Cumulative effect of changes in accounting principles, net of tax (1) for the year ended December 31, 2002 consists of a loss of $242.6 million as a result of a change in accounting for goodwill and other intangible assets; (2) for the year ended December 31, 2001 includes a gain of $4.5 million as a result of a change in accounting for derivative instruments and hedging activities and a loss of $1.3 million as a result of a change in accounting for securitized financial assets; and (3) for the year ended December 31, 1999 includes a loss of $135.0 million as a result of a change in accounting for insurance- related assessments and a gain of $22.9 million as a result of a change in accounting for insurance and reinsurance contracts that do not transfer insurance risk.
Total liabilities include minority interest liabilities of $104.6 million, $87.0 million and $1.368 billion at December 31, 2003, 2002 and 1999, respectively.
Dividends per common share reflect the recapitalization effected as part of the Company’s corporate reorganization. See note 1 to the Consolidated Financial Statements. During 2002, the Company paid dividends of $5.095 billion in the form of a note payable and $158.0 million in cash to Citigroup, its then sole shareholder. During 2001, the Company paid dividends of $526.0 million to Citigroup, its then sole shareholder.
The following discussion and analysis of Travelers Property Casualty Corp. (TPC) and subsidiaries (collectively, the Company) financial condition and results of operations should be read in conjunction with the consolidated financial statements of the Company and related notes included elsewhere in this Form 10-K. These financial statements retroactively reflect TPC’s 2002 corporate reorganization for all periods presented.
Net income of $1.696 billion or $1.69 per share basic and $1.68 per share diluted
No asbestos charges in 2003 compared to 2002 charges of $1.394 billion, net of reinsurance, taxes and the benefit from the Citigroup indemnification agreement
Total assets of $64.9 billion, up $0.7 billion from the prior year
The Company entered into an agreement and plan of merger with The St. Paul Companies, Inc. (St. Paul). Each share of the TPC class A and class B common stock will be exchanged for 0.4334 of a share (the exchange ratio) of St. Paul common stock. The transaction is expected to close in the second quarter of 2004. A special meeting of the Company’s shareholders will be held on March 19, 2004 to consider and to vote upon this proposed transaction.
Royal & SunAlliance - purchased renewal rights to its commercial lines national accounts, middle market and marine businesses, and standard and preferred personal lines businesses
Issued $1.4 billion of senior notes comprising $400.0 million of 3.75% senior notes, $500.0 million of 5.00% senior notes and $500.0 million of 6.375% senior notes
TPC 2002 Corporate Reorganization, Initial Public Offering and Concurrent Convertible Junior Subordinated Notes Offering
On August 20, 2002, in connection with the Citigroup Distribution, stock-based awards held by Company employees on that date under Citigroup’s various incentive plans were cancelled and replaced by awards under the Company’s own incentive programs (see note 10 of notes to the Company’s consolidated financial statements for a further discussion), which awards were granted on substantially the same terms, including vesting, as the former Citigroup awards.
At December 31, 2001, TPC had a note payable to Citigroup in the amount of $1.198 billion, in conjunction with its purchase of TIGHI’s outstanding shares in April 2000. On February 7, 2002, this note agreement was replaced by a new note agreement. Under the terms of the new note agreement, interest accrued on the aggregate principal amount outstanding at the commercial paper rate (the then current short-term rate) plus 10 basis points per annum. Interest was compounded monthly. This note was prepaid following the offerings.
On February 28, 2002, the Company sold CitiInsurance to other Citigroup affiliated companies for $402.6 million, its net book value. The Company applied $137.8 million of the proceeds from this sale to repay intercompany indebtedness to Citigroup. In addition, the Company purchased from Citigroup affiliated companies the premises located at One Tower Square, Hartford, Connecticut and other properties for $68.2 million. Additionally, certain liabilities relating to employee benefit plans and lease obligations were assigned and assumed by Citigroup affiliated companies. In connection with these assignments, the Company transferred $172.4 million and $87.8 million, respectively, to Citigroup affiliated companies.
Net income of $1.696 billion or $1.69 per share basic and $1.68 per share diluted in 2003 compared to a net loss of $(27.0) million or $(0.03) per share, basic and diluted in 2002. Net income for 2003 reflected the continuing favorable, but moderating, rate environment in excess of loss cost trends and lower unfavorable prior year reserve development, partially offset by higher weather-related catastrophe losses in 2003. Catastrophe losses of $229.0 million, net of reinsurance and after tax, in 2003 compared to $54.7 million in 2002. Net unfavorable prior year reserve development in 2003 of $309.4 million, which included $338.7 of charges related to reserve strengthening at Gulf, compared to $1.487 billion of unfavorable prior year reserve development in 2002, which included $1.394 billion of charges related to asbestos reserve strengthening. In December 2002, the Company strengthened its asbestos reserves to $3.404 billion, after reinsurance recoverables, and fully utilized the $800.0 million pretax benefit under the Citigroup indemnification agreement. For additional information see “-Asbestos Claims and Litigation.” After tax net investment income increased $12.7 million from 2002 due to higher average invested assets resulting from strong cash flows from operations in 2003, partially offset by the lower interest rate environment and the shortening of the fixed maturity portfolio duration. Net income included $20.7 million of net realized investment gains compared to $99.0 million of net realized investment gains in 2002. Net loss for 2002 included a charge for the cumulative effect of a change in accounting principle of $242.6 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 loss of $(27.0) million in 2002 or $(0.03) per share, basic and diluted, compared to net income of $1.065 billion or $1.39 per share, basic and diluted, in 2001. Results in 2002 benefited from the favorable rate environment that was significantly in excess of loss cost trends and lower weather-related catastrophe losses of $54.7 million compared to $67.1 million in 2001. The comparison to 2001 also benefited from the inclusion in 2001 of losses of $489.5 million related to the terrorist attack on September 11th. Results in 2002 reflected unfavorable prior year reserve development of $1.487 billion, which included the asbestos charge discussed above, compared to $38.7 million of favorable prior year reserve development in 2001. After tax net investment income decreased $89.4 million or 6% in 2002 due to reduced returns in the Company’s public equity investments and the lower interest rate environment. Net income in 2002 was favorably impacted by the elimination of goodwill amortization and lower interest expense. Net realized investment gains were $99.0 million and $209.9 million in 2002 and 2001, respectively, and the net loss for 2002 included a charge of $242.6 million due to the adoption of FAS 142.
Earned premiums increased $1.390 billion or 12% in 2003 due to rate increases on renewal business, growth in targeted new business and strong customer retention in both Commercial and Personal Lines. Commercial Lines earned premiums increased $921.6 million or 14% in 2003, despite a planned reduction of business volume at Northland and Associates. Personal Lines earned premiums increased $468.5 million or 11% in 2003. In 2002, earned premiums increased $1.744 billion or 19% over 2001 due to rate increases on renewal business in both Commercial and Personal Lines and the full-year inclusion of Northland and Associates in 2002.
Net investment income decreased $11.7 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 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. Pretax net investment income decreased $153.5 million or 8% in 2002. The decline resulted from a reduction in investment yields to 6.0% in 2002 from 6.9% in 2001. The decrease in yields reflected reduced returns in the Company’s public equity investments and the lower interest rate environment. The impact of lower yields was partially offset by the rise in average invested assets due to the Northland and Associates acquisitions and increased cash flow from operations. Net investment income related to Northland and Associates was $91.5 million in 2002, an increase of $68.4 million over 2001 which only included the fourth quarter.
Fee income increased $105.1 million or 23% in 2003 and $107.5 million or 31% in 2002. Fees rose 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 that are serviced by National Accounts.
Net realized investment gains were $38.0 million in 2003 compared to $146.7 million in 2002. Net realized investment gains included $90.2 million of impairment charges in 2003 compared to $284.1 million in 2002. These impairment charges were mostly related to corporate bonds in the healthcare, communications, aviation and energy sectors. Net realized investment gains in 2003 also included losses of $26.6 million related to U.S. Treasury futures contracts which are settled daily. Net realized investment gains of $322.5 million in 2001 included impairment charges of $146.2 million mostly related to the telecommunications and energy sectors.
Net written premiums increased $1.256 billion or 11% in 2003. The 2003 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, partially offset by the withdrawal in 2002 of business at American Equity Insurance Company, a subsidiary of Northland (American Equity) and Associates and a one-time additional $115.0 million of net written premiums in 2002 due to the termination of certain reinsurance contracts by Northland. Net written premiums for Northland and Associates were $546.8 million in 2003 and $824.8 million in 2002, a decrease of 34% from 2002. Commercial Lines net written premiums, excluding business written in Northland and Associates, increased $1.028 billion or 16% in 2003. Personal Lines net written premiums increased $506.4 million or 11% in 2003.
Net written premiums increased $2.099 billion or 21% in 2002. The increase in net written premiums in 2002 was due to rate increases and strong retention in both Commercial and Personal Lines and the full year inclusion of Northland and Associates in 2002. Net written premiums for Northland and Associates were $935.8 million in 2002, an increase of $743.1 million over 2001 which only included the fourth quarter of 2001. Commercial Lines net written premiums, excluding business written in Northland and Associates, increased $974.5 million or 17% in 2002. Personal Lines net written premiums increased $467.1 million or 11% in 2002.
General and administrative expenses increased $217.3 million or 15% in 2003 and $90.8 million or 7% in 2002. These increases related to business growth and higher contingent commissions that resulted from improved underwriting results. In addition, the 2002 comparison to 2001 reflects the elimination of goodwill amortization due to the adoption of FAS 142.
The Company’s effective tax rate was 24.1%, (183.4)% and 23.5% in 2003, 2002 and 2001, respectively. The 2003 increase in the effective rate reflected a higher level of pretax income associated with improved underwriting performance primarily related to the impact of the 2002 fourth quarter asbestos charge previously discussed and the impact of non-taxable recoveries of $520.0 million related to the Citigroup indemnification agreement in 2002, partially offset by a higher level of non-taxable investment income in 2003. The 2002 decrease in the effective rate reflected lower pretax income and the impact of the non-taxable recoveries from Citigroup as discussed above, in addition to a higher level of non-taxable net investment income in 2002 compared to 2001.
The 2003 operating income of $1.295 billion compared to an operating loss of $(125.8) million in 2002. The 2003 operating income reflected the continuing favorable, but moderating, rate environment in excess of loss cost trends and increased business volumes. Catastrophe losses of $67.4 million, net of reinsurance and after tax, compared to no catastrophes in 2002. The 2003 operating income contained no asbestos charges compared to $1.394 billion of unfavorable prior year reserve development related to asbestos in 2002, net of the benefit from the Citigroup indemnification agreement. Commercial Lines had a non-asbestos-related prior year reserve development charge of $447.2 million ($688.0 pretax) in 2003 compared to a $112.2 million charge ($172.7 million pretax) in 2002. The
most significant component of the 2003 prior year reserve development charge was $338.7 million of charges ($521.1 million pretax) related to reserve strengthening at Gulf. Reserve strengthening at Gulf primarily related to a line of business that insured the residual values of leased vehicles and that was placed in runoff in late 2001 and the resolution of a residual value claim dispute. Reserves for certain other business lines at Gulf were also strengthened as was its allowance for uncollectible reinsurance recoverables. In addition to these Gulf charges, there was additional other Commercial Lines net unfavorable prior year reserve development of $108.5 million which included a $74.8 million charge associated with American Equity and a $38.9 million increase in environmental reserves. Net investment income of $1.152 billion in 2003 was $28.6 million higher than 2002 due to higher average invested assets from strong operating cash flows along with higher returns in the Company’s arbitrage fund investments, partially offset by slightly lower returns in private equity investments and the impact of shortening the fixed maturity portfolio duration.
