The Company owns its corporate headquarters buildings located at 385 Washington Street and 130 West Sixth Street, St. Paul, Minnesota. These buildings are adjacent to one another and consist of approximately 1.1 million square feet of gross floor space. The Company also owned properties in Woodbury, Minnesota, where an administrative services building and off-site computer processing operations were located. The Woodbury properties were sold in April of 2005.
(1) On April 1, 2004, Travelers Property Casualty Corp. (TPC) merged with a subsidiary of The St. Paul Companies, Inc. (SPC), as a result of which TPC became a wholly-owned subsidiary of SPC and SPC changed its name to The St. Paul Travelers Companies, Inc. On October 1, 2001, TPC purchased The Northland Company and its subsidiaries (Northland) from Citigroup. On October 3, 2001, Citigroup contributed the capital stock of Commercial Guaranty Casualty Insurance Company to TPC.
(7) Dividends per common share reflect the recapitalization effected as part of TPC’s corporate reorganization in 2002. See Item 1 - Business. During 2002, TPC paid dividends of $5.10 billion in the form of a note payable and $158 million in cash to Citigroup, its then sole shareholder. During 2001, TPC paid dividends of $526 million to Citigroup, its then sole shareholder.
The following is a discussion and analysis of the financial condition and results of operations of The St. Paul Travelers Companies, Inc. (together with its subsidiaries, the Company). On April 1, 2004, Travelers Property Casualty Corp. (TPC) merged with a subsidiary of The St. Paul Companies, Inc. (SPC), as a result of which TPC became a wholly-owned subsidiary of SPC, and SPC changed its name to The St. Paul Travelers, Inc. In connection with the merger, each issued and outstanding share of TPC class A (including the associated Companies preferred stock purchase rights) and class B par value $0.01 common stock was exchanged for 0.4334 of a share of the Company’s common stock without designated par value. Share and per share amounts for all periods presented have been restated to reflect the second quarter exchange of TPC common stock for the Company’s common stock in the merger. For accounting purposes, this transaction was accounted for as a reverse acquisition with TPC treated as the accounting acquirer. Accordingly, this transaction was accounted for as a purchase business combination, using TPC historical financial information and applying fair value estimates to the acquired assets, liabilities, and commitments of SPC as of April 1, 2004. Beginning on April 1, 2004, the results of operations and financial condition of SPC were consolidated with TPC’s. Accordingly, all financial information presented herein for the twelve months ended December 31, 2005 reflects the consolidated accounts of SPC and TPC. The financial information presented herein for the twelve months ended December 31, 2004 reflects only the accounts of TPC for the three months ended March 31, 2004 and the consolidated accounts of SPC and TPC for the nine months ended December 31, 2004. The financial information presented herein for 2003 reflects the accounts of TPC.
For more information regarding the completion of the merger, including the calculation and allocation of the purchase price, refer to note 2 of notes to the Company’s consolidated financial statements included in this report.
• Net income of $1.62 billion, or $2.39 per share basic and $2.33 diluted, including loss from discontinued operations of $439 million, or $0.65 per share basic and $0.62 diluted
• Total cost of catastrophes of $2.19 billion pretax (net of reinsurance) and $1.47 billion after-tax, primarily relating to Hurricanes Katrina, Rita and Wilma
• Net unfavorable prior year reserve development of $325 million pretax and $216 million after-tax, primarily due to a pretax charge of $830 million ($548 million after-tax) to increase asbestos reserves
• Gross written premiums of $23.74 billion; net written premiums of $20.39 billion; net written premiums reduced by $121 million of reinstatement premiums related to catastrophes
• Total investments of $68.29 billion, up $3.92 billion from December 31, 2004; fixed maturities and short-term securities comprise 93% of total investments
• Increase in investments resulted from proceeds from Nuveen Investments’ divestiture and strong operating cash flows
(1) The weighted average number of common shares used in the diluted earnings per share calculation for the year ended December 31, 2004 excluded the potentially dilutive effect of the Company’s convertible junior subordinated notes because their effect was anti-dilutive.
