• GAAP combined ratio of 101.3, including 10.7 points from catastrophe losses
• Shareholders’ equity of $22.30 billion, up $1.10 billion from December 31, 2004; book value per common share of $31.94
The Company allocates invested assets and the related net investment income to its identified business segments. Pretax net investment income is allocated based upon an investable funds concept, which takes into account liabilities (net of non-invested assets) and appropriate capital considerations for each segment. The investment yield for investable funds reflects the duration of the loss reserves’ future cash flows, the interest rate environment at the time the losses were incurred and A+ rated corporate debt instruments. This duration yield is compared to the average portfolio yield and a new average yield is determined. It is this average yield that is used in the calculation of net investment income on investable funds.
Operating income of $786 million in 2004 declined $275 million, or 26%, from 2003. The decline was driven by net unfavorable prior year reserve development of $1.34 billion in 2004, primarily related to asbestos and environmental reserve strengthening. Net unfavorable prior year reserve development totaled $676 million in 2003, primarily related to reserve strengthening in the Gulf operation due to a line of business that insured the residual values of leased vehicles. Operating income in 2004 also included $363 million for the cost of catastrophes, compared with $103 million in 2003.
The underwriting expense ratio in 2005 was 1.7 points higher than 2004, primarily reflecting the significant earned premium declines described previously, and the 0.4 point negative impact of the $52 million in reinstatement premiums and $18 million of catastrophe-related state assessments. These factors were partially offset by the favorable impact of merger-related expense savings throughout the segment and personnel reductions in the Commercial Other sector. The 2004 underwriting expense ratio included the impact of merger-related restructuring charges and an increase in the allowance for uncollectible amounts due from policyholders. The 2.9 point increase in the underwriting expense ratio in 2004 compared to 2003 primarily reflected the impact of the higher underwriting expense ratio of business in runoff (some of which was acquired in the merger), the merger-related restructuring charges and the increase in the allowance for uncollectible amounts due from policyholders.
The increase in net loss for Interest Expense and Other for 2005 compared with 2004 was primarily due to incremental interest expense on debt assumed in the merger and a reduction in net investment income, which were mostly offset by the absence of non-recurring merger-related charges and a reduction in non-interest related other expenses in 2005.
Home office, field office and other relates to policyholders for which settlement agreements have not been reached, and also includes unallocated IBNR. Policyholders are identified for home office review based upon, among other factors: aggregate ultimate expected payments in excess of a specified threshold (currently $100,000), perceived level of exposure, number of reported claims, products/completed operations and potential “non-product” exposures, size of policyholder and geographic distribution of products or services sold by the policyholder. In addition to incurred but not reported (IBNR) amounts contained in the reserves for home office and field office policyholders, the Company has established a reserve for further adverse development related to existing policyholders, new claims from policyholders reporting claims for the first time and policyholders for which there is, or may be, litigation and direct actions against the Company.
Changes in the general interest rate environment affect the returns available on new investments. While a rising interest rate environment enhances the returns available on new fixed income investments, it reduces the market value of existing fixed maturity investments and the availability of gains on disposition. A decline in interest rates reduces the returns available on new investments but increases the market value of existing investments and the availability of realized investment gains on disposition. In 2005, short-term interest rates continued to increase, while long-term interest rates remained consistent with 2004 levels. Consequently, yields available on new investments began to grow, but remained below the existing portfolio’s average book yield. The continuation of an upward trend in interest rates in 2006 would favorably impact the average book yield of the Company’s fixed income holdings.
In November 2005, the Company issued $400 million of 5.50% senior notes due December 1, 2015. The notes pay interest semi-annually on June 1 and December 1 of each year, beginning June 1, 2006, are senior unsecured obligations and rank equally with all of the Company’s other senior unsecured indebtedness. The Company may redeem some or all of the notes prior to maturity at a redemption price equal to the greater of: 100% of the principal amount of senior notes to be redeemed; or the sum of the present values of the remaining scheduled payments of principal and interest on the senior notes to be redeemed (exclusive of interest accrued to the date of redemption) discounted to the date of redemption on a semiannual basis at the then current Treasury Rate plus 20 basis points. The majority of the proceeds was used to pay down the Company’s commercial paper outstanding, with the remainder used for general corporate purposes.
The $810 million increase in gross reinsurance recoverables over year-end 2004 was primarily due to recoverables resulting from Hurricanes Katrina, Rita and Wilma. Amounts recoverable from reinsurers are estimated in a manner consistent with the associated claim liability. The Company evaluates and monitors the financial condition of its reinsurers under voluntary reinsurance arrangements to minimize its exposure to significant losses from reinsurer insolvencies. In addition, in the ordinary course of business, the Company becomes involved in coverage disputes with its reinsurers. Some of these disputes could result in lawsuits and arbitrations brought by or against the reinsurers to determine the Company’s rights and obligations under the various reinsurance agreements. The Company employs dedicated specialists and aggressive strategies to manage reinsurance collections and disputes.