Operating loss of $(125.8) million for 2002 compared to operating income of $752.2 million in 2001. The 2002 operating loss reflected the benefit of the favorable premium rate environment in excess of loss cost trends and increased business volumes. Operating loss in 2002 was favorably impacted by no catastrophe losses compared to $470.5 million of catastrophe losses in 2001, including $447.9 million related to the terrorist attack on September 11, 2001. The 2002 prior year reserve development included the $1.394 billion charge related to asbestos discussed above compared to an asbestos-related charge of $122.7 million in 2001. Commercial Lines also had a non-asbestos-related prior year reserve development charge of $112.2 million ($172.7 pretax) in 2002 compared to a $141.2 million benefit ($217.2 million pretax) in 2001. Despite the benefit of higher average invested assets resulting from strong cash flows from underwriting, net investment income of $1.123 billion was $69.5 million lower than 2001 due to reduced returns in the Company’s public equity investments and the lower interest rate environment. The 2002 operating loss also reflects the elimination of goodwill amortization.
Net investment income increased $11.6 million in 2003 due to higher average invested assets resulting from strong cash flows from operations partially offset by the reduction in 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. Net investment income decreased $121.0 million in 2002. The decline resulted from a reduction in investment yields to 6.0% in 2002 from 6.9% in 2001. The decrease in yields reflected reduced returns in the Company’s public equity investments and the lower interest rate environment. The impact of lower yields was partially offset by the rise in average invested assets due to the Northland and Associates acquisitions and increased cash flow from operations. Net investment income related to Northland and Associates was $88.2 million in 2002, an increase of $65.8 million over 2001 which only included the fourth quarter.
Fee income increased $105.1 million or 23% in 2003 and $107.5 million or 31% in 2002. 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. Fees rose reflecting new business levels, price increases and more workers’ compensation business being written by state residual market pools.
Bond provides a variety of fidelity and surety bonds and executive liability coverages to clients of all sizes through independent agents and brokers. Bond net written premiums increased $150.6 million or 24% in 2003. This increase reflected a favorable premium rate environment and strong new business, principally in executive liability product lines, which target middle and small market private accounts, partially offset by higher reinsurance costs. In addition, the surety product lines benefited from higher premium rates in 2003. Bond net written premiums increased $39.7 million or 7% in 2002. The 2002 amount was reduced by $17.5 million due to a change in the Bond Executive Liability excess of loss reinsurance treaty that was effective January 1, 2002. Excluding this reinsurance adjustment, Bond net written premiums increased $133.1 million or 21% during 2003. In addition, the 2001 amount was increased by $34.1 million due to the termination of the Master Bond Liability reinsurance treaty effective January 1, 2001. Excluding both reinsurance adjustments, Bond net written premiums increased $91.3 million during 2002. This increase reflected a favorable premium rate environment and strong production growth in executive liability product lines. In addition, the surety product lines benefited from higher premium rates in 2002.
The 30.5 point improvement in the 2003 GAAP combined ratio before policyholder dividends reflected an improvement in both the loss and LAE ratio and the underwriting expense ratio. The improvement in the loss and LAE ratio resulted from lower unfavorable prior year reserve development, primarily due to no asbestos-related charges in 2003 compared to the 2002 asbestos-related charges discussed above that added 31.5 points to the 2002 combined ratio. The impact of premium rate increases that exceeded loss cost trends was mostly offset by the catastrophe losses that occurred in 2003 compared to no catastrophe losses in 2002. The decrease in the underwriting expense ratio was primarily due to the benefits of the favorable rate environment and higher fee income, partially offset by higher contingent commissions that result from improved underwriting performance.
Earned premiums increased $468.5 million or 11% in 2003 primarily due to higher rates as well as increased new business volumes and strong retention. Earned premiums in 2002 increased $390.2 million or 10% primarily due to rate increases in all product lines and the full-year inclusion of Northland. Earned premiums for Northland were $112.1 million in 2002, an increase of $91.2 million over 2001 which only included the fourth quarter.
Personal Lines net written premiums increased $506.4 million or 11% in 2003 due to renewal price increases and higher business volumes in both the Automobile and Homeowners and Other lines of business. Net written premiums in 2002 increased $467.1 million or 11% due to renewal price increases in both the Automobile and Homeowners and Other lines of business and the full-year inclusion of Northland. Net written premiums for Northland were $111.0 million in 2002, an increase of $85.7 million over 2001 which only included the fourth quarter.
Homeowners and Other net written premiums increased $296.0 million or 17% in 2003 due to higher business volumes and renewal price increases. Renewal price change increases averaged 11% in 2003 compared to 15% for 2002. The higher level of renewal price change increases in 2002 was mostly attributable to rate increases in Texas. Policies in force increased 6% in 2003. Retention levels also remained favorable and averaged 81%, up one percentage point from 2002. Homeowners and Other net written premiums increased $214.9 million or 14% in 2002. Excluding the impact of Northland, which contributed $13.5 million and $1.6 million to 2002 and 2001, respectively, Homeowners and Other net written premiums increased 13% to $1.719 billion. Renewal price changes averaged 15% for 2002, up 5 percentage points from 2001. Policies in force were flat in 2002. Retention levels also remained favorable and averaged 80% in both 2002 and 2001.
Catastrophe losses, net of reinsurance, were $248.6 million, $84.1 million and $132.5 million in 2003, 2002 and 2001, respectively. Catastrophe losses in 2003 were primarily due to winter storms in the Mid-Atlantic states, the Northeast and Colorado in the first quarter and hail, ice storms and tornados in the second quarter. Catastrophes in the third quarter were primarily due to Hurricane Isabel and in the fourth quarter were due to the California wildfires and wind, hail and tornados in the Midwest and East. Catastrophe losses in 2002 were primarily due to winter storms in the Midwest and New York in the first quarter, wind and hailstorms in the Mid-Atlantic region in the second and third quarters, and Tropical Storm Lili and wind, hail and ice storms in the Southeast in the fourth quarter. Catastrophe losses in 2001 were primarily due to the terrorist attack on September 11, Tropical Storm Allison and wind and hailstorms in the Midwest and Texas in the second quarter.
Amortization of deferred acquisition costs increased $63.4 million or 9% in 2003 and $63.6 million or 9% in 2002 due to higher commission and premium taxes associated with the increases in earned premium previously described.
General and administrative expenses increased $34.9 million or 9% in 2003 and $2.2 million or 1% in 2002. These increases are related to business growth and higher contingent commissions that resulted from improved underwriting results. In addition, 2002 comparison to 2001 reflects the elimination of goodwill amortization due to the adoption of FAS 142.
The 5.0 point improvement in the 2003 GAAP combined ratio reflected an improvement in both the loss and LAE ratio and in the underwriting expense ratio. The improvement in the loss and LAE ratio 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. The improvement in the underwriting expense ratio was primarily due to the benefits of the favorable rate environment and further expense leverage.
The 4.4 point improvement in the 2002 GAAP combined ratio reflected an improvement in both the loss and LAE ratio and the underwriting expense ratio. The improvement in the loss and LAE ratio was primarily attributed to renewal price increases that exceeded loss cost trends, slightly higher natural catastrophes in 2002, the impact in 2001 of the terrorist attack on September 11, and slightly lower favorable prior year reserve development. The improvement in the underwriting expense ratio was primarily attributed to the benefit of premium rate increases and the elimination of goodwill amortization. An increase in contingent commissions, resulting from the improved underwriting performance, offset an overall reduction in other expenses.
The Company believes that the property and casualty insurance industry has suffered from court decisions and other trends that have attempted to expand insurance coverage for asbestos claims, far beyond the intent of insurers and policyholders. As a result, the Company continues to experience an increase in the number of asbestos claims being tendered to the Company by the Company’s policyholders (which includes others seeking coverage under a policy) including claims against the Company’s policyholders by individuals who do not appear to be impaired by asbestos exposure. Factors underlying these increases include more intensive advertising by lawyers seeking asbestos claimants, the increasing focus by plaintiffs on new and previously peripheral defendants and entities seeking bankruptcy protection as a result of asbestos-related liabilities. In addition to contributing to the increase in claims, bankruptcy proceedings may increase the volatility of asbestos-related losses by initially delaying the reporting of claims and later by significantly accelerating and increasing loss payments by insurers, including the Company. The Company is currently involved in coverage litigation concerning a number of policyholders who have filed for bankruptcy, including, among others, ACandS, Inc., who in some instances, have asserted that all or a portion of their asbestos-related claims are not subject to aggregate limits on coverage as described generally in the next paragraph. (Also see “-Legal Proceedings.”) Particularly during the last few months of 2001 and continuing through 2002, the trends described above both accelerated and became more apparent. As expected, these trends continued into 2003. As a result of the trends described above, there is a high degree of uncertainty with respect to future exposure from asbestos claims.
Other policyholders with active claims are identified as home office review or field office review policyholders. Policyholders are identified for home office review based upon, among other factors: aggregate 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. During 2003, an additional 48 policyholders, previously part of the field office review, were included in the home office review. Paid losses for policyholders in the home office review category increased by $28.7 million during the year, due to an acceleration in expected payments coupled with the inclusion of the additional policyholders in this category. Accounts under field office review increased by 73 policyholders from 2002, as additional peripheral defendants continue to be named in suits.
The Company continues to receive claims from policyholders who allege that they are liable for injury or damage arising out of their alleged disposition of toxic substances. Mostly, these claims are due to various legislative as well as regulatory efforts aimed at environmental remediation. For instance, the Comprehensive Environmental Response, Compensation and Liability Act, or CERCLA, enacted in 1980 and later modified, enables private parties as well as federal and state governments to take action with respect to releases and threatened releases of hazardous substances. This federal statute permits the recovery of response costs from some liable parties and may require liable parties to undertake their own remedial action. Liability under CERCLA may be joint and several with other responsible parties.
The Company has been, and continues to be, involved in litigation involving insurance coverage issues pertaining to environmental claims. The Company believes that some court decisions have interpreted the insurance coverage to be broader than the original intent of the insurers and policyholders. These decisions often pertain to insurance policies that were issued by the Company prior to the mid-1970s. These decisions continue to be inconsistent and vary from jurisdiction to jurisdiction. Environmental claims when submitted rarely indicate the monetary amount being sought by the claimant from the policyholder, and the Company does not keep track of the monetary amount being sought in those few claims which indicate a monetary amount.