The Company’s discussions related to all items, other than net income, income from continuing operations, income (loss) from discontinued operations, and segment operating income (loss), are presented on a pretax basis, unless otherwise noted. Throughout the following discussion, the Company references the “impact of the merger,” which in the context of a comparison between 2005 and 2004 refers to the Company’s 2005 results reflecting a full year of combined post-merger operations, whereas the Company’s 2004 results reflect combined post-merger operations for the nine months subsequent to the April 1, 2004 merger date, plus the results of TPC only for the three months ended March 31, 2004. In the context of a comparison between 2004 and 2003, the “impact of the merger” refers to the Company’s 2004 results reflecting the components described above, whereas the Company’s 2003 results include the results of TPC only for the full year.
In 2005, the Company sold its equity interest in Nuveen Investments, which constituted its Asset Management segment. The Company recorded a net loss from discontinued operations of $439 million in 2005, consisting primarily of $710 million of tax expense which resulted from the difference between the tax basis and the GAAP carrying value of the Company’s investment in Nuveen Investments, partially offset by the $224 million after-tax gain on the divestiture and the Company’s share of Nuveen Investments’ net income for 2005. Income from discontinued operations of $88 million in 2004 represented the Company’s share of Nuveen Investments’ net income for the year.
Income from continuing operations in 2004 totaled $867 million, or $1.40 per share diluted, compared with $1.70 billion, or $3.80 per share diluted, in 2003. The $829 million decline in 2004 compared with 2003 was driven by $2.39 billion of net unfavorable prior-year reserve development. That net unfavorable prior year reserve development in 2004 was concentrated in the Commercial and Specialty segments and was primarily comprised of $928 million to strengthen asbestos reserves as a result of the completion of the Company’s annual asbestos liability review, merger-related reserve strengthening of $500 million for construction and $300 million for surety, $290 million to strengthen environmental reserves, $252 million related to the financial condition of a specific construction contractor and $113 million related to the commutation of agreements with a major reinsurer. These charges are described in more detail in the following segment discussions. In addition, 2004 income from continuing operations included $296 million of pretax charges to increase the allowance for estimated amounts due from reinsurance recoverables, policyholder receivables and co-surety participations on a specific construction contractor claim. Net unfavorable reserve development in the Commercial and Specialty segments in 2004 more than offset additional income resulting from the merger and strong operating income generated by the Company’s Personal segment. In addition, the cost of catastrophes in 2004 of $772 million was $420 million higher than in 2003. The catastrophe losses in 2004 were primarily driven by four hurricanes that struck the southeastern United States in the third quarter.
The $1.30 billion increase in earned premiums in 2005 over 2004 primarily reflected the impact of the merger, which was partially offset by a significant decline in earned premiums in the Commercial segment’s runoff operations, where business is intentionally being non-renewed, and a decline in Commercial’s ongoing operations due to a lower level of net written premium volume in the last half of 2004 and first half of 2005. Earned premiums in 2005 were reduced by $121 million of reinstatement premiums related to catastrophe losses, which are described in more detail in the “Cost of Catastrophe” section of this discussion. Earned premiums in 2004 were reduced by $76 million of reinstatement premiums primarily related to reserve charges recorded in the Surety operation. Partially offsetting these factors were the impacts of new business growth and increased retention in many of the Company’s insurance operations in 2005. In 2004, the $6.49 billion growth in earned premiums over 2003 was primarily due to the merger, as well as the earned premium effect of rate increases on renewal business over the previous 12 months and strong customer retention levels throughout a majority of the markets served by the Company’s insurance operations.
