39 billion of charges related to asbestos reserve strengthening. In December 2002, the Company increased its asbestos reserves to $3.40 billion, net of reinsurance recoverables, and fully utilized the $800 million pretax benefit under the Citigroup indemnification agreement. (For additional information see “—Asbestos Claims and Litigation”). The net loss in 2002 included an after-tax charge for the cumulative effect of a change in accounting principle of $243 million due to the adoption of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets (FAS 142). Net income in 2003 included $21 million of net realized investment gains, compared with $99 million of net realized investment gains in 2002.
Consolidated Revenues
The Company’s consolidated revenues were as follows:
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Table of ContentsIndex to Financial StatementsThe $6.49 billion growth in earned premiums over 2003 was primarily due to the merger, and also reflected the earned premium effect of rate increases on renewal business over the last 12 months and strong customer retention levels throughout a majority of the markets served by the Company’s insurance segments.
Net investment income in 2004 increased $794 million over 2003, due largely to the increase in invested assets resulting from the merger. In addition, strong operational cash flows in 2004 contributed to the growth in invested assets. The average pretax investment yield in 2004 of 4.8% declined from 5.3% in 2003, due to a higher proportion of tax-exempt investments and lower yields on fixed income securities and alternative investments. In addition, SPC’s investment portfolio acquired in the merger was recorded at its fair value as of the merger date in accordance with purchase accounting, which reduced the Company’s reported average investment yield in 2004. Net investment income in 2004 included $111 million of income resulting from the initial public trading of an investment in its private equity portfolio.
Fee income in 2004 grew 26% over 2003, primarily driven by new business in the National Accounts sector of the Company’s Commercial segment, as described in more detail in the segment narrative that follows.
Asset management revenues of $390 million were generated by Nuveen Investments, which was acquired in the merger. Nuveen Investments’ gross sales of investment products in 2004 from the date of the merger totaled $19.86 billion.
The Company’s net pretax realized investment losses of $39 million in 2004 included impairment charges totaling $80 million, whereas net pretax realized gains of $38 million in 2003 included $90 million of impairment charges. Net realized investment gains (losses) in 2004 and 2003 also included losses of $44 million and $27 million, respectively, related to U.S. Treasury futures contracts which are settled daily. Further information regarding the nature of impairment charges in each year is included in the “Critical Accounting Estimates” section later in this discussion. Other revenues in all periods presented primarily consist of premium installment charges.
Earned premiums in 2003 increased $1.39 billion, or 12%, over 2002 due to rate increases on renewal business, growth in targeted new business and strong customer retention.
Net investment income decreased $12 million, or less than 1%, in 2003, despite higher average invested assets resulting from strong cash flows from operations. The decline resulted from a reduction in pretax investment yields from 6.0% in 2002 to 5.3% in 2003. That decrease reflected the lower interest rate environment, the shortening of the average effective duration of the fixed maturity portfolio, a higher proportion of tax-exempt investment holdings and reduced returns in the Company’s private equity investments. These factors were partially offset by higher returns in arbitrage fund investments.
Fee income increased $105 million, or 23%, in 2003, as both new business and pricing levels in the Company’s National Accounts business increased and more workers’ compensation business was written by state residual market pools serviced by National Accounts.
Net realized investment gains were $38 million in 2003, compared with $147 million in 2002. Net realized investment gains included $90 million of impairment charges in 2003, compared with $284 million in 2002.
Recoveries from former affiliate of $520 million, net of tax, in 2002 represent funds recovered under the Citigroup indemnification agreement.
Effective with the merger, the Company’s business operations consist of the following four segments: Commercial, Specialty, Personal (collectively comprising the Company’s insurance segments) and Asset Management. The Asset Management segment was acquired in the merger. Prior period results for the three insurance segments have been restated, to the extent practicable, to conform with the 2004 presentation.
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Table of ContentsIndex to Financial StatementsConsolidated net written premiums were as follows:
The $5.74 billion, or 43%, increase in consolidated net written premiums in 2004 compared with 2003 primarily reflected the impact of the merger. On a pro forma combined basis, net written premiums in 2004 were level with 2003. Business retention levels in the majority of the Company’s insurance operations remained consistent with 2003 levels, as the Company focused on retaining its existing book of well priced, profitable business. Rate increases, however, continued to moderate in 2004, reflecting more aggressive pricing in the marketplace. New business volume in the Commercial and Specialty segments in 2004 declined when compared with the combined new business volume of SPC and TPC in the prior year, reflecting the competitive marketplace and the impact of new business premiums in 2003 from renewal rights transactions. The non-renewal of certain commercial property, construction and surety risks and certain personal lines business in the Company’s operations at Lloyd’s also negatively impacted premium volume in 2004. Personal net written premiums increased 17% in 2004 over 2003, due to strong organic growth, new business resulting from a renewal rights transaction, strong business retention levels and price increases.
Net written premiums increased $1.26 billion, or 11%, in 2003. The increase was primarily due to higher but moderating rate increases, new business growth in favorable markets and strong retention across all major lines of business. These factors were partially offset by the withdrawal in 2002 of business at American Equity Insurance Company and Commercial Guaranty Casualty Insurance Company, both subsidiaries of The Northland Company (Northland), a subsidiary of the Company, and a one-time additional $115 million of net written premiums in 2002 due to the termination of certain reinsurance contracts by Northland. Net written premiums for Northland’s subsidiaries in 2003 were $547 million, a decrease of 34% from the 2002 total of $825 million. Commercial net written premiums, excluding business written in Northland’s subsidiaries, increased $1.03 billion, or 16%, in 2003. Personal net written premiums increased $506 million, or 11%, in 2003.