The Company’s reserves for environmental claims are not established on a claim-by-claim basis. The Company carries an aggregate bulk reserve for all of the Company’s environmental claims that are in dispute until the dispute is resolved. This bulk reserve is established and adjusted based upon the aggregate volume of in-process environmental claims and the Company’s experience in resolving those claims. At December 31, 2003, approximately 82% of the net environmental reserve (approximately $236.5 million) is carried in a bulk reserve and includes unresolved and incurred but not reported environmental claims for which the Company has not received any specific claims as well as for the anticipated cost of coverage litigation disputes relating to these claims. The balance, approximately 18% of the net environmental reserve (approximately $53.6 million), consists of case reserves for resolved claims.
Because the primary purpose of the investment portfolio is to fund future claims payments, the Company employs a conservative investment philosophy. The Company’s fixed maturity portfolio at December 31, 2003 totaled $33.046 billion, comprising $32.563 billion of publicly traded fixed maturities and $482.8 million of private fixed maturities. The weighted average quality ratings of the Company’s publicly traded fixed maturity portfolio and private fixed maturity portfolio at December 31, 2003 were Aa2 and Baa1, respectively. Included in the fixed maturity portfolio at that date was approximately $2.057 billion of below investment grade securities. During 2003, holdings of tax-exempt securities were increased to $15.391 billion to take advantage of their relatively high credit quality and attractive after-tax yields. The average effective duration of the fixed maturity portfolio, including short-term investments, was 4.1 years as of December 31, 2003 (4.3 years excluding short-term investments), as compared to 5.0 years at December 31, 2002.
As previously discussed, the Company announced the proposed merger with St. Paul. The following discussion does not reflect the impact, if any, of the proposed merger including the integration of the Company’s business with that of St. Paul.
A variety of other factors continue to affect the property and casualty insurance market and the Company’s core business outlook, including continued price increases in the commercial lines marketplace, although at a moderating level, a continuing highly competitive personal lines marketplace, inflationary pressures on loss cost trends, including medical inflation and auto loss costs, asbestos-related developments and rising reinsurance and litigation costs.
The Company’s strategic objective is to enhance its position as a consistently profitable market leader and a cost-effective provider of property and casualty insurance in the United States.
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 2003, interest rates remained near their lowest levels since the 1950’s. Consequently, yields available on new investments remain below the existing portfolio’s average book yield. The continuation of this trend will create downward pressure on the average book yield of fixed income holdings.
In 2003, the trend of higher rates continued in Commercial Lines, although at a moderated level over 2002, and some of the increases varied significantly by region, business segment and line of business. These increases were necessary to offset the impact of rising loss cost trends, reduction in investment yields and the decline in profitability from the competitive pressures of the last decade. Since the terrorist attack on September 11, 2001, there has been greater concern over the availability, terms and conditions, and pricing of reinsurance. As a result, the primary insurance market is expected to continue to see rate increases, although at moderated levels from the past two years, and continued restrictive terms and conditions for certain coverages where adequate pricing cannot be achieved.
Also in Commercial Accounts, during 2002 the operations of American Equity and Associates were determined to be non-strategic. Accordingly, these operations were placed in run-off during the first and fourth quarters of 2002, respectively, which included non-renewals of inforce policies and a cessation of writing new business, where allowed by law. These operations were acquired in the fourth quarter of 2001 from Citigroup as part of the Northland and Associates acquisitions previously discussed. Net written premium for these combined operations was $1.0 million and $86.8 million in 2003 and 2002, respectively.
Bond achieved significant growth in 2003 in both the surety and executive liability markets. A decrease in capacity in the surety industry, driven by an increase in claim frequency and severity in accident years 1999 through 2001 for the surety industry, enabled Bond to increase prices for all surety products. In 2004, Bond expects surety price increases to moderate compared to 2003 price increases. In the executive liability market for middle and small private accounts and not-for-profit accounts, Bond’s expanding array of products and recognized local expertise enabled it to further enhance its product and customer diversification, as well as profit opportunities, while realizing significant price increases. Bond’s focus remains on selective underwriting, selling its products to customers that provide the greatest opportunities for profit. Bond is also focused on the Company’s efforts to cross-sell its expanding array of products to existing customers of Commercial Lines and Personal Lines.
There are currently various state and federal legislative and judicial proposals to require asbestos claimants to demonstrate an asbestos illness. At this time it is not possible to predict the likelihood or timing of such proposals being enacted or the effect if they are enacted. The Company’s ongoing analysis of its asbestos reserves did not assume the adoption of any asbestos reforms.
Personal Lines strategy is to profitably grow its customer base in the independent agent and additional distribution channels. The core factors underlying the business are controlling operating expenses, sophisticated pricing segmentation, providing responsive and fair claim settlement practices and providing an efficient sales platform for our distributors.
Personal Lines reported strong property underwriting results in 2003 as market conditions for property insurance improved in 2003. Significant rate increases were earned and the effects of increased underwriting discipline and product modification were recognized. Catastrophe losses in the year were above average while non-catastrophe claim frequencies remained below historical averages. Property rate increases are expected to moderate in 2004 but should continue to offset increases in loss costs.
See note 16 of notes to the Company’s consolidated financial statements for a description of these and other intercompany arrangements and transactions between the Company and Citigroup.
Net cash flows provided by operating activities totaled $3.833 billion, $2.926 billion and $1.219 billion in 2003, 2002 and 2001, respectively. The 2003 net cash flows provided by operating activities benefited from premium rate increases, the receipt of $360.7 million from Citigroup related to recoveries under the asbestos indemnification agreement and $530.9 million of federal income taxes refunded from the Company’s net operating loss carryback. The 2002 net cash flows provided by operating activities also benefited significantly from premium rate increases compared to 2001.
Net cash flows used in investing activities totaled $2.475 billion, $2.270 billion and $95.5 million in 2003, 2002 and 2001, respectively. The 2003 net cash flows used in investing activities primarily reflected the investing of net cash from operating activities of $3.833 billion. This was offset, in part, by sales of securities to fund net payment activity of $771.6 million related to debt and TIGHI’s junior subordinated debt securities held by subsidiary trusts. In addition, cash was used to pay quarterly dividends to shareholders of $281.8 million. The 2002 net cash flows used in investing activities principally reflected investing of net cash from operating activities of $2.926 billion and the receipt of $4.090 billion from the first quarter 2002 initial public offering and the concurrent issuance of $867.0 million of convertible notes payable, partially offset by the repayment of $6.349 billion of notes payable to a former affiliate. The 2001 net cash flows used in investing activities principally reflected investing of net cash from operating activities of $1.219 billion, partially offset by sales of securities to fund the repayment of $1.040 billion of notes payable to a former affiliate and the payment of $526.0 million of dividends.
Net cash flows are generally invested in marketable securities. The Company closely monitors the duration of these investments, and investment purchases and sales are executed with the objective of having adequate funds available to satisfy the Company’s liabilities. As the Company’s investment strategy focuses on asset and liability durations, and not specific cash flows, asset sales may be required to satisfy obligations and/or rebalance asset portfolios. The Company’s invested assets at December 31, 2003 totaled $38.653 billion, including $348.8 million of securities in process of settlement, of which 91% was invested in fixed maturity and short-term investments, 2% in common stocks and other equity securities, 1% in mortgage loans and real estate held for sale and 6% in other investments. The effective average duration of fixed maturities and short-term securities, net of securities lending activities and net receivables and payables on investment sales and purchases, was 4.1 years as of December 31, 2003, a 0.9 decrease from 5.0 years as of December 31, 2002. The reduction in effective average duration resulted from the investment of underwriting cash flows and investment maturities and sales proceeds in shorter-term investments along with the sale of certain treasury futures contracts.
The Company’s ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery.
The investee has announced, or the Company has become aware of, adverse changes or events such as changes or planned changes in senior management, restructurings, or a sale of assets;
The regulatory, economic, or technological environment has changed in a way that is expected to adversely affect the investee’s profitability;
A secondary equity offering at a price substantially lower than the holder’s cost;
A breach of a covenant or the failure to service debt;
For debt and equity investments, factors that may indicate that a decline in value is not other-than-temporary include the following:
Bond interest or preferred stock dividend rate (on cost) is lower than rates for similar securities issued currently but quality of investment is not adversely affected;
Financial condition, market share, backlog and other key statistics indicate growth.
Impairment charges included in net realized investment gains (losses) were as follows:
The Company recognized other-than-temporary impairments of $65.4 million in the fixed income portfolio during 2003 related to various issuers, with $8.3 million due to companies filing bankruptcy and the remainder related to credit risk associated with the issuer’s deteriorated financial position.
For publicly traded securities, the amounts of the impairments were determined by writing down the investments to quoted market prices. For non-publicly traded securities, impairments are determined by writing down the investment to its estimated fair value, as determined during the Company’s quarterly internal review process.
The Company’s investment portfolio includes non-publicly traded investments, such as real estate partnerships and joint ventures, investment partnerships, private equities and certain fixed income securities. The real estate partnerships and joint ventures, investment partnerships and certain private equities are accounted for using the equity method of accounting. These investments are carried at cost, adjusted for the Company’s share of earnings or losses and reduced by any cash distributions. Certain other private equity investments which are not subject to the provisions of FAS 115 are reported at fair value.
The following is a summary of the approximate carrying value of the Company’s non-publicly traded securities:
The following table summarizes for all fixed maturities and equity securities available for sale for which fair value is less than 80% of amortized cost at December 31, 2003, the gross unrealized investment loss by length of time those securities have continuously been in an unrealized loss position:
No individual security had a greater than $2.0 million unrealized loss as of December 31, 2003.
TPC is a holding company whose principal asset is the capital stock of TIGHI and its insurance operating subsidiaries. TIGHI’s insurance subsidiaries are subject to various regulatory restrictions that limit the maximum amount of dividends available to be paid to their parent without prior approval of insurance regulatory authorities. A maximum of $1.647 billion will be available by the end of 2004 for such dividends without prior approval of the Connecticut Insurance Department. TIGHI received $927.0 million of dividends from its insurance subsidiaries during 2003.
There were no amounts outstanding under the Lines of Credit at December 31, 2003. Previous lines of credit between TIGHI and Citigroup have been terminated.
Notes payable to former affiliates, long-term debt, convertible notes and TIGHI junior subordinated debt securities outstanding at December 31, were as follows:
On March 11, 2003, TPC issued $1.400 billion of senior notes comprising $400.0 million of 3.75% senior notes due March 15, 2008, $500.0 million of 5.00% senior notes due March 15, 2013 and $500.0 million of 6.375% senior notes due March 15, 2033. The notes pay interest semi-annually on March 15 and September 15 of each year, beginning September 15, 2003, are senior unsecured obligations and rank equally with all of TPC’s other senior unsecured indebtedness. TPC may redeem some or all of the notes prior to maturity by paying a “make-whole” premium based on U.S. Treasury rates. The net proceeds from the sale of these notes were contributed to its primary subsidiary, TIGHI, so that TIGHI could prepay and refinance $500.0 million of 3.60% indebtedness to Citigroup and to redeem $900.0 million aggregate principal amount of TIGHI’s 8.00% to 8.08% junior subordinated debt securities held by subsidiary trusts. These trusts, in turn, used these funds to redeem $900.0 million of preferred capital securities on April 9, 2003.