Net investment income of $3.17 billion in 2005 grew $502 million, or 19%, over 2004, reflecting the impact of the merger, as well as an increase in invested assets over the last twelve months, higher short-term interest rates and a decline in investment expenses. The increase in invested assets in 2005 was driven by continued strong operational cash flows and the investment of the $2.40 billion in proceeds from the divestiture of the Company’s equity interest in Nuveen Investments. The average pretax investment yield in 2005 of 4.7% declined slightly from 4.8% in 2004, due to the maturity of higher yielding bonds and a higher proportion of tax-exempt investments. Net investment income in 2004 included $111 million from the initial public offering of one investment.
The Company’s net pretax realized investment losses of $39 million in 2004 included impairment charges totaling $80 million, whereas net pretax realized gains of $38 million in 2003 included $90 million of impairment charges. Net pretax realized investment gains (losses) in 2004 and 2003 also included net losses of $44 million and $27 million, respectively, related to U.S. Treasury futures contracts. Further information regarding the nature of impairment charges in each year is included in the “Critical Accounting Estimates” section later in this discussion.
Gross and net written premiums in 2005 both increased 7% over 2004, primarily reflecting the impact of the merger. However, gross and net written premium volumes in 2005 were down when compared to 2004 on a pro forma combined basis. The declines were concentrated in the Commercial segment, reflecting the planned non-renewal of business in runoff and reduced premium volume in ongoing operations due to increasingly competitive market conditions. In addition, premium volume in the Specialty segment’s Construction operation was lower than in 2004 on a pro forma basis due to the now-completed process of aligning the underwriting profile of the two predecessor companies. Net written premiums in 2005 were reduced by $121 million of reinstatement premiums related to catastrophe losses discussed later in this narrative, whereas 2004 net written premium volume was reduced by $76 million of reinstatement premiums primarily related to reserving actions in the Specialty segment. However, premium volume in the Personal segment increased over 2004, driven by continued renewal price increases and unit growth in the homeowners line of business. During 2005, the Company experienced strong retention levels on a company-wide basis, as the Company focused on retaining its existing book of well priced, profitable business. New business levels in several of the Company’s insurance operations also increased over 2004. Rate increases, however, were generally lower in 2005 compared with 2004, reflecting increased competition and more aggressive pricing in the marketplace. Rates for certain products in selected markets declined from 2004 levels.
The $5.81 billion, or 44%, increase in consolidated net written premiums in 2004 compared with 2003 primarily reflected the impact of the merger. On a pro forma combined basis, net written premiums in 2004 were level with 2003. Business retention levels in the majority of the Company’s insurance operations remained consistent with 2003 levels. The level of rate increases, however, continued to decline during 2004, reflecting the increasingly competitive marketplace. New business volume in the Commercial and Specialty segments in 2004 declined when compared with the combined new business volume of SPC and TPC in the prior year, reflecting the competitive marketplace and the impact of new business premiums in 2003 from renewal rights transactions. The non-renewal of certain commercial property, construction and surety risks as well as certain personal lines business in the Company’s operations at Lloyd’s also negatively impacted premium volume in 2004. Personal net written premiums increased 17% in 2004 over 2003, due to strong organic growth, new business resulting from a renewal rights transaction, strong business retention levels and price increases.
Claims and claim adjustment expenses of $14.93 billion in 2005 were $512 million lower than the 2004 total of $15.44 billion. The 2005 total included $2.03 billion of catastrophe losses, compared with $761 million of such losses in 2004. The cost of catastrophes is discussed in more detail in the following narrative. The 2005 total also included $325 million of net unfavorable prior year reserve development, compared with $2.39 billion of net unfavorable prior year reserve development in 2004. The net unfavorable prior year reserve development in 2005 was concentrated in the Commercial segment and was primarily the result of a charge to increase asbestos reserves as a result of the Company’s annual asbestos liability review. That charge was partially offset by other, non-asbestos related, net favorable prior year development in the Personal and Commercial segments. Claims and claim adjustment expenses in 2005 also reflected improvement in current accident year non-catastrophe related loss experience as compared with 2004.