Consolidated claims and expenses were as follows:
Claims and claim adjustment expenses of $15.44 billion in 2004 were $6.32 billion higher than the comparable 2003 total, primarily reflecting growth in business volume resulting from the merger. The 2004 total also included $2.39 billion of net unfavorable prior year reserve development, of which $928 million represented a provision to strengthen asbestos reserves primarily as a result of the completion of the Company’s annual asbestos liability review in the fourth quarter and $290 million represented a provision to strengthen environmental reserves. Additional components of 2004 unfavorable prior year reserve development are described below. Net unfavorable prior year reserve development in 2003 totaled $476 million and was primarily the result of reserve strengthening at the Company’s Gulf subsidiary. The 2004 total also included $772 million of catastrophe losses (net of reinsurance), compared with catastrophe losses of $352 million in 2003.
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Table of ContentsIndex to Financial StatementsDuring the second quarter of 2004, the company recorded $500 million and $300 million of net unfavorable prior year reserve development related to Specialty’s construction and surety reserves, respectively, acquired in the merger. Upon having access to each company’s detailed policyholder information, including underwriting, claim, and actuarial files on April 1, 2004, in connection with the closing of the merger, the Company was able to begin the detailed process of developing a uniform and consistent approach to estimating the combined company’s loss reserves. As part of that process, a team of actuaries representing the historical actuarial perspectives, judgments and methods applied by each legacy company, discussed their views, methodologies, and analysis of available data.
In addition to the discussion in the Critical Accounting Estimates section of this report, other items specifically considered in the process of developing a uniform and consistent approach to estimating the combined company’s loss reserves include interpreting the actuarial and claim data in a uniform manner and determining an appropriate level of data segmentation for estimation purposes. This type of analysis involves a high degree of judgment and can, and often does, lead to reserve estimates that differ materially from those of prior periods, particularly in low frequency, high severity and complex exposures. In addition, since the reserving process also considers the expectations of future outcomes, the actuaries involved had to analyze their differing views on key assumptions, such as predicting inflation, estimating claim development patterns and determining expectations related to judicial rulings and interpretations, among others. This “informed judgment” is brought into the process by individuals such as actuaries, underwriters, claim adjusters, and company management. Ultimately, this process required an analysis of the varying actuarial judgments and forward-looking assessments. The result was similar to a single, ongoing insurance enterprise obtaining more information in a reporting period than it had previously and identifying a change in estimate in its insurance reserves in that period. Accordingly, the Company recorded a $500 million and $300 million charge for construction and surety, respectively, in the second quarter of 2004.
Additional information on the analysis performed is included in the Specialty segment discussion below.
In June of 2004, the Company decided to commute certain reinsurance agreements with a major reinsurer resulting in a $113 million prior year reserve charge (in addition to a current year loss of $40 million). Commutations are a complete and final settlement with a reinsurer that results in a discharge of all obligations of the parties to the terminated reinsurance agreement. The Company also recorded a charge of $252 million related to a specific construction contractor as described in the Specialty segment discussion.
Other items increasing the 2004 claims and expenses compared to 2003 include $296 million of charges to increase the allowances for estimated amounts due from reinsurance recoverables, policyholders receivables, and co-surety participations on a specific construction contractor claim. The increase in the allowance for uncollectible reinsurance recoverables recognized a change in estimated disputes with reinsurers and is based upon the Company’s reinsurance strategy of reduced reinsurance utilization, including the cessation of ongoing business relationships with certain of SPC’s reinsurers, and aggressive collection of reinsurance recoverables. A provision was also made to increase the estimated uncollectible amounts due from policyholders for loss sensitive business (primarily high deductible business). This increase recognized a change in estimated uncollectible amounts due and resulted from applying the Company’s credit based methodology for determining uncollectible amounts to the recoverables acquired in the merger. Because reinsurance recoverables and amounts due from policyholders for loss sensitive business are insurance contract-related assets, these assets are subject to the same types of estimation variables as loss reserves. Also during the second quarter of 2004, a participating co-surety on a contract surety exposure announced that insurance regulators had approved its submitted run-off plan. Based upon industry knowledge of the co-surety’s run-off plan and an analysis of the co-surety’s financial condition, the Company concluded that it was unlikely to collect the full amount projected to be owed by the co-surety and established an appropriate level of reserves.
Other 2004 claims and expenses related to the merger include $29 million of restructuring charges, $92 million of amortization expense related to finite-lived intangible assets acquired in the merger, and a benefit of $58 million associated with the accretion of the fair value adjustment to claims and claim adjustment expenses and reinsurance recoverables. Interest expense in 2004 included $100 million of additional interest expense on SPC debt assumed in the merger.
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Table of ContentsIndex to Financial StatementsClaims and claim adjustment expenses decreased $2.02 billion, or 18%, in 2003 primarily due to a decline in unfavorable prior year reserve development in 2003, which was partially offset by increased loss costs, growth in business volume and higher catastrophe losses. Catastrophe losses, net of reinsurance, were $352 million in 2003 compared to $84 million in 2002. Unfavorable prior year reserve development included in claims and claim adjustment expenses was $476 million for 2003, compared to $3.09 billion in 2002. Unfavorable prior year reserve development in 2002 included $2.95 billion of asbestos incurred losses (prior to the benefit related to recoveries under the Citigroup indemnification agreement), whereas 2003 included no asbestos-related unfavorable prior year reserve development.