Includes contracts with various building maintenance contractors for company owned and occupied real estate.
Includes commitments to vendors entered in the ordinary course of business for goods and services including office supplies, archival services, etc.
Represents amounts due under renewal rights purchase agreements based on the estimated final purchase price. Amounts relate to the renewal rights purchased by the Company in the third quarter of 2003. See note 5 of the notes to the Company’s consolidated financial statements for a further discussion.
Represents estimated timing for amounts payable under reinsurance agreements that are accounted for as deposits (amounts reported on a present value basis consistent with the balance sheet presentation).
TPC has the option to defer interest payments on its convertible junior subordinated notes for a period not exceeding 20 consecutive quarterly interest periods. If TPC elects to defer interest payments on the notes, it will not be permitted, with limited exceptions, to pay dividends on its common stock during a deferral period.
The Company considers its most significant accounting estimates to be those applied to claim and claim adjustment expense reserves and related reinsurance recoverables.
The Company reports its reinsurance recoverables net of an allowance for estimated uncollectible reinsurance recoverables. The allowance is based upon the Company’s ongoing review of amounts outstanding, length of collection periods, changes in reinsurer credit standing, applicable coverage defenses and other relevant factors. Accordingly, the establishment of reinsurance recoverables and the related allowance for uncollectible reinsurance recoverables is also an inherently uncertain process involving estimates. During 2003, the Company increased the allowance by a net amount of $57.3 million in connection with the Company’s ongoing review process. The allowance for estimated uncollectible reinsurance recoverables was $386.4 million at December 31, 2003. Changes in these estimates could result in additional income statement charges.
In most cases, multiple estimation methods will be valid for the particular facts and circumstances of the claim liabilities being evaluated. This will result in a range of reasonable estimates for any particular claim liability. The Company uses such range analyses to back test whether previously established estimates for reserves at the reporting segments are reasonable, given subsequent information. Reported values found to be closer to the endpoints of a range of reasonable estimates are subject to further detailed reviews. These reviews may substantiate the validity of management’s recorded estimate or lead to a change in the reported estimate.
A key assumption in most actuarial analyses is that past patterns demonstrated in the data will repeat themselves in the future, absent a material change in the associated risk factors discussed below. To the extent a material change affecting the ultimate claim liability is known, such change is quantified to the extent possible through an analysis of internal company (and, if necessary, external) data. Such a measurement is specific to the facts and circumstances of the particular claim portfolio and the known change being evaluated.
The major causes of material uncertainty (“risk factors”) generally will vary for each product line, as well as for each separately analyzed component of the product line. In some cases, such risk factors are explicit assumptions of the estimation method and in others, they are implicit. For example, a method may explicitly assume that a certain percentage of claims will close each year, but will implicitly assume that the legal interpretation of existing contract language will remain unchanged. Actual results will likely vary from expectations for each of these assumptions, resulting in an ultimate claim liability that is different from that being estimated currently.
While some changes in the claim environment are sudden in nature (such as a new court ruling affecting the interpretation of all contracts in that jurisdiction), others are more evolutionary. Evolutionary changes can occur when multiple factors affect final claim values, with the uncertainty surrounding each factor being resolved separately, in step-wise fashion. The final impact is not known until all steps have occurred.
General liability is considered a long tail line, as it takes a relatively long period of time to finalize and settle claims from a given accident year. The speed of claim reporting and claim settlement is a function of the specific coverage provided, the jurisdiction, and specific policy provisions such as self-insured retentions. There are numerous components underlying the general liability product line. Some of these have relatively moderate payment patterns (with most of the claims for a given accident year closed within 5 to 7 years), while others can have extreme lags in both reporting and payment of claims (e.g., a reporting lag of a decade for “construction defect” claims).
Legal fees are also a part of the insured costs covered by liability policies and can be significant, sometimes greater than the cost of the actual paid claims.
Property is considered a short tail line with a simpler and faster claim adjustment process than liability coverages, and less uncertainty in the reserve setting process. The claim reporting and settlement process for property coverage claim reserves is generally restricted to the insured and the insurer.
Property reserves are typically analyzed in two components, one for catastrophic or other large single events, and another for all other events. Examples of common risk factors that can change and, thus, affect the required property reserves (beyond those included in the general discussion section) include:
Lags in reporting claims (e.g. winter damage to summer homes, hidden damage after an earthquake)
Changes in the interpretations and processes of the workers’ compensation commissions’ oversight of claims1
Surety is also considered a short tail coverage. The frequency of losses in surety correlates with economic cycles as the primary cause of surety loss is the inability to perform financially. The volatility of surety reserves is generally related to the type of business performed by the insured, the type of bonded obligation, the amount of limit exposed to loss, and the amount of assets available to the insurer to mitigate losses, such as unbilled contract funds, collateral, first and third party indemnity, and other security positions of an insured’s assets. Surety claims are generally high severity, low frequency in nature. Other claim factors affecting reserve variability of surety includes litigation related to amounts owed by and due the insured (e.g., salvage and subrogation efforts) and the results of financial restructuring of an insured.
Examples of common risk factors that can change and, thus, affect the required fidelity and surety reserves (beyond those included in the general discussion section) include:
Personal automobile includes both short and long tail coverages. The payments that are made quickly typically pertain to auto physical damage (property) claims and property damage (liability) claims. The payments that take longer to finalize and are more difficult to estimate relate to bodily injury claims. This mixture of claim payments creates a moderate estimation risk.
Prior to the IPO, the Company participated in Citigroup’s Capital Accumulation Plan (CAP) that provided for the issuance of shares of Citigroup common stock in the form of restricted stock awards to eligible officers and other key employees. On August 20, 2002, in connection with the Citigroup Distribution, the unvested outstanding awards of restricted stock and deferred shares held by Company employees on that date under Citigroup CAP awards, were cancelled and replaced by awards comprised primarily of 3.1 million newly issued shares of class A common stock at a total market value of $53.3 million based on the closing price of the class A common stock on August 20, 2002. These replacement awards were granted on substantially the same terms, including vesting, as the former Citigroup awards. The value of these newly issued shares along with class A and class B common stock received in the Citigroup Distribution on the Citigroup restricted shares, were equal to the value of the cancelled Citigroup restricted share awards. In addition the Board of Directors plan allows deferred receipt of shares of class A common stock (deferred stock) to a future distribution date or upon termination of their service.
Prior to the Citigroup Distribution on August 20, 2002, unearned compensation expense associated with the Citigroup restricted common stock grants is included in other assets in the consolidated balance sheet. Following the Citigroup Distribution and the issuance of replacement stock awards in the Company’s class A and class B shares on August 20, 2002, the unamortized unearned compensation expense associated with these awards is included as unearned compensation in the consolidated balance sheet. Unearned compensation expense is recognized as a charge to income ratably over the vesting period. The after-tax compensation cost charged to earnings for these restricted stock and deferred stock awards was $17.1 million, $17.0 million and $19.4 million for the years ended December 31, 2003, 2002 and 2001, respectively. See note 10 of notes to the Company’s consolidated financial statements for a discussion of restricted common stock awards.
This report contains, and oral statements by management of the Company may contain, certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. All statements, other than statements of historical facts, may be forward-looking statements. Specifically, the Company has forward-looking statements about the Company’s results of operations, financial condition, liquidity, and the sufficiency of the Company’s asbestos reserves. These forward-looking statements also include statements about the Company’s proposed merger with St. Paul, including but not limited to statements regarding the integration of the Company’s business with St. Paul’s under the heading “Outlook” and elsewhere.
Many risks and uncertainties may impact the matters addressed in these forward-looking statements. Actual results may differ materially from those expressed or implied. In particular, the sufficiency of the Company’s asbestos reserves, as well as the Company’s results of operations, financial condition and liquidity, to the extent impacted by the sufficiency of the Company’s asbestos reserves, is subject to a number of potential adverse developments including, among others, adverse developments involving asbestos claims and related litigation, the willingness of parties, including the Company, to settle disputes, the impact of aggregate policy coverage limits, and the impact of bankruptcies of various asbestos producers and related businesses. In addition, we may not be able to fully integrate the Company’s business with that of St. Paul’s in the manner or in the time frame currently anticipated.
We have audited the accompanying consolidated balance sheet of Travelers Property Casualty Corp. and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income (loss), changes in shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
Includes foreign currency translation adjustments, changes in value of private equity securities and the cumulative effect of the change in accounting for derivative instruments.
TPC was reorganized in connection with its initial public offering (IPO) on March 21, 2002. Pursuant to the reorganization, which was completed on March 19, 2002, TPC’s consolidated financial statements have been adjusted to exclude the accounts of certain formerly wholly-owned TPC subsidiaries, principally The Travelers Insurance Company (TIC) and its subsidiaries (U.S. life insurance operations), certain other wholly-owned noninsurance subsidiaries of TPC and substantially all of TPC’s assets and certain liabilities not related to the property casualty business.
In conjunction with the corporate reorganization and the offerings described above, during March 2002, the Company entered into an agreement with Citigroup (the Citigroup indemnification agreement) which provided that in any year in which the Company recorded additional asbestos-related income statement charges in excess of $150.0 million, net of any reinsurance, Citigroup would pay to the Company the amount of any such excess up to a cumulative aggregate of $800.0 million, reduced by the tax effect of the highest applicable federal income tax rate. During 2002, the Company recorded $2.945 billion of asbestos incurred losses, net of reinsurance, and accordingly has fully utilized the total benefit available under the agreement. For the year ended December 31, 2002, revenues include $520.0 million from Citigroup under this agreement. At December 31, 2002, other assets included a $360.7 million receivable from Citigroup under this agreement, which was received during the first quarter of 2003. Included in federal income taxes in the consolidated statement of income is a tax benefit of $280.0 million related to the asbestos charge covered by the agreement.
On August 20, 2002, in connection with the Citigroup Distribution, stock-based awards held by Company employees on that date under Citigroup’s various incentive plans were cancelled and replaced by awards under the Company’s own incentive programs.
In December 2003, the Financial Accounting Standards Board (FASB) issued Revised Interpretation No. 46, “Consolidation of Variable Interest Entities” (FIN 46R). FIN 46R clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements”, to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support. FIN 46R separates entities into two groups: (1) those for which voting interests are used to determine consolidation and (2) those for which variable interests are used to determine consolidation. FIN 46R clarifies how to identify a variable interest entity (VIE) and how to determine when a business enterprise should include the assets, liabilities, non-controlling interests and results of activities of a VIE in its consolidated financial statements. A company that absorbs a majority of a VIE’s expected losses, receives a majority of a VIE’s expected residual returns, or both, is the primary beneficiary and is required to consolidate the VIE into its financial statements. FIN 46R also requires disclosure of certain information where the reporting company is the primary beneficiary or holds a significant variable interest in a VIE (but is not the primary beneficiary).