Other 2004 Claims and Expenses. Other items increasing the 2004 claims and expenses compared to 2003 include $296 million of charges to increase the allowances for estimated amounts due from reinsurance recoverables, policyholders receivables, and co-surety participations on a specific construction contractor claim. The increase in the allowance for uncollectible reinsurance recoverables recognized a change in estimated disputes with reinsurers and is based upon the Company’s reinsurance strategy of reduced reinsurance utilization, including the cessation of ongoing business relationships with certain of SPC’s reinsurers, and aggressive collection of reinsurance recoverables. A charge was also recorded to increase the estimated uncollectible amounts due from policyholders for loss sensitive business (primarily high deductible business). This increase recognized a change in estimated uncollectible amounts due and resulted from applying the Company’s credit based methodology for determining uncollectible amounts to the recoverables acquired in the merger. Because reinsurance recoverables and amounts due from policyholders for loss sensitive business are insurance contract-related assets, these assets are subject to the same types of estimation variables as loss reserves. Also during the second quarter of 2004, a participating co-surety on a contract surety exposure announced that insurance regulators had approved its submitted run-off plan. Based upon industry knowledge of the co-surety’s run-off plan and an analysis of the co-surety’s financial condition, the Company concluded that it was unlikely to collect the full amount projected to be owed by the co-surety and established an appropriate level of reserves.
The $50 million increase in interest expense in 2005 over 2004 primarily reflected the impact of a full year of interest expense on SPC debt assumed in the merger on April 1, 2004. The Company’s debt outstanding at December 31, 2005 declined by a net $463 million compared with year-end 2004. In 2004, the $69 million increase in interest expense over 2003 reflected the incremental expense associated with SPC debt assumed in the merger.
The loss and loss adjustment expense ratio in 2004 included a 4.0 point impact from catastrophes and a 12.6 point impact from net unfavorable prior year reserve development. The respective impacts of these factors on the 2003 loss and loss adjustment expense ratio were 3.8 points and 2.8 points. The 2.7 point increase in the underwriting expense ratio in 2004 primarily reflected the impact of higher underwriting expenses related to the business acquired in the merger, as well as expenses associated with the merger.
The Company recorded a net operating loss from discontinued operations of $663 million in 2005, consisting primarily of $710 million of tax expense due to the difference between the tax basis and the GAAP carrying value of the Company’s investment in Nuveen Investments, partially offset by the Company’s share of Nuveen Investments’ net income prior to divestiture. The Company recorded a pretax gain on disposal of $345 million ($224 million after-tax) in 2005. Income from discontinued operations of $88 million in 2004 represented the Company’s share of Nuveen Investments’ net income for the year.
During the third quarter of 2003, TPC purchased from Royal & SunAlliance USA (RSA), an unaffiliated insurer, the renewal rights to RSA’s commercial lines national accounts, middle market and marine businesses, and standard and preferred personal lines businesses. Also during the third quarter of 2003, TPC purchased from Atlantic Mutual, an unaffiliated insurer, the renewal rights to the majority of Atlantic Mutual’s commercial lines inland marine and ocean cargo businesses written by Atlantic Mutual’s Marine Division. The total purchase price for these renewal rights transactions, which was based in part on the level of business renewed by the Company, was $69 million.
The $242 million decline in earned premiums in 2005 compared with 2004 reflected a significant decline in runoff operations, where business is intentionally being non-renewed, and a decline in ongoing operations due to a lower level of written premium volume in the last half of 2004 and first half of 2005. These declines were partially offset by the impact of the merger. In addition, the reinstatement premiums described in the “Consolidated Overview” section herein reduced net earned premium volume in 2005 by $52 million. In 2004, earned premium growth of $2.26 billion over 2003 was primarily due to the merger and also reflected the earned premium effect of moderating renewal price increases over the previous twelve months in the Company’s ongoing Commercial business lines. In addition, incremental premiums resulting from the renewal rights transactions with Royal & SunAlliance and Atlantic Mutual in the third quarter of 2003 contributed to premium growth in 2004.