Amortization of deferred acquisition costs increased $174 million, or 10%, in 2003, reflecting higher commission and premium taxes associated with the increases in earned premiums previously described. Interest expense increased $9 million, or 6%, in 2003 due to certain one time costs associated with first and second quarter refinancing activities that lowered average interest costs, and higher levels of temporary debt. General and administrative expenses increased $217 million, or 15%, in 2003, reflecting business growth and higher commissions that resulted from improved underwriting results.
Effective Tax Rate. The Company’s effective tax rate was 12.2%, 24.1% and (183.4)% in 2004, 2003 and 2002, respectively. The decrease in the 2004 effective rate primarily reflected the impact of an increase in nontaxable investment income on a lower level of pretax income. The 2003 increase in the effective rate reflected a higher level of pretax income associated with improved underwriting performance. The 2002 effective rate reflected the impact of the 2002 asbestos charge previously discussed, as well as the impact of non-taxable recoveries of $520 million related to the Citigroup indemnification agreement.
The GAAP combined ratios before policyholder dividends were as follows:
The GAAP combined ratio in 2004 included a 12.6 point impact from net unfavorable prior year reserve development and a 4.0 point impact from catastrophes. The respective impacts of these factors on the 2003 combined ratio were 3.8 points and 2.8 points. Excluding these impacts from both years, the adjusted ratio of 91.1 in 2004 was 1.4 points higher than the adjusted 2003 combined ratio of 89.7. The increase in the adjusted ratio primarily reflected the impact of the higher underwriting expense ratio of the business acquired in the merger, as well as expenses associated with the merger.
The 20.3 point improvement in the 2003 GAAP combined ratio resulted from lower unfavorable prior year reserve development, primarily due to having no asbestos charges in 2003, compared to asbestos charges in 2002 that added 19.2 points. The benefit from premium rate increases that exceeded loss cost trends were largely offset by higher catastrophe losses.
Renewal Rights Purchases
During the third quarter of 2003, TPC purchased from Royal & SunAlliance USA (RSA), an unaffiliated insurer, the renewal rights to RSA’s commercial lines national accounts, middle market and marine businesses, and standard and preferred personal lines businesses. Also during the third quarter of 2003, TPC purchased from Atlantic Mutual, an unaffiliated insurer, the renewal rights to the majority of Atlantic Mutual’s commercial lines inland marine and ocean cargo businesses written by Atlantic Mutual’s Marine Division. The minimum purchase price for both transactions, which has been paid, was $48 million. The final purchase price, which is expected to be determined in 2005 and is currently estimated to be $66 million, is dependent on the level of business renewed by the Company.
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Table of ContentsIndex to Financial StatementsCommercial Insurance Resources, Inc.
On August 1, 2002, Commercial Insurance Resources, Inc. (CIRI), a subsidiary of the Company and the holding company for the Gulf Insurance Group (Gulf), completed a transaction with a group of outside investors and senior employees of Gulf. Capital investments made by the investors and employees included 9.7 million shares of mandatorily convertible preferred stock for a purchase price of $8.83 per share, $50 million of convertible notes and 0.4 million common shares for a purchase price of $8.83 per share, representing a 24% ownership interest of CIRI, on a fully diluted basis. The dividend rate on the preferred stock was 6.0%. The interest rate on the notes was 6.0% payable on an interest-only basis. The notes would have matured on December 31, 2032. Trident II, L.P., Marsh & McLennan Capital Professionals Fund, L.P., Marsh & McLennan Employees’ Securities Company, L.P. and Trident Gulf Holding, LLC (collectively Trident) invested $125 million, and a group of approximately 75 senior employees of Gulf invested $14 million. Fifty percent of the Gulf senior employees’ investment was financed by CIRI. This financing was collateralized by the CIRI securities purchased and was forgivable if Trident achieved certain investment returns. The applicable agreements provided for registration rights and transfer rights and restrictions and other matters customarily addressed in agreements with minority investors.
On May 28, 2004, The Travelers Indemnity Company (Indemnity), a subsidiary of the Company, completed its purchase of all of the outstanding shares (8,970,000 shares) of the mandatorily convertible preferred stock held by Trident at a purchase price of $8.83 per share and the convertible notes held by Trident for $46 million. By June 30, 2004, Indemnity completed its purchase from employees of $7 million of the mandatorily convertible preferred stock at a purchase price of $8.83 per share, convertible notes with an aggregate principal amount of $4 million, and common equity of $3 million at a purchase price of $8.83 per share. The notes that were previously issued to employees to finance 50% of their investment in CIRI were assumed by Indemnity as part of the agreement to purchase the employees’ investments in CIRI. The excess of the cost to repurchase the minority interest over the minority interest carrying value on the consolidated balance sheet was recorded as a charge to additional paid-in capital during the second quarter.
RESULTS OF OPERATIONS BY SEGMENT
“Operating income” in the following discussion represents net income excluding the after-tax impact of net realized investment gains (losses).
Commercial
Results of the Company’s Commercial segment were as follows:
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Table of ContentsIndex to Financial StatementsOperating income of $862 million in 2004 declined $199 million, or 19%, from 2003, which did not include the results of SPC. Included in 2004 results were $233 million of after-tax catastrophe losses, compared with after-tax catastrophe losses of $67 million in 2003. Also impacting 2004 operating income was net after-tax unfavorable prior year reserve development of $802 million ($1.18 billion, pretax), primarily related to asbestos and environmental reserve strengthening. Net after-tax unfavorable prior year reserve development totaled $439 million in 2003.
Total revenues of $11.11 billion in 2004 reflected growth of $2.12 billion in earned premiums, which was primarily due to the merger and also reflected the earned premium effect of moderating renewal price increases over the last twelve months in the Company’s core Commercial operations. In addition, incremental premiums resulting from the renewal rights transaction with Royal & SunAlliance in the third quarter of 2003 contributed to premium growth in 2004.