FIN 46R is effective for public companies that have interests in VIEs or potential VIEs that are special-purpose entities for periods ending after December 15, 2003. Application by public companies for all other types of entities is required for periods ending after March 15, 2004. The Company has chosen to adopt FIN 46R effective December 31, 2003.
To buy and sell U.S. and non-U.S. assets with a primary focus on a diversified pool of structured mortgage and asset-backed securities offering attractive and relative value.
The Company does not have any unfunded commitments associated with these hedge fund investments, and its exposure to loss is limited to the investment carrying amounts reported in the consolidated balance sheet.
In December 2002, the FASB issued Statement of Financial Standards No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure” (FAS 148), an amendment to FASB Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (FAS 123). Provisions of this statement provide two additional alternative transition methods: modified prospective method and retroactive restatement method, for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. The statement eliminates the use of the original FAS 123 prospective method of transition alternative for those entities that change to the fair value based method in fiscal years beginning after December 15, 2003. It also amends the disclosure provisions of FAS 123 to require prominent annual disclosure about the effects on reported net income in the Summary of Significant Accounting Policies and also requires disclosure about these effects in interim financial statements. These provisions are effective for financial statements for fiscal years ending after December 15, 2002. Accordingly, the Company adopted the applicable disclosure requirements of this statement beginning with year-end 2002 reporting. The transition provisions of this statement apply upon adoption of the FAS 123 fair value based method.
A financial instrument issued in the form of shares that is mandatorily redeemable - that embodies an unconditional obligation requiring the issuer to redeem it by transferring its assets at a specified or determinable date (or dates) or upon an event that is certain to occur;
Effective January 1, 2002, the Company adopted FASB Statements of Financial Accounting Standards No. 141, “Business Combinations” (FAS 141) and No. 142, “Goodwill and Other Intangible Assets” (FAS 142). These standards change the accounting for business combinations by, among other things, prohibiting the prospective use of pooling-of-interests accounting and requiring companies to stop amortizing goodwill and certain intangible assets with an indefinite useful life created by business combinations accounted for using the purchase method of accounting. Instead, goodwill and intangible assets deemed to have an indefinite useful life will be subject to an annual review for impairment. Other intangible assets that are not deemed to have an indefinite useful life will continue to be amortized over their useful lives.
During the quarter ended March 31, 2002, the Company performed the transitional impairment tests using the fair value approach required by FAS 142. Based on these tests, the Company impaired $220.0 million after tax of goodwill and $22.6 million after tax of indefinite-lived intangible assets representing the value of insurance operating licenses, all attributable to The Northland Company and subsidiaries (Northland), as a cumulative effect adjustment as of January 1, 2002. The fair value of the Northland reporting unit was based on the use of a multiple of earnings model. The fair value of Northland’s indefinite-lived intangible assets was based on the present value of estimated net cash flows. The Northland reporting unit is a component of the Commercial Lines operating segment.
As a result of adopting FAS 133, the Company recorded a benefit of $4.5 million after tax, reflected as a cumulative effect adjustment in the consolidated statement of income and a charge of $4.0 million after tax, reflected as a cumulative effect adjustment in the accumulated other changes in equity from nonowner sources section of shareholders’ equity. In addition, the Company redesignated certain investments as trading from available for sale in accordance with the transition provisions of FAS 133 resulting in a gross gain of $8.0 million after tax, reflected in net realized investment gains.
Fixed maturities include bonds, notes and redeemable preferred stocks. Fixed maturities are valued based upon quoted market prices or dealer quotes, or if quoted market prices or dealer quotes are not available, discounted expected cash flows using market rates commensurate with the credit quality and maturity of the investment. Also included in fixed maturities are loan-backed and structured securities, which are amortized using the retrospective method. The effective yield used to determine amortization is calculated based upon actual historical and projected future cash flows, which are obtained from a widely-accepted securities data provider. Fixed maturities, including instruments subject to securities lending agreements, are classified as available for sale and are reported at fair value, with unrealized investment gains and losses, net of income taxes, charged or credited directly to shareholders’ equity.
Real estate held for sale is carried at the lower of cost or fair value less estimated costs to sell. Fair value is established at the time of acquisition by internal analysis or external appraisers, using discounted cash flow analyses and other acceptable techniques. Thereafter, an impairment is taken if the carrying value of the property exceeds its current fair value less estimated costs to sell.
Other invested assets include certain private equity securities along with partnership investments and real estate joint ventures and are accounted for on the equity method of accounting. Undistributed income is reported in net investment income.
The Company adopted FAS 141 and FAS 142 effective January 1, 2002. Upon adoption of FAS 141 and FAS 142, the Company stopped amortizing goodwill. Instead, goodwill is tested for impairment at least annually using a two-step process. The first step is performed to identify potential impairment and, if necessary, the second step is performed for the purpose of measuring the amount of impairment, if any. Other intangible assets that are not deemed to have an indefinite useful life continue to be amortized over their useful lives. The Company does not have indefinite-lived intangible assets as of December 31, 2003.
Claims and claim adjustment expense reserves represent estimated provisions for both reported and unreported claims incurred and related expenses. The reserves are adjusted regularly based upon experience. Included in the claims and claim adjustment expense reserves in the consolidated balance sheet at December 31, 2003 and 2002 are $1.325 billion and $1.370 billion, respectively, of reserves related to workers’ compensation that have been discounted using an interest rate of 5%. Also included at December 31, 2003 and 2002 are $445.4 million and $456.1 million, respectively, of reserves related to certain fixed and determinable asbestos-related settlements, where all payment amounts and their timing are known, that have been discounted using a range of interest rates of 1.56% to 5.50%.
Payables for investment purchases represent amounts owed by the Company to investment brokers for securities purchased, which are recorded as of trade date, for which the Company, in the normal course of securities settlement, has not yet settled the purchase.
The Company also engages in dollar-roll repurchase activities from which it generates net investment income from selling mortgage-backed securities and simultaneously agreeing to repurchase from the same party substantially the same securities. The Company invests the proceeds from the sale in a short-term investment pool, the sold securities remain a recorded asset of the Company and a liability is recorded to recognize the Company’s obligation to repurchase substantially the same securities at the end of a specified period.
Also included in other liabilities is an accrual for policyholder dividends. Certain insurance contracts, primarily workers’ compensation, are participating whereby dividends are paid to policyholders in accordance with contract provisions. Net written premiums for participating dividend policies were approximately 1%, 2% and 2% of total Company net written premiums for the years ended December 31, 2003, 2002 and 2001, respectively. Policyholder dividends are accrued against earnings using best available estimates of amounts to be paid. Policyholder dividends were $13.1 million, $14.4 million and $28.3 million for the years ended December 31, 2003, 2002 and 2001, respectively.
In conjunction with and subsequent to the IPO in March 2002 and the Citigroup Distribution in August 2002, the Company’s stock option awards provide for the purchase of the Company’s class A common shares. Prior to 2002, the stock option awards provided for the purchase of Citigroup common stock. The following tables illustrate the effect on net income (loss) and earnings per share for each period indicated as if the Company had applied the fair value recognition provisions of FAS 123 to all outstanding and unvested stock-based employee awards.
EPS has been computed in accordance with Financial Accounting Standards No. 128, “Earnings per Share”. Basic EPS is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. The computation of diluted EPS reflects the effect of potentially dilutive outstanding employee stock-based awards, principally the incremental shares which are assumed to be issued under the Company’s 2002 Incentive Plan. Excluded from the computation of diluted EPS were 38.6 million of potentially dilutive shares related to convertible junior subordinated notes because the contingency conditions for their issuance have not been satisfied. Shares for the years ended December 31, 2002 and 2001 have been adjusted to give effect to the recapitalization in March 2002, prior to the IPO, whereby the outstanding shares of common stock (1,500 shares) were changed into 269.0 million shares of class A common stock and 500.0 million shares of class B common stock.
The Company comprises two business segments: Commercial Lines and Personal Lines.
National Accounts provides casualty products to large companies, with particular emphasis on workers’ compensation, general liability and automobile liability. Products are marketed through national and regional brokers. Programs offered by National Accounts include risk management services, such as claims settlement, loss control and risk management information services, which are generally offered in connection with a large deductible or self-insured program, and risk transfer, which is typically provided through a guaranteed cost or retrospectively rated insurance policy. National Accounts also includes the Company’s residual market business, which primarily offers workers’ compensation products and services to the involuntary market.
Commercial Accounts serves primarily mid-sized businesses for casualty products and large, mid-sized and small businesses for property products. Commercial Accounts sells a broad range of property and casualty insurance products, with an emphasis on guaranteed cost products, through a large network of independent agents and brokers. Within Commercial Accounts the Company has a specialty unit which primarily writes coverages for the transportation industry and has dedicated operations that exclusively target the construction industry, providing insurance and risk management services for virtually all areas of construction. These dedicated operations reflect the Company’s focus on industry specialization.
Select Accounts serves small businesses. Select Accounts’ products are generally guaranteed cost policies, often a packaged product covering property and liability exposures. The products are sold through independent agents.
Bond markets its products to national, mid-sized and small customers as well as individuals, and distributes them through both national and wholesale brokers, and retail agents and regional brokers. Bond’s range of products includes fidelity and surety bonds, directors’ and officers’ liability insurance, errors and omissions insurance, professional liability insurance, employment practices liability insurance, fiduciary liability insurance, and other related coverages.
Personal Lines writes virtually all types of property and casualty insurance covering personal risks. The primary coverages in Personal Lines are automobile and homeowners insurance sold to individuals. These products are distributed through independent agents, sponsoring organizations such as employee and affinity groups, and joint marketing arrangements with other insurers.
The Company also has exposure to significant losses from terrorism, primarily in the commercial property and workers’ compensation lines of business. On November 26, 2002, the Terrorism Risk Insurance Act of 2002 (the Terrorism Act) was enacted into Federal law and established 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, committed by or on behalf of a foreign interest. In order for a loss to be covered under the Terrorism Act (i.e., 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 Insurance Program (the Program) generally requires that all commercial property casualty insurers licensed in the U.S. participate in the Program. The Program became effective upon enactment and terminates on December 31, 2005. The amount of compensation paid to participating insurers under the Program is 90% of subject losses, after an insurer deductible, subject to an annual cap. The deductible under the Program was 7% for 2003 and is 10% for 2004 and 15% for 2005. In each case, the deductible percentage is applied to the insurer’s direct earned premiums from the calendar year immediately preceding the applicable year. The Program also contains an annual cap that limits the amount of subject losses to $100 billion aggregate per program year. 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 deductible under this federal program is $927.7 million for 2004. The Company had no terrorism-related losses in 2003.
The Company comprises two reportable business segments: Commercial Lines and Personal Lines. See note 1 - Nature of Operations for a discussion of the Commercial Lines and Personal Lines segments.
Operating income (loss) equals net income (loss) excluding the after-tax impact of net realized investment gains (losses) and cumulative effect of changes in accounting principles. For 2002 and prior, operating income also excludes non-recurring restructuring charges related to periods prior to the spin-off from Citigroup.