• the length of time and the extent to which fair value has been below cost. It is likely that the Company will conclude that the decline is “other-than-temporary” if the market value has been below cost for six to nine months;
The Company adopted the fair value method of accounting under FAS 123 on January 1, 2003. The impact of FAS 123R will be: a.) the recognition of additional expense in earnings for the remaining unamortized expense relating to unvested awards granted prior to the Company’s adoption of FAS 123 (January 1, 2003) and which remain outstanding on the date of adoption of FAS 123R and b.) the accelerated recognition of compensation cost attributable to awards granted to retiree eligible employees or to employees that become retirement eligible before an award’s vesting date for which the right to receive or retain equity shares is no longer contingent on the satisfaction of a market performance or service condition. The Company does not expect the impact of adopting FAS 123R to have a significant effect on operations, financial condition or liquidity.
SOP 05-1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier adoption encouraged. The Company does not expect the impact of adopting SOP 05-1 to have a significant effect on operations, financial condition or liquidity.
(8) The merger-related assets and liabilities of Nuveen Investments that were included in the allocation of the purchase price were removed from the respective lines of the Company’s consolidated balance sheet and are reported on a net basis under the above caption “Net assets of discontinued operations” at December 31, 2004. Included in “Net assets of discontinued operations” at December 31, 2004 were goodwill of $1.70 billion and intangible assets of $651 million related to Nuveen Investments. See note 3.
• The Company holds significant interests in hedge fund investments that are accounted for under the equity method of accounting and are included in other investments in the consolidated balance sheet. Hedge funds are unregistered private investment partnerships, limited liability companies, funds or pools that may invest and trade in many different markets, strategies and instruments (including securities, non-securities and derivatives). As of December 31, 2005, one hedge fund was determined to be a significant VIE. The value for all investors combined of the hedge fund that was determined to be a significant VIE was approximately $53 million at December 31, 2005. The Company’s share of this fund had a carrying value of approximately $11 million at December 31, 2005. The Company’s involvement with this fund began in the third quarter of 2003. The Company does not have any unfunded commitments related to this fund. The Company’s exposure to loss is limited to the investment carrying amounts reported in the consolidated balance sheet.
These senior notes were sold to qualified institutional buyers as defined under Rule 144A under the Securities Act of 1933 (the Securities Act) and outside the United States in reliance on Regulation S under the Securities Act. Accordingly, the notes (the restricted notes) were not registered under the Securities Act or any state securities laws and could not be transferred or resold except pursuant to certain exemptions. As part of this offering, the Company agreed to file a registration statement under the Securities Act to permit the exchange of the notes for registered notes (the Exchange Notes) having terms identical to those of the senior notes described above (Exchange Offer). On April 14, 2003, the Company initiated the Exchange Offer pursuant to a Form S-4 that was filed with the Securities and Exchange Commission. Accordingly, each series of Exchange Notes has been registered under the Securities Act, and the transfer restrictions and registration rights relating to the restricted notes do not apply to the Exchange Notes. As of May 13, 2003 (the Expiration Date of the Exchange Offer), 99.8%, 99.4% and 100% of the company’s 5, 10, and 30-year restricted notes, respectively, were exchanged for Exchange Notes.
The articles of incorporation allow the Company to issue five million undesignated shares. The Board of Directors may designate the type of shares and set the terms thereof. The Board designated 1,450,000 shares as Series B Convertible Preferred Stock in connection with the 401(k) Savings Plan.
The Company may issue awards of restricted stock and deferred stock to eligible officers and key employees pursuant to the 2004 Incentive Plan. Such awards include restricted stock grants under the Capital Accumulation Program (CAP) and Equity Awards program established pursuant to the 2004 Incentive Plan. Awards issued under the CAP program are in the form of restricted stock and the number of shares included in the restricted stock award is calculated at a 10% discount from the market price on the date of the award and generally vest in full after a two-year period from the date of grant. The CAP program has been discontinued following the issuance of CAP awards in February 2006. Other restricted stock awards issued under the Equity Awards program generally vest in full after a three-year period from the date of grant. Except under limited
Equity securities include 797,600 shares of the Company’s common stock with a market value of $36 million at December 31, 2005.
The Company purchases investments that have embedded derivatives, primarily convertible debt securities. These embedded derivatives are carried at fair value with changes in value reflected in net realized investment gains (losses). Derivatives embedded in convertible debt securities are reported on a combined basis with their host instrument and are classified as fixed maturity securities.
The carrying value and fair value of the Company’s debt at December 31, 2005 was $5.85 billion and $5.82 billion, respectively. The respective totals at December 31, 2004 were $6.31 billion and $6.30 billion.
Four 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 a hearing was held before the district court on February 22, 2006. 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.
During the second quarter of 2004, the Company’s management approved and committed to plans to terminate and relocate certain employees and to exit certain activities. The cost of these actions has been recognized as a liability and is included in either the allocation of the purchase price or recorded as part of general and administrative expenses. The following table summarizes the Company’s costs related to these plans.