Net investment income in 2004 increased $384 million over 2003 due largely to the increase in invested assets as a result of the merger, strong operational cash flows that contributed to the growth in invested assets over 2003, and investment income related to the initial public trading of an investment. Also impacting net investment income was the effect of a decline in pretax investment yields due to a higher proportion of tax-exempt investments, and lower yields on fixed income securities and alternative investments.
National Accounts is the primary source of fee income due to its service businesses, which include claim and loss prevention services to large companies that choose to self-insure a portion of their insurance risks, and claims and policy management services to workers’ compensation residual market pools, automobile assigned risk plans and to self-insurance pools. The strong increase in 2004 fee income reflected higher new business levels, resulting, in part, from the third quarter 2003 renewal rights transaction with Royal & SunAlliance, renewal price increases and more workers’ compensation business being written by state residual market pools.
Claim and claim adjustment expenses in 2004 included $1.18 billion of net unfavorable prior year reserve development in the Commercial segment, of which $927 million represented a provision to strengthen asbestos reserves primarily as a result of the completion of the Company’s annual asbestos liability review in the fourth quarter and $286 million represented a provision to strengthen environmental reserves. The asbestos provision primarily resulted from an increase in litigation costs and activity surrounding peripheral defendants. With regard to the environmental provision, new claims for hazardous waste and pollution continue to decline, though the pace of the decrease has slowed. The average severity of claims has increased, however, leading the Company to conclude that reserves for environmental losses needed to be increased. In June 2004, the Company decided to commute certain reinsurance agreements with a major reinsurer, resulting in a prior year reserve charge of $38 million. Also included in net unfavorable prior-year reserve development in the Commercial segment in 2004 was a strengthening of Gulf reserves, which was more than offset by favorable prior year reserve development in core Commercial operations due to reductions in the frequency of non-catastrophe related losses. In 2003, unfavorable prior-year loss development in the Commercial segment totaled $676 million, the most significant component of which was $521 million of reserve strengthening in the Gulf operations. That reserve strengthening was primarily related to a line of business that insured the residual values of leased vehicles and that had been placed in runoff in late 2001, and the resolution of a residual value claim dispute.
Also included in claim and claim adjustment expenses in 2004 were catastrophe losses of $358 million, compared with catastrophe losses of $103 million in 2003. The losses in 2004 primarily resulted from the four hurricanes that made landfall in the southeastern United States in the third quarter, whereas the 2003 losses resulted from a variety of storms throughout the year, including Hurricane Isabel.
Other items increasing 2004 claims and expenses compared to 2003 include $72 million of charges to increase the allowances for estimated amounts due from reinsurance recoverables and policyholders receivables, previously described in the Consolidated Overview section.
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Table of ContentsIndex to Financial StatementsThe loss and loss adjustment expense ratio in 2004 included a 13.6 point impact from prior-year reserve development and a 4.1 point impact from catastrophe losses. In 2003, the impacts of these factors on the loss and loss expense ratio were 10.3 points and 1.6 points, respectively. Excluding those factors in both years, the adjusted loss and loss expense ratio in 2004 of 62.3 was 1.2 points improved over the adjusted 2003 ratio of 63.5. The 3.3 point increase in the underwriting expense ratio in 2004 compared to 2003 primarily reflected the impact of the higher underwriting expense ratio of the business acquired in the merger and operating expenses associated with Commercial other (where premium volume declined significantly).
Operating income of $1.06 billion in 2003 was a significant improvement over the operating loss of $310 million in 2002. Operating results in 2003 reflected a favorable, but moderating, rate environment characterized by rate increases in excess of loss cost trends, and increased business volumes. After-tax catastrophe losses totaled $67 million in 2003, whereas in 2002 the Commercial segment incurred no catastrophes. The 2002 operating loss was driven by significant asbestos-related unfavorable prior-year reserve development.
Earned premiums in 2003 grew $721 million, or 12%, over 2002, primarily due to premium rate increases, growth in targeted new business and strong customer retention. The strong growth in 2003 earned premiums was partially offset by a $214 million decline in earned premiums at the Northland subsidiaries that resulted from the withdrawal in 2002 of business at American Equity Insurance Company and Commercial Guaranty Casualty Insurance Company. Net investment income in 2003 increased $17 million over 2002 due to higher average invested assets resulting from strong cash flows from operations, partially offset by the reduction in average pretax investment yields to 5.3% in 2003 from 6.0% in 2002. The decrease in yields reflected the lower interest rate environment, the shortening of the average effective duration of the fixed maturity portfolio, a higher proportion of tax-exempt investments and reduced returns in the Company’s private equity investments; partially offset by higher returns in arbitrage fund investments. The $99 million, or 22%, increase in fee income in 2003 over 2002 reflected higher new business levels, price increases and more workers’ compensation business being written by state residual market pools.
Claims and claim adjustment expenses in 2003 decreased $2.23 billion, or 30%, primarily due to a significant decline in unfavorable prior year reserve development, which was partially offset by an increase in catastrophe losses and increased loss costs resulting from growth in business volume. Catastrophe losses totaled $103 million in 2003, compared with no catastrophe losses in 2002. Catastrophe losses in 2003 were primarily the result of a severe winter storm in Colorado in the first quarter, severe storms in the second quarter in a number of Southern and Midwestern states and Hurricane Isabel in the third quarter. Unfavorable prior year reserve development included in claims and claim adjustment expenses was $676 million in 2003 compared to $3.12 billion in 2002. The most significant component of 2003 prior year development was the Gulf reserve strengthening of $521 million referred to previously. In addition to the Gulf charges, unfavorable prior-year reserve development in 2003 included charges associated with American Equity Insurance Company and an increase in environmental reserves. No asbestos-related prior year reserve development was recorded in 2003. Unfavorable prior year reserve development in 2002 included $2.95 billion of asbestos-related charges (prior to the benefit related to recoveries under the Citigroup indemnification agreement). For additional information see “—Asbestos Claims and Litigation.”