Other assets consist primarily of goodwill in 2003 and 2002, a receivable under the Citigroup indemnification agreement in 2002, and the investment in CitiInsurance in 2001.
At December 31, 2003 and 2002, the Company held CMOs classified as available for sale with a fair value of $3.932 billion and $4.120 billion, respectively. Approximately 46% and 58% of the Company’s CMO holdings are fully collateralized by GNMA, FNMA or FHLMC securities at December 31, 2003 and 2002, respectively. In addition, the Company held $3.802 billion and $4.815 billion of GNMA, FNMA, FHLMC or FHA mortgage-backed pass-through securities classified as available for sale at December 31, 2003 and 2002, respectively. Virtually all of these securities are rated Aaa.
Proceeds from sales of equity securities were $254.1 million, $127.2 million and $469.7 million in 2003, 2002 and 2001, respectively, resulting in gross realized gains of $21.7 million, $18.1 million and $61.1 million and gross realized losses of $9.2 million, $13.7 million and $33.4 million, respectively.
Identification and evaluation of investments which have possible indications of impairment;
Analysis of investments with gross unrealized investment losses that have fair values less than 80% of amortized cost during successive quarterly periods over a rolling one-year period;
Review of investment advisor(s) recommendations for other-than-temporary impairments based on the investee’s current financial condition, liquidity, near-term recovery prospects and other factors, as well as consideration of other investments that were not recommended for other-than-temporary impairments;
The gross unrealized investment losses and related fair value for fixed maturities and equity securities available for sale at December 31, 2003 were as follows:
Underperforming mortgage loans, which include delinquent loans, loans in the process of foreclosure and loans modified at interest rates below market, were $30.7 million at December 31, 2003. There were no underperforming mortgage loans at December 31, 2002.
Included in fixed maturities are below investment grade assets totaling $2.057 billion and $1.945 billion at December 31, 2003 and 2002, respectively. The Company defines its below investment grade assets as those securities rated below investment grade by external rating agencies, or the equivalent by the Company’s investment advisors when a public rating does not exist. Such assets include publicly traded below investment grade bonds and certain other privately issued bonds that are classified as below investment grade loans.
During the third quarter of 2003, the Company purchased the renewal rights to Royal & SunAlliance USA Inc.’s commercial lines national accounts, middle market and marine businesses, and standard and preferred personal lines businesses. Also in the third quarter of 2003, the Company purchased 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 $48.0 million. The final purchase price, currently estimated to be $84.5 million, is dependent on the level of business renewed by the Company. The Company recorded customer-related intangible assets of $79.5 million and a marketing-related intangible asset of $5.0 million related to these transactions. These intangible assets are estimated to have useful lives of 5 years.
The Company participates in reinsurance in order to limit losses, minimize exposure to large risks, provide additional capacity for future growth and to effect business-sharing arrangements. In addition, the Company assumes 100% of the workers’ compensation premiums written by the Accident Department of its former affiliate, The Travelers Insurance Company (TIC). The Company is also a member of and participates as a servicing carrier for several pools and associations.
Reinsurance is placed on both a quota-share and excess of loss basis. Ceded reinsurance arrangements do not discharge the Company as the primary insurer, except for cases involving a novation.
Certain of the assumed reinsurance contracts that the Company has entered into with non-affiliated companies on an excess of loss basis do not transfer insurance risk. These contracts are accounted for using deposit accounting and are included in other liabilities in the consolidated balance sheet and totaled $325.2 million and $274.4 million at December 31, 2003 and 2002, respectively.
In 1996, Lloyd’s of London (Lloyd’s) restructured its operations with respect to claims for years prior to 1993 and reinsured these into Equitas Limited (Equitas). Amounts recoverable from unaffiliated insurers at December 31, 2003 and 2002 include $269.1 million and $296.5 million, respectively, recoverable from Equitas. The outcome of the restructuring of Lloyd’s continues to be uncertain and the impact, if any, on collectibility of amounts recoverable by the Company from Equitas cannot be quantified at this time. It is possible that an unfavorable impact on collectibility could have a material adverse effect on the Company’s results of operations in a future period. However, in the opinion of the Company’s management, it is not likely that the outcome could have a material adverse effect on the Company’s financial condition or liquidity.
The Company reports its reinsurance recoverables net of an allowance for estimated uncollectible reinsurance recoverables. The allowance is based upon the Company’s ongoing review of amounts outstanding, length of collection periods, amounts in dispute, changes in reinsurer credit standing, and other relevant factors. Amounts deemed to be uncollectible, including amounts due from known insolvent reinsurers, are written off and charged against the allowance for estimated uncollectible reinsurance recoverables. Any subsequent collections of amounts previously written off are reported as part of underwriting results.
The increase in the claims and claim adjustment expense reserves in 2002 from 2001 was primarily due to the strengthening of the Company’s asbestos reserves, principally in connection with the Company’s asbestos reserve study completed in fourth quarter 2002. Partially offsetting the above were net payments of $521.7 million in 2002 for asbestos and environmental claims.
In 2003, estimated claims and claim adjustment expenses for claims arising in prior years was a net unfavorable development of $390.0 million. This included $548.7 million of net unfavorable development which impacted results of operations, primarily due to unfavorable development of $521.1 million related to reserve strengthening at Gulf Insurance, a majority-owned subsidiary that writes specialty insurance. Claims arising in prior years for 2003 also included unfavorable development of $115.0 million related to American Equity, an operation that was placed in run-off in the second quarter of 2002 and $59.8 million related to environmental claims. This was partially offset by net favorable development in other Commercial Lines businesses, principally property coverages, in which the Company has experienced lower non-catastrophe-related claim frequency. In addition, Personal Lines had a $162.0 million net prior year reserve development benefit in 2003 principally due to continued reduced levels of non-catastrophe claim frequency in both homeowners and non-bodily injury automobile businesses and a $50.0 million reduction in reserves held related to the terrorist attack on September 11, 2001. In 2003, estimated claims and claim adjustment expenses for claims arising in prior years included $42.4 million of net favorable loss development on Commercial Lines loss sensitive policies in various lines; however, since the business to which it relates is subject to premium adjustments, there is no impact on results of operations. For each of the years ended December 31, 2003, 2002 and 2001, changes in allocations between policy years of loss adjustment expenses, pursuant to regulatory reporting requirements, are included in claims and claim adjustment expenses for claims arising in prior years and did not impact results of operations.
In 2002, estimated claims and claim adjustment expenses for claims arising in prior years was a net unfavorable development of $3.031 billion. This included $3.132 billion of net unfavorable development which impacted results of operations primarily due to unfavorable development of $2.945 billion related to asbestos. Claims arising in prior years for 2002 also included unfavorable development of $150.1 million related to environmental claims and favorable development of $100.1 million related to cumulative injury claims. In addition, estimated claims and claim adjustment expenses for claims arising in prior years included net unfavorable development, primarily related to certain Commercial Lines coverages, predominantly in assumed reinsurance specialty businesses, partially offset by favorable development in Commercial Lines workers’ compensation and Personal Lines automobile. In 2002, estimated claims and claim adjustment expenses for claims arising in prior years included $71.2 million of net favorable loss development on Commercial Lines loss sensitive policies in various lines; however, since the business to which it relates is subject to premium adjustments, there is no impact on results of operations.
In 2001, estimated claims and claim adjustment expenses for claims arising in prior years was a net favorable development of $41.0 million which included $14.4 million of net favorable development which impacted results of operations, primarily related to certain Commercial Lines coverages. The $14.4 million includes favorable development in commercial multi-peril and other claim adjustment expenses partially offset by unfavorable development in general liability, commercial auto liability and specialty businesses. Included in the net unfavorable development in Commercial Lines general liability was $188.8 million for asbestos claims and $45.7 million for environmental claims partly reduced by favorable development of $44.9 million for cumulative injury claims. In addition, estimated claims and claim adjustment expenses for claims arising in prior years included net favorable loss development of $43.0 million on Commercial Lines loss sensitive policies in various lines; however, since the business to which it relates is subject to premium adjustments, there is no impact on results of operations.
Because each policyholder presents different liability and coverage issues, the Company generally evaluates the exposure presented by each policyholder on a policyholder-by-policyholder basis. In the course of this evaluation, the Company considers: available insurance coverage, including the role of any umbrella or excess insurance the Company has issued to the policyholder; limits and deductibles; an analysis of each policyholder’s potential liability; the jurisdictions involved; past and anticipated future claim activity and loss development on pending claims; past settlement values of similar claims; allocated claim adjustment expense; potential role of other insurance; the role, if any, of non-asbestos claims or potential non-asbestos claims in any resolution process; and applicable coverage defenses or determinations, if any, including the determination as to whether or not an asbestos claim is a products/completed operation claim subject to an aggregate limit and the available coverage, if any, for that claim. When the gross ultimate exposure for indemnity and related claim adjustment expense is determined for a policyholder, the Company calculates, by each policy year, a ceded reinsurance projection based on any applicable facultative and treaty reinsurance, as well as past ceded experience. Adjustments to the ceded projections also occur due to actual ceded claim experience and reinsurance collections. Conventional actuarial methods are not utilized to establish asbestos reserves. The Company’s evaluations have not resulted in any data from which a meaningful average asbestos defense or indemnity payment may be determined.
With respect to asbestos exposures, the Company also compares its historical direct and net loss and expense paid experience, year-by-year, to assess any emerging trends, fluctuations or characteristics suggested by the aggregate paid activity. As anticipated, losses paid have increased in 2003 compared to prior years. There has been acceleration in the amount of payments, including those from prior settlements of coverage disputes entered into between the Company and certain of its policyholders. For the years ended December 31, 2003 and 2002, approximately 57% and 54%, respectively, of total paid losses relate to policyholders with whom the Company previously entered into settlement agreements that limit the Company’s liability. Net asbestos paid losses were $451.8 million and $361.1 million for the years ended December 31, 2003 and 2002, respectively, reflective of the items previously described.
At December 31, 2002, asbestos reserves were $3.404 billion compared to $820.4 million as of December 31, 2001. Net incurred losses and loss adjustment expenses were $2.945 billion for 2002 compared to $188.8 million for 2001. The increase in reserves was based on the Company’s analysis of asbestos claims and litigation trends. As part of a periodic, ground-up study of asbestos reserves, the Company studied the implications of these and other significant developments, with special attention to major asbestos defendants and non-products claims alleging that the Company’s coverage obligations are not subject to aggregate limits. In addition, Company management expanded its historical methodology in response to recent trends. This included further categorization of policyholders, conducting a detailed examination of recent claim activity from policyholders reporting claims for the first time, and conducting a detailed review of past settlements.