Separately, the Company strengthened its environmental reserves in the 2002 fourth quarter, which was mostly offset by reductions in its reserves for other general liability exposures. These actions were taken as a result of payment and settlement experience. In addition, in 2003 the Company strengthened prior year reserves for certain run-off lines of business, including assumed reinsurance, and experienced favorable development in certain on-going businesses.
Amortization of deferred acquisition costs increased $82 million, or 9%, in 2003, reflecting higher commission and premium taxes associated with the increase in earned premiums. General and administrative expenses in 2003 increased $150 million, or 18%, over 2002, driven by business growth and higher commission expense that resulted from improved underwriting results.
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Table of ContentsIndex to Financial StatementsThe 33.9 point improvement in the 2003 GAAP loss and loss adjustment expense ratio over 2002 primarily resulted from lower unfavorable prior year reserve development. The prior-year asbestos-related charges in 2002 added 36.8 points to that year’s loss and loss adjustment expense ratio, whereas in 2003 no prior-year asbestos-related charges were incurred. The favorable impact of premium rate increases that exceeded loss cost trends in 2003 was largely offset by the impact of catastrophe losses. No catastrophe losses were incurred in 2002. The 0.6 point decrease in the underwriting expense ratio in 2003 compared with 2002 was primarily due to the benefits of the favorable rate environment and higher fee income, largely offset by higher commissions that result from improved underwriting performance.
Commercial net written premiums by market were as follows:
Commercial net written premiums in 2004 increased $1.35 billion, or 20%, over 2003, primarily reflecting the impact of the merger. Business retention rates remained strong and renewal price change increases moderated to the low-single digit levels in 2004. New business volume declined, however, when compared with the combined new business volume of SPC and TPC in 2003, reflecting the increasingly competitive marketplace and the impact of higher premium flow in 2003 associated with several renewal rights transactions.
Commercial Accounts’ premium volume of $4.21 billion in 2004 grew $960 million, or 30%, over 2003 volume of $3.25 billion, primarily due to the merger. Retention rates remained strong and renewal price change increases were essentially flat by the end of the year. New business levels moderated during the second half of 2004 as the benefit from the Atlantic Mutual and Royal & SunAlliance renewal rights transactions completed in the third quarter of 2003 diminished in the second half of the year.
Select Accounts’ 2004 premium volume of $2.56 billion increased $508 million, or 25%, over 2003, reflecting the impact of the merger. Overall retention rates were strong and renewal price increases moderated to the mid single-digits. Retention and growth were strongest in smaller, high transaction volume accounts, reflecting the Company’s competitive advantage in agency automation, product offerings and service to agents.
The 13% increase in National Accounts’ premium volume in 2004 reflected new business from the third-quarter 2003 Royal & SunAlliance renewal rights transaction and higher business volumes in residual market pools, the impacts of which were partially offset by a shift to deductible and fee-based products by some of the Company’s clients.
In the Commercial Other business, the $226 million, or 31%, decline in 2004 premium volume compared with 2003 primarily reflected the placement of Gulf operations in runoff in the second quarter of 2004. Subsequently, certain business previously written by Gulf is now being written in the Commercial or Specialty segments. The runoff healthcare, reinsurance and international business acquired in the merger produced minimal written premium volume in 2004.
Commercial net written premiums increased $532 million, or 8%, in 2003. Renewal price increases, higher new business levels, and strong customer retention across all major lines of business combined to drive premium growth over 2002. This premium growth was partially offset by the decrease in net written premiums at the Northland subsidiaries due to the withdrawal in 2002 of business at certain of those subsidiaries and a one-time
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Table of ContentsIndex to Financial Statementsadditional $115 million of net written premium in 2002 related to the termination of certain reinsurance contracts. Net written premiums for the Northland subsidiaries were $547 million in 2003 compared to $825 million in 2002. The Commercial business of those subsidiaries is included with Commercial Accounts.
Commercial Accounts net written premiums increased $100 million, or 3%, in 2003. Net written premiums associated with the Northland subsidiaries declined to $547 million in 2003 from $825 million in 2002 due to the factors described above. Excluding the Northland subsidiaries’ net written premiums in both 2003 and 2002, Commercial Accounts premium volume in 2003 grew 16% over 2002. The increase was primarily due to renewal price increases, new business growth in targeted markets and strong retention across all major product lines.
Select Accounts net written premiums in 2003 increased $178 million, or 10%, over 2002. The increase primarily reflected renewal price increases, new business and strong retention. New business growth was especially strong in property, general liability and commercial multi-peril lines of business. Select Accounts retention levels in 2003 were strongest for small commercial business handled through the Company’s Service Centers, while premium growth was centered in the commercial multi-peril and property product lines.
National Accounts net written premiums in 2003 increased $190 million, or 30%, over 2002, primarily due to the continued benefit from rate increases, higher new business levels that, in part, resulted from the Company’s third quarter 2003 renewal rights transaction with Royal & SunAlliance and higher business volume in residual market pools.
The Commercial Other sector of the Commercial segment in 2003 and 2002 consisted primarily of results from the Company’s Gulf subsidiary, which marketed products to national, mid-sized and small customers and distributed them through both wholesale brokers and retail agents and brokers throughout the United States with particular emphasis on management and professional liability coverages and excess and surplus lines of insurance. Gulf net written premiums increased $83 million, or 14%, in 2003 as a result of significant rate increases across all classes of management liability products.
Specialty
The Specialty segment’s results for the twelve months ended December 31, 2004 reflect the results of TPC’s Bond and Construction operations for the three months ended March 31, 2004 and the post-merger combined results of SPC’s specialty operations and TPC’s Bond and Construction operations for the nine months ended December 31, 2004. Results for 2003 and 2002 represent TPC’s Bond and Construction operations only.
The operating loss of $724 million in 2004 was driven by after-tax unfavorable prior year reserve development of $1.03 billion ($1.59 billion, pretax) including $500 million and $300 million (pretax) of net unfavorable prior year loss development related to the construction and surety reserves, respectively, acquired in
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Table of ContentsIndex to Financial Statementsthe merger as well as other net reserving actions that are described in the narrative that follows. In June 2004, the Company decided to commute certain reinsurance agreements with a major reinsurer, resulting in a prior year reserve charge of $75 million. Operating results in 2004 also included $155 million of after-tax catastrophe losses resulting from the four hurricanes described previously, whereas 2003 results included no catastrophe losses.
Domestic Specialty earned premiums totaled $3.86 billion in 2004, compared with $1.17 billion in 2003. International Specialty earned premiums in 2004 were $930 million, whereas 2003 results included minimal international premiums. The increases over 2003 were primarily driven by incremental premiums resulting from the merger, and also reflected the impact of price increases. Net investment income increased $324 million over 2003 due to the increase in invested assets as a result of the merger. In addition, strong operational cash flows contributed to the growth in invested assets over the same period of 2003. Also impacting in net investment income is the effect of a decline in pretax investment yields due to a higher proportion of tax-exempt investments and lower yields on fixed income securities and alternative investments.
The following discussion provides more information regarding the net unfavorable prior year loss development related to the construction and surety reserves, acquired in the merger as well as other net reserving actions.
Construction Reserves
Beginning on April 1, 2004, upon the completion of the merger of TPC and SPC, personnel from the predecessor companies were able to share detailed policyholder information, claim files and actuarial data related to the acquired construction reserves. This enabled an analysis to be performed in the second quarter of the acquired construction reserves using TPC’s long-established practices that includes evaluating exposures by type of claim (e.g. construction defect, construction wrap up, other), by type of coverage, (e.g. guaranteed cost, loss responsive, other) and by detailed line of business (general liability, commercial auto, etc.), among others. For general liability exposures, which include construction defect and construction wrap-up, interpretation of underlying trends (both present and future) and the related reserve estimation process is highly judgmental due to the low frequency/high severity and complex nature of these exposures. In particular, for construction defect, there is a high degree of uncertainty relating to whether coverage exists, when losses occur, the size of each loss, expectations for future interpretive rulings concerning contract provisions and the extent to which the assertion of these claims will expand geographically. As a result, material variations can and do occur among actuarial reserve estimates for these types of exposures. In a merger, these differences are likely to be even more pronounced. Prior to a merger, each legacy company consistently applies its assumptions, judgments and actuarial methods to estimate reserves. Differences between these assumptions, judgments and actuarial methods need to be understood and reconciled, and a uniform approach needs to be adopted for the merged entity. In this situation, material adjustments can and do occur for reserves related to exposures having a high degree of uncertainty.
Analysis of the acquired construction reserves was completed near the end of the second quarter of 2004. Based upon the results of this analysis, the Company increased its estimate of the acquired net construction reserves by $500 million, including $400 million for construction defect and $100 million for construction wrap-up claims, and recognized this change in estimate as an income statement charge in the second quarter. There was no reinsurance associated with this charge.
Surety Reserves
Beginning on April 1, 2004, upon completion of the merger of TPC and SPC, personnel from the predecessor companies were able to share the detailed SPC policyholder information, including underwriting, claim and actuarial files related to surety reserves. Access to this detailed information enabled the Company to perform a claim-by-claim review of reserves and claims handling strategies during the second quarter of 2004 using the combined expertise of claims adjusters from the legacy companies. This type of review involves considerable judgment, especially with respect to the economic outlook within which claims will be settled,
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Table of ContentsIndex to Financial Statementsestimates for dates of loss occurrence and evaluations of IBNR exposures for each insured. For example, as a result of the detailed information obtained concerning contractors with reported claims, the Company considered whether or not losses were incurred but not yet reported on one or more additional projects for each contractor examined.
Also on April 1, 2004, the Company could begin to use this detailed information to compare SPC’s assumptions, judgments and actuarial methods that were underlying the acquired reserves with its own assumptions, judgments and actuarial methods. Similarities and differences were found to exist. Similarities included, but were not limited to, recognizing claim reserves when it was determined that contractors and commercial surety insureds were in default and thereby unable to meet their obligations, estimating initial IBNR provisions, and periodically re-evaluating, at least quarterly, the adequacy of the reserves established based on actual claims recorded and revised estimates of IBNR. Differences included judgments and methods related to determining IBNR development factors and expected salvage, among others.
That these differences exist is not unusual for surety reserve estimates. Surety is a line of business for which there are low frequency, high severity, very complex claims for certain exposures, particularly those related to large construction contractors and commercial surety insureds. Determining the date of loss in these circumstances requires a high degree of judgment. In addition, the claim reserve estimates even for reported claims are also highly judgmental. These two factors, among others, combine to make IBNR reserve estimations for surety extremely difficult. Due to this high degree of uncertainty, the informed judgments of different actuaries could and do vary materially. As discussed above, in a merger, these differences are likely to be even more pronounced.