As a result of the processes and procedures described above, management believes that the reserves carried for asbestos and environmental claims at December 31, 2003 are appropriately established based upon known facts, current law and management’s judgment. However, the uncertainties surrounding the final resolution of these claims continue, and it is presently not possible to estimate the ultimate exposure for asbestos and environmental claims and related litigation. As a result, the reserve is subject to revision as new information becomes available or as information is reevaluated in light of evolving circumstances. The continuing uncertainties include, without limitation, the risks and lack of predictability inherent in major litigation, any impact from the bankruptcy protection sought by various asbestos producers and other asbestos defendants, a further increase or decrease in asbestos and environmental claims which cannot now be anticipated, the role of any umbrella or excess policies the Company has issued, the resolution or adjudication of some disputes pertaining to the amount of available coverage for asbestos claims in a manner inconsistent with the Company’s previous assessment of these claims, the number and outcome of direct actions against the Company, and future developments pertaining to the Company’s ability to recover reinsurance for asbestos and environmental claims. It is also not possible to predict changes in the legal and legislative environment and their impact on the future development of asbestos and environmental claims. This development will be affected by future court decisions and interpretations, as well as changes in applicable legislation. It is also difficult to predict the ultimate outcome of large coverage disputes until settlement negotiations near completion and significant legal questions are resolved or, failing settlement, until the dispute is adjudicated. This is
particularly the case with policyholders in bankruptcy where negotiations often involve a large number of claimants and other parties and require court approval to be effective.
Because of the uncertainties set forth above, 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 operating results and financial condition in future periods.
Notes payable to former affiliates, long-term debt and convertible notes payable outstanding were as follows:
On April 13, 2001, TIGHI entered into a $500.0 million revolving line of credit agreement (the line of credit) with Citigroup, which expires in December 2006. On April 16, 2001, TIGHI borrowed $275.0 million on the line of credit. Proceeds from this borrowing together with $225.0 million of commercial paper proceeds were used to pay the $500.0 million 6.75% long-term note payable, which was due on April 16, 2001. On November 8, 2001, TIGHI borrowed another $225.0 million under the line of credit. The proceeds were used to pay off maturing commercial paper. The maturity for all $500.0 million borrowed under this line was extended to November 7, 2003, and the interest rate was fixed at 3.60%. The weighted average interest rate for the line of credit was 3.60% and 3.82% for 2002 and 2001, respectively. TIGHI had an additional $250.0 million revolving line of credit from Citigroup. TIGHI paid a commitment fee to Citigroup for this line of credit, which expires in 2006. This agreement became effective on December 19, 2001 and replaced a previous facility with a syndicate of banks. Borrowings under this line of credit carry a variable interest rate based upon LIBOR plus 50 basis points. During December 2002, the Company borrowed $250.0 million and subsequently repaid $50.0 million under this line of credit. At December 31, 2002, borrowings outstanding under this line of credit were $200.0 million, and the weighted average interest rate for these borrowings was 1.87% and 1.92% for 2003 and 2002, respectively. These lines of credit were repaid during March 2003.
At December 31, 2001, TPC had a note payable to Citigroup in the amount of $1.198 billion, in conjunction with the purchase of TIGHI’s outstanding shares in April 2000. On February 7, 2002, this note payable was replaced by a new note agreement. Under the terms of the new note agreement, interest accrued on the aggregate principal amount outstanding at the commercial paper rate (the then current short-term rate) plus 10 basis points per annum. Interest was compounded monthly. This note was prepaid following the offerings.
In February 2002, TPC paid a dividend of $1.000 billion to Citigroup in the form of a non-interest bearing note payable on December 31, 2002. This note would have begun to accrue interest from December 31, 2002 on any outstanding balance at the floating base rate of Citibank, N.A., New York City plus 2.0%. On December 31, 2002, this note was repaid in its entirety.
In February 2002, TPC also paid a dividend of $3.700 billion to Citigroup in the form of a note payable in two installments. This note was substantially prepaid following the offerings. The balance of $150.0 million was due on May 9, 2004. This note would have begun to bear interest from May 9, 2002 at a rate of 7.25% per annum. This note was prepaid on May 8, 2002.
Unless previously redeemed or repurchased, the notes are convertible into shares of class A common stock at the option of the holders at any time after March 27, 2003 and prior to April 15, 2032 if at any time (1) the average of the daily closing prices of class A common stock for the 20 consecutive trading days immediately prior to the conversion date is at least 20% above the then applicable conversion price on the conversion date, (2) the notes have been called for redemption, (3) specified corporate transactions have occurred, or (4) specified credit rating events with respect to the notes have occurred. The notes will be convertible into shares of class A common stock at a conversion rate of 1.0808 shares of class A common stock for each $25 principal amount of notes (equivalent to an initial conversion price of $23.13 per share of class A common stock), subject to adjustment in certain events. On or after April 18, 2007, the notes may be redeemed at TPC’s option. TPC is not required to make mandatory redemption or sinking fund payments with respect to the notes. The notes are general unsecured obligations and are subordinated in right of payment to all existing and future Senior Indebtedness. The notes are also effectively subordinated to all existing and future indebtedness and other liabilities of any of TPC’s current or future subsidiaries.
On March 11, 2003, TPC issued $1.400 billion of senior notes comprising of $400.0 million of 3.75% senior notes due March 15, 2008, $500.0 million of 5.00% senior notes due March 15, 2013 and $500.0 million of 6.375% senior notes due March 15, 2033. The notes pay interest semi-annually on March 15 and September 15 of each year, beginning September 15, 2003, are senior unsecured obligations and rank equally with all of TPC’s other senior unsecured indebtedness. TPC may redeem some or all of the notes prior to maturity by paying a “make-whole” premium based on U.S. Treasury rates. The net proceeds from the sale of these notes were contributed to TIGHI, so that TIGHI could prepay and refinance $500.0 million of 3.60% indebtedness to Citigroup and to redeem $900.0 million aggregate principal amount of TIGHI’s 8.00% to 8.08% junior subordinated debt securities held by subsidiary trusts. These trusts, in turn, used these funds to redeem $900.0 million of preferred capital securities on April 9, 2003.
As of March 28, 2002, as a result of the IPO, the Company is no longer included in the Citigroup consolidated federal income tax return. As of that date, the Company began filing its own consolidated federal income tax return.
At December 31, 2002, the Company had a net operating loss carryforward of $1.390 billion. Under terms of the tax sharing agreement with Citigroup, the Company is entitled to carry operating losses back to prior years upon receiving Citigroup’s consent. During the first quarter of 2003, the Company received Citigroup’s consent and, as a result, the Company’s deferred tax asset was reduced by $486.5 million with a corresponding reduction to the current federal income tax payable (included in other cash flows from operating activities in the consolidated statement of cash flows.) On June 9, 2003, the Company received a federal income tax refund of $530.9 million representing the full utilization of the net operating loss carryforward.
Under the arrangements, taken as a whole, payments due are fully and unconditionally guaranteed on a subordinated basis. During May 2002, TPC fully and unconditionally guaranteed the payment of all principal, premium, if any, and interest of the debt obligations of TIGHI.
On January 22, 2004 and January 23, 2003, the Company, through its Capital Accumulation Program (CAP), issued 1,955,682 and 1,943,627 shares, respectively, of class A common stock in the form of restricted stock to participating officers and other key employees. The fair value per share of the class A common stock was $17.92 and $16.18, respectively. The restricted stock generally vests after a three-year period.
On March 21, 2002, TPC sold approximately 231.0 million shares of its class A common stock in a public offering for net proceeds of $4.090 billion.
In 2002, prior to the Company’s IPO, the Company’s Board of Directors adopted a shareholder rights plan as a result of which each outstanding share of the Company’s class A common stock and class B common stock carries with it the right to acquire one-thousandth of a share in a new series of the Company’s preferred stock designated as series A junior participating preferred stock. On March 20, 2002, the Board of Directors designated three million of the 50 million shares of preferred stock authorized as Series A Junior Participating Preferred Stock (the Series A Preferred Stock).
Ten business days after the announcement that a person is making a tender or exchange offer for 15% or more of the Company’s general voting power or acquires 15% or more of the Company’s general voting power (other than as a result of repurchases of stock by the Company or through inadvertence by certain shareholders that subsequently divest all excess shares as set forth in the rights agreement), the Rights detach from the common stock and become freely tradable and exercisable, entitling a holder to purchase one-thousandth of a share in the Company’s Series A Preferred Stock at $77.50, subject to adjustment.
The Company’s stock incentive plan provides settlement alternatives to employees in which the Company repurchases shares to cover tax withholding costs and exercise costs. At December 31, 2003 and 2002, TPC had purchased $17.6 million and $3.7 million, respectively, of its common stock under this plan.
The Company also has a commitment in conjunction with the Citigroup Distribution, for which it prepaid $15.1 million, to acquire class A and class B common stock held by the Citigroup Capital Accumulation Program (Citigroup CAP) upon forfeiture of plan participants. This commitment expires over three years upon vesting of the Citigroup CAP participants. At December 31, 2003 and 2002, TPC had acquired $3.9 million and $1.3 million, respectively, of its common stock pursuant to this arrangement.
TIGHI’s insurance subsidiaries are subject to various regulatory restrictions that limit the maximum amount of dividends available to be paid to their parent without prior approval of insurance regulatory authorities. A maximum of $1.647 billion will be available by the end of 2004 for such dividends without prior approval of the Connecticut Insurance Department.
The Company has established stock option programs pursuant to the 2002 Incentive Plan: the Management stock option program and the Wealthbuilder stock option program (see also Restricted Stock and Deferred Stock Programs below). The Management stock option program provides for the granting of stock options to officers and key employees of the Company and its participating subsidiaries. The Wealthbuilder stock option program provides for the granting of stock options to all employees meeting certain requirements. The exercise price of options is equal to the fair market value of the Company’s class A common stock at the time of grant. Generally, options vest 20% each year over a five-year period and may be exercised for a period of ten years from the date of the grant only if the optionee is employed by the Company, and for certain periods after employment termination, depending on the cause of termination. The Management stock option program also permits an employee exercising an option to be granted a new option (a reload option) in an amount equal to the number of shares of class A common stock used to satisfy both the exercise price and withholding taxes due upon exercise of an option. The reload options are granted at an exercise price equal to the fair market value of the class A common stock on the date of grant, vest six months after the grant date and are exercisable for the remaining term of the related original option. The reload feature is not available for initial option grants after January 23, 2003. The Wealthbuilder stock option program does not contain a reload feature.
The Company, through its Capital Accumulation Program (CAP) established pursuant to the 2002 Incentive Plan, issues shares of the Company’s common stock in the form of restricted stock awards to eligible officers and key employees. Certain CAP participants may elect to receive part of their awards in restricted stock and part in stock options. The number of shares included in the restricted stock award is calculated at a 25% discount from the market price at the time of the award and generally vest in full after a three-year period. Except under limited circumstances, during this period the stock cannot be sold or transferred by the participant, who is required to render service to the Company during the restricted period. CAP awards granted to non-U.S. CAP participants are in the form of deferred stock awards. These deferred stock awards are subject to the same conditions as the restricted stock awards except that the shares are not issued until the vesting criteria are satisfied.
On August 20, 2002, in connection with the Citigroup Distribution, the Company established a 401(k) savings plan under which substantially all employees are eligible to participate. Through December 31, 2003, the Company matches employee contributions up to 3% of eligible pay but not more than $1,500 annually. Effective January 1, 2004, the maximum amount of the Company’s match increased to $2,500 annually. The expense related to this plan was $20.3 million and $17.0 million for the years ended December 31, 2003 and 2002, respectively. Prior to the IPO and the Citigroup Distribution, substantially all of the Company’s employees were eligible to participate in a 401(k) savings plan sponsored by Citigroup, for which there was no Company matching contribution for substantially all employees.