The claim reviews and actuarial analyses were both completed near the end of the second quarter of 2004. Based upon the results of these reviews and analyses, the Company increased its estimate of the acquired net surety reserves by $300 million, net of $170 million of reinsurance, and recognized this change in estimate as an income statement charge in the second quarter.
Prior to the merger and beginning in the third quarter of 2003, SPC disclosed that a large construction contractor for which it had written several surety bonds was experiencing financial difficulty. Based upon an analysis of the financial condition of the construction contractor that was performed in the third quarter of 2003, a restructuring plan was adopted by the construction contractor, its banks, and SPC, among others, as a means to minimize estimated losses. SPC monitored the progress of the construction contractor toward meeting the requirements of the restructuring plan throughout subsequent quarters. SPC also estimated and disclosed its estimated ultimate net losses related to this exposure, beginning in the third quarter of 2003 and updated each quarter thereafter, including the effects of advances made or expected to be made to the construction contractor, applicable collateral, co-surety participations and reinsurance. The size and complexity of these particular construction contracts, coupled with the deteriorating credit quality of the construction contractor and the inherent uncertainty as to whether it would meet the obligations of the restructuring plan, resulted in a high degree of judgment in estimating potential losses.
A comprehensive analysis that began in the first quarter of 2004 was completed during the last half of the second quarter. Based upon this analysis, the Company concluded that the contractor would not be able to meet the targets set forth in its business and restructuring plans. Therefore, the Company moved from supporting the contractor’s restructuring plan to adopting a workout plan as a means to minimize estimated losses. Under the workout plan, the Company would no longer provide additional surety bonds for new projects of the construction contractor. Also as part of the workout plan, the Company was able to implement additional accounting and engineering procedures for each open project, which included using specialists to implement additional forecasting, cash management, and reporting procedures, on both a project-by-project and consolidated level. Based upon this second quarter change to a workout plan and the detailed financial analysis that was able to be performed, the Company increased its estimate of the ultimate net loss by $252 million, including $9 million of reinsurance. This estimate took into consideration paid amounts, net receivables, liquidated damages, overhead
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Table of ContentsIndex to Financial Statementscosts, additional completion costs, including costs associated with replacing the contractor, receivable discounts, current and future claims from owners and subcontractors against the contractor, and the value of collateral, among others.
Also during the last half of the second quarter of 2004, a participating co-surety on this exposure announced that insurance regulators had approved its submitted run-off plan. Based upon industry’s knowledge of the co-surety’s run-off plan and the Company’s analysis of its financial condition, the Company concluded that it was unlikely to collect the full amount projected to be owed by the co-surety and established an appropriate level of reserves.
Claim and claim adjustment expenses in 2004 included $225 million of catastrophe losses, compared with no such losses in 2003. Results in 2004 also reflected increased current year loss provisions on portions of the Bond and Construction books of business, and $150 million of unfavorable prior year reserve development recorded in TPC’s Construction operation prior to the merger. Excluding the impact of catastrophes, the majority of the remaining markets comprising this segment recorded strong underwriting results, driven by favorable current year loss experience.
Other items increasing 2004 claims and expenses compared to 2003 include $224 million of charges to increase the allowances for estimated amounts due from reinsurance recoverables, policyholders receivables, and a co-surety on a specific construction contractor claim previously described in the Consolidated Overview section.
The combined ratio in 2004 included a 33.1 point impact of unfavorable prior year reserve development and a 4.8 impact of catastrophe losses. The impact of both items in 2003 was negligible.
The $50 million increase in operating earnings in 2003 over 2002 reflected strong results from the Company’s Bond operation. The $201 million, or 21%, increase in earned premiums over 2002 primarily resulted from premium rate increases, growth in targeted new business and strong customer retention. The $5 million decline in net investment income in 2003 primarily reflected a reduction in pretax investment yields from 6.0% in 2002 to 5.3% in 2003.
Claims and expenses in 2003 included unfavorable prior year reserve development totaling $12 million, compared with unfavorable development of $3 million in 2002.
The 5.3 point improvement in the combined ratio in 2003 reflected the impact of price increases, higher new business volumes and controlled expense growth.
Specialty net written premiums by market were as follows:
The $3.54 billion increase in net written premium volume over 2003 reflected the impact of the merger. However, the repositioning of the Bond and Construction books of business primarily accounted for a decline in net written premium volume in 2004 compared with the 2003 combined premium volume of SPC and TPC. In Construction, that repositioning resulted in reduced retention levels when compared with 2003, and new business
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Table of ContentsIndex to Financial Statementslevels also declined substantially. In Bond, the repositioning of the book of business was primarily centered in the SPC business acquired in the merger.
Net written premiums in 2004 in the majority of the Company’s remaining domestic specialty businesses were strong, with retention levels at or above historical levels. The Company continued to focus on retaining the profitable and well-priced book of business that has been built in recent years. Renewal price change increases in these operations moderated throughout the year to the upper single-digit level. New business levels in 2004 were down compared with 2003, when renewal rights transactions contributed to strong growth in new business. The impact of the decline in new business levels in 2004 was partially offset by premium growth resulting from the transfer of certain business from the Company’s Gulf operation, which was placed in runoff in the second quarter of the year. In addition, premium volume in these domestic businesses benefited in 2004 from a small amount of additional transfers of certain business previously written in the Commercial segment’s commercial accounts operation.
In International Specialty, acquired in the merger, business retention levels (excluding Lloyd’s) were strong relative to pre-merger levels. New business levels were consistent with 2003, while the rate of renewal price change increases moderated to the low—single digit levels. The Company continued to focus on retaining its profitable book of existing international specialty business. At Lloyd’s, premium volume was negatively impacted by the planned non-renewal of certain personal lines insurance coverages.
The $218 million, or 21%, increase in net written premiums in 2003 over 2002 reflected a favorable premium rate environment and strong new business, particularly in Bond’s executive liability lines.
Personal
Results of the Company’s Personal segment were as follows:
Operating income of $939 million in 2004 increased $447 million over 2003. The significant improvement in 2004 was driven by historically low loss frequency levels, particularly in the property line, after-tax favorable prior year reserve development of $246 million, an increase in investment income, and strong premium growth reflecting the impact of unit growth and price increases.
The $758 million, or 16%, growth in earned premiums over 2003 was primarily due to an increase in organic new business volume, new business associated with the Royal & SunAlliance renewal rights transaction completed in the third quarter of 2003, continued strong business retention levels and renewal price increases. Net investment income in 2004 grew 22% over 2003, driven by strong operational cash flows during the year that contributed to a significant growth in invested assets since the end of 2003. In addition, net investment income in 2004 benefited from $39 million of income resulting from the initial public trading of an investment in the first
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Table of ContentsIndex to Financial Statementsquarter of the year. Also impacting net investment income in 2004 was the effect of a decline in pretax investment yields resulting from a higher proportion of tax-exempt investments, and generally lower yields on fixed-income securities purchased during the year.
Claim and claim adjustment expenses in 2004 included $378 million of favorable prior-year reserve development, primarily driven by a decline in the frequency of non-catastrophe related homeowners’ losses, as well as an improvement in the frequency and severity trends in the automobile line of business. In 2003, favorable prior-year reserve development totaled $212 million, also primarily due to a decline in the frequency of non-catastrophe related homeowners’ losses. The 2003 total included a $50 million reduction in the provision for losses resulting from the September 11, 2001 terrorist attack. In addition, claim and claim adjustment expenses in 2004 reflected the benefit of lower current accident year frequency of non-catastrophe claims in the homeowners’ line of business than in 2003. Claims and expenses in 2004 included catastrophe losses of $189 million, compared with catastrophe losses of $249 million in 2003. The 2004 losses were primarily the result of the four hurricanes described previously, whereas the 2003 losses resulted from a variety of storms across the United States, including Hurricane Isabel in the third quarter of the year and wildfires in California. Claims and expenses in 2004 also reflected continued investments in process re-engineering pilots targeted to improve loss severity.
The amortization of deferred acquisition costs totaled $941 million in 2004, an 18% increase over the 2003 total of $800 million. The increase was due to higher commission and premium taxes associated with the increases in earned premium previously described, as well as a change in product mix. General and administrative expenses of $536 million in 2004 were 28% higher than comparable expenses of $420 million in 2003, primarily due to business growth, higher commission expense related to improved underwriting results and investments in personnel, technology and infrastructure to support business growth and product development.
The loss and loss adjustment expense ratio in 2004 reflected a 6.8 point favorable impact from prior-year reserve development, compared with a favorable prior-year impact of 4.4 points on the 2003 ratio. Catastrophe losses accounted for 3.4 points and 5.2 points of the 2004 and 2003 ratios, respectively. In addition to these factors, the significant improvement in the 2004 loss and loss adjustment expense ratio reflected the earned impact of price increases that continued to exceed loss cost trends. The 1.2 point increase in the underwriting expense ratio reflected the investments described previously, as well as the impact of higher commission expenses related to improved underwriting results.
Operating income in 2003 increased $145 million, or 42%, over 2002. Operating income in 2003 benefited from a favorable, but moderating, premium rate environment in both automobile and property, increased business volumes and a continued moderation in the increase in loss costs.
Earned premiums increased $468 million, or 11%, in 2003, primarily due to higher rates, growth in new business volumes and strong retention levels. Net investment income in 2003 decreased $24 million compared with 2002, despite an increase in average invested assets resulting from strong operational cash flows. The decline resulted from a reduction in pretax investment yields, which reflected a lower interest rate environment, the shortening of the average effective duration of the fixed maturity portfolio, a higher proportion of tax-exempt investments and slightly lower returns from the Company’s private equity investments.
Claim and claim adjustment expenses in 2003 included favorable prior-year reserve development of $212 million, compared with favorable development of $30 million in 2002. The favorable development in 2003 resulted from improvement in non-catastrophe-related claim frequency for both homeowners and non-bodily-injury automobile businesses, and a $50 million reduction in reserves related to the terrorist attack on September 11, 2001 (also due to lower than expected claim frequency). Catastrophe losses of $249 million in 2003 were significantly higher than comparable losses of $84 million in 2002. Catastrophe losses in both years were driven by numerous storms across the United States. Losses in 2003 also reflected the impact of Hurricane Isabel and wildfires in California.
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Table of ContentsIndex to Financial StatementsThe amortization of deferred acquisition costs, which totaled $800 million in 2003, increased $63 million, or 9%, over 2002 due to higher commission and premium taxes associated with the increases in earned premium previously described. General and administrative expenses in 2003 also increased 9% over 2002, driven by business growth and higher commissions that resulted from improved underwriting results.
The 4.5 point improvement in the loss and loss adjustment expense ratio over 2002 was due to renewal price increases that exceeded loss cost trends, continued reduced levels of non-catastrophe property claim frequency and higher favorable prior year reserve development, partially offset by higher catastrophes.
Personal net written premiums by product line were as follows:
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