The significant assumptions used in estimating the fair value on the date of the grant for original options and reload options granted in 2003 and 2002 and for replacement awards issued August 20, 2002 to Company employees who held Citigroup stock option awards on that date were as follows:
The expected volatility is based on the average volatility of an industry peer group of entities because the Company only became publicly traded in March 2002.
All original and reload stock options granted under the TPC stock option programs had an exercise price equal to the market value of the Company’s class A common stock on the date of the grant. The replacement awards granted on August 20, 2002 retained the intrinsic value of the awards immediately prior to conversion and therefore the exercise price either exceeded the market value or was less than the market value on August 20, 2002. The following table presents the weighted average exercise price and weighted average grant date fair value information with respect to these grants:
Under agreements with Citigroup, TPC assumed liabilities for nonqualified pension, post retirement health care and life insurance benefit liabilities related to active Company plan participants as of August 20, 2002. The initial projected benefit obligation of the Company’s nonqualified pension plan at August 20, 2002 was $21.3 million. Because Citigroup assumed liabilities for the same benefits for retired or inactive plan participants, the Company transferred short-term securities of $171.1 million and recorded a payable of $13.5 million in 2002 to Citigroup affiliated companies, and reduced other liabilities and deferred taxes by $284.0 million and $99.4 million, respectively, related to retired or inactive employees, pending final agreements on the amounts. Final agreement on settlement amounts was reached and an additional $2.2 million was paid to Citigroup during the first quarter of 2003.
In addition, the Company assumed liabilities for qualified pension plan benefits for active Company employees. As a result, assets and liabilities for qualified pension plan benefits relating to active, but not retired or inactive, plan participants were transferred from the Citigroup qualified pension plan to the Company’s newly established qualified pension plan. The initial projected benefit obligation of the Company’s qualified pension plan at August 20, 2002 was $445.0 million. Assets of $390.0 million were transferred from the Citigroup pension plan to the Company’s pension plan in 2002 and were invested primarily in a Standard & Poors stock index fund and in a Lehman Brothers Aggregate bond index fund at December 31, 2002. A final asset transfer of $37.9 million occurred in May 2003.
The following tables summarize the funded status, obligations and amounts recognized in the consolidated balance sheet for TPC’s plans. The Company uses a December 31 measurement date for its pension and postretirement benefit plans.
The accumulated benefit obligation for the Company’s defined benefit pension plans was $573.7 and $476.0 million at December 31, 2003 and 2002, respectively.
The pretax minimum liability included in other comprehensive income decreased by $95.3 million from December 31, 2002 to December 31, 2003.
Future minimum annual rental payments under noncancellable operating leases are $81.6 million, $68.3 million, $52.9 million, $39.3 million, $21.9 million and $37.6 million for 2004, 2005, 2006, 2007, 2008 and 2009 and thereafter, respectively. Future sublease rental income of approximately $1.9 million will partially offset these commitments.
During 2003, the Company engaged in U.S. Treasury note futures transactions to modify the duration of the investment portfolio. The Company entered into 90 day futures contracts on 2 year, 5 year, 10 year and 30 year U.S. Treasury notes which require a daily mark to market settlement with the broker. The notational value of the open U.S. Treasury futures contracts was $1.482 billion at December 31, 2003. These derivative instruments are not designated and do not qualify as hedges under FAS 133 rules and as such the daily mark to market settlement is reflected in net realized investment gains (losses).
The carrying values of $284.3 million and $607.5 million of financial instruments classified as other assets approximated their fair values at December 31, 2003 and 2002, respectively. The carrying values of $2.690 billion and $2.272 billion of financial instruments classified as other liabilities at December 31, 2003 and 2002, respectively, also approximated their fair values. Fair value is determined using various methods including discounted cash flows, as appropriate for the various financial instruments.
The fair value of the notes payable to former affiliates is based upon discounted cash flows. The fair value of the convertible notes and the long-term debt is based upon bid price at December 31, 2003 and 2002. The fair value of the TIGHI Securities is based upon the closing price at December 31, 2002.
One of the proceedings was an arbitration 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 the Company’s favor that asbestos bodily injury claims paid by ACandS on or after that decision date 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.). The Company has filed its opposition to ACandS’ motion to vacate.
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 the Company. 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 $2.8 billion. ACandS asserts that based on a prior agreement between the Company and ACandS and ACandS’ interpretation at the July 31, 2003 arbitration panel ruling, the Company is liable for 45% of the $2.8 billion. In August 2003, ACandS filed a new lawsuit against the Company seeking to enforce this position (ACandS, Inc. v. Travelers Casualty and Surety Co., U.S.D. Ct., E.D. Pa.). The Company has not yet responded to the complaint but intends to vigorously contest ACandS’ assertions and believes that it has meritorious defenses.
In addition to the proceedings described above the Company and ACandS are also involved in litigation (ACandS, Inc. v. Travelers Casualty and Surety Co., U.S.D.Ct., E.D. Pa.) commenced in September 2000. This litigation primarily involves the extent to which the asbestos bodily injury claims against ACandS are subject to occurrence limits under insurance policies issued by the Company. The Company has filed a motion to dismiss this action based upon the July 31, 2003 arbitration decision.
The Company believes that it has meritorious defenses in all these proceedings, which it is vigorously asserting, including, among others, that the purported settlements are not final, are unreasonable in amount and are not binding on the Company; that any bankruptcy plan of reorganization which ACandS files is defective to the extent it seeks to accelerate any of the Company’s obligations under policies issued to ACandS or to deprive the Company of its right to litigate the claims against ACandS; that the arbitration award is valid and binding on the parties and applies the claims purportedly settled by ACandS during the pendency of the arbitration proceeding; and that the occurrence limits in the policies substantially reduce or eliminate the Company’s obligations, if any, with respect to the purportedly settled claims.
The Company has numerous defenses in all of the direct action cases. Many of these defenses have been raised in initial motions to dismiss filed by the Company and other insurers. There have been favorable rulings during 2003 in Texas on some of these motions filed by other insurers during the pendency of the Johns Manville stay that dealt with statute of limitations and the validity of the alleged causes of actions. The Company’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; that to the extent that they have not been released by virtue of prior settlement agreements by the claimants with the Company’s policyholders, all of these claims were released by virtue of approved settlements and orders entered by the Johns Manville bankruptcy court; and that the applicable statute of limitation as to many of these claims has long since expired.
Gulf Insurance Company (Gulf), a majority-owned subsidiary of TPC, brought an action on May 22, 2003, as amended on July 29, 2003, 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), and three other reinsurance companies 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. On May 22, 2003, as amended on September 5, 2003, Transatlantic brought an action against Gulf regarding the same dispute, which has been consolidated with Gulf’s action. Transatlantic seeks rescission of its vehicle residual value reinsurance contracts issued to Gulf and unspecified damages for breach of contract. XL Reinsurance America, Inc. (XL), Odyssey America Reinsurance Corporation (Odyssey) and Employers Reinsurance Company (Employers), the other defendant reinsurers, also filed answers and counterclaims in the Gulf action asserting positions similar to Transatlantic, including counterclaims for rescission of vehicle residual value reinsurance contracts issued to Gulf. 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. After the settlement, the Gulf action now seeks from the remaining three defendants a total of $90.9 million currently due under the reinsurance contracts, a declaration that $11.6 million will be payable under a second installment due in 2004, and consequential and punitive damages. 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 action.
TPC and its board of directors have been named as defendants in three purported class action lawsuits brought by four of TPC’s shareholders seeking injunctive relief as well as unspecified monetary damages. The actions are 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 Hartford, CT December 15, 2003). The Henzel and Vozzolo actions were consolidated and transferred to the complex litigation docket in Waterbury, Connecticut; the Farina action is pending in Hartford, Connecticut.
All the complaints allege that TPC and its board of directors breached their fiduciary duties to TPC’s shareholders in connection with the adoption of the merger and the merger agreement with St. Paul. According to the plaintiffs, the merger enriches TPC management to the detriment of TPC’s shareholders. The plaintiffs further claim that the defendants failed to adequately investigate alternatives to the merger. The Farina complaint also names St. Paul and Adams Acquisition Corp, a wholly-owned subsidiary of St. Paul, as defendants, alleging that they aided and abetted the alleged breach of fiduciary duty. TPC believes the suits are wholly without merit and intends to vigorously defend against the suits.
See note 7 for additional discussion of asbestos and environmental reserves and claims matters.
if the other party (i) terminates the merger agreement as a result of the paying party having made a change of recommendation; or (ii) willfully and materially breaches its obligations or certain of its obligations in connection with the filing with the SEC of the companies’ joint proxy statement/prospectus;
Prior to the Citigroup Distribution, the Company provided and purchased services to and from Citigroup affiliated companies, including facilities management, banking and financial functions, benefit coverages, data processing services, and short-term investment pool management services. Charges for these shared services were allocated at cost. In connection with the Citigroup Distribution, the Company and Citigroup and its affiliates entered into a transition services agreement for the provision of certain of these services, tradename and trademark and similar agreements related to the use of trademarks, logos and tradenames and an amendment to the March 26, 2002 Intercompany Agreement with Citigroup. During the first quarter of 2002, Citigroup provided investment advisory services on an allocated cost basis, consistent with prior years. On August 6, 2002, the Company entered into an investment management agreement, which has been applied retroactively to April 1, 2002, with an affiliate of Citigroup whereby the affiliate of Citigroup is providing investment advisory and administrative services to the Company with respect to its entire investment portfolio for a period of two years and at fees mutually agreed upon, including a component based on performance. Charges incurred related to this agreement were $59.7 million and $47.2 million for the year ended December 31, 2003 and for the period from April 1, 2002 through December 31, 2002, respectively. This agreement terminates on March 31, 2004. The Company intends to arrange an orderly transition of the investment management and the associated accounting and administrative services to St. Paul Travelers following the merger with St. Paul. The Company and Citigroup also agreed upon the allocation or transfer of certain other liabilities and assets, and rights and obligations in furtherance of the separation of operations and ownership as a result of the Citigroup Distribution. The net effect of these allocations and transfers, in the opinion of management, was not significant to the Company’s results of operations or financial condition.
For a period of two years following the Citigroup Distribution, the Company has the right of first offer to provide Citigroup property and casualty coverage that it does not currently provide to it and Citigroup has the right of first offer to provide the Company any financial service it does not currently provide to the Company, at market rates, terms and conditions at the time of the offer. Neither party is required to purchase the services at rates, terms or conditions less favorable than those offered by any third party at the time of the offer.
In the ordinary course of business, the Company purchases and sells securities through formerly affiliated broker-dealers. These transactions are conducted on an arm’s-length basis. Commissions are not paid for the purchase and sale of debt securities. Citigroup was the underwriter of the offerings and received underwriting discounts and commissions of approximately $90.0 million.