National Accounts is the primary source of fee income due to its service businesses, which include claim and loss prevention services to large companies that choose to self-insure a portion of their insurance risks, and claims and policy management services to workers’ compensation residual market pools, automobile assigned risk plans and to self-insurance pools. The $51 million, or 8%, decline in fee income in 2005 compared with 2004 was primarily due to increased competition, including the loss of several large customers in the second half of 2004 and in early 2005. The strong increase in 2004 fee income over 2003 reflected higher new business levels, resulting, in part, from the third quarter 2003 renewal rights transaction with Royal & SunAlliance, renewal price increases and more workers’ compensation business being written by state residual market pools.
Claims and claim adjustment expenses in 2005 totaled $7.45 billion, compared with $7.52 billion in 2004. Included in those totals were $1.17 billion and $363 million, respectively, of catastrophe losses (net of reinsurance). Net unfavorable prior year reserve development in the Commercial segment totaled $694 million in 2005, primarily due to charges to increase asbestos reserves by $830 million and environmental reserves by $30 million. That unfavorable development was partially offset by other net favorable prior year reserve development of $166 million, primarily in the commercial automobile, commercial multi-peril, workers’ compensation and property lines of business. Net unfavorable prior year reserve development totaled $1.34 billion in 2004, which included a $927 million charge to strengthen asbestos reserves and a $286 million charge to strengthen environmental reserves. Also included in the net unfavorable prior year reserve development in 2004 was a $157 million addition to the reserve for uncollectible reinsurance recoverables, $38 million from the commutation of agreements with a major reinsurer and other net unfavorable prior year reserve development primarily concentrated in the Company’s Gulf operations. Partially offsetting the impact of these reserve increases in 2004 was favorable prior year reserve development in core Commercial operations, which resulted from reductions in the frequency of non-catastrophe related losses.
In 2003, net unfavorable prior-year loss development in the Commercial segment totaled $676 million, the most significant component of which was $521 million of reserve strengthening in the Gulf operations. That reserve strengthening was primarily related to a line of business that insured the residual values of leased vehicles and that had been placed in runoff in late 2001, and the resolution of a residual value claim dispute. In addition, in 2003 the Company strengthened prior year reserves for certain runoff lines of business, including assumed reinsurance. Catastrophe losses in 2003 totaled $103 million.
The loss and loss adjustment expense ratio in 2005 included a 14.0 point impact from catastrophe losses, compared with a 4.1 point impact from catastrophe losses in 2004. Net unfavorable prior year reserve development accounted for 8.1 points and 15.3 points, respectively, of the 2005 and 2004 loss and loss adjustment expense ratios. Excluding these factors from both years, the adjusted 2005 loss and loss adjustment expense ratio was 0.9 points less than the comparable 2004 adjusted ratio, reflecting the improvement in current accident year loss experience compared with 2004. The adjusted 2004 loss and loss adjustment expense ratio was 1.1 points better than the 2003 loss and loss adjustment expense ratio adjusted to exclude prior year reserve development and catastrophes, primarily driven by a reduction in non-catastrophe weather-related losses during the year.
In Commercial Core operations, gross and net written premiums increased 6% and 7% over 2004 totals, primarily reflecting the impact of the merger. However, 2005 written premium volume in Commercial Core operations declined when compared with 2004 on a pro forma combined basis, due to increasing competition in the marketplace and pricing levels that were flat with 2004. Business retention levels throughout the Core Commercial operations, however, increased over 2004, and new business levels improved over 2004. Net written premiums in 2005 for Commercial Core operations were reduced by the $52 million of reinstatement premiums related to catastrophe losses described in the “Consolidated Overview” section herein. In Commercial Other operations, gross and net written premiums declined 84% and 82%, respectively, from the comparable 2004 totals, reflecting the intentional non-renewal of business in the runoff operations comprising this category.
Commercial’s gross and net written premiums in 2004 increased 23% and 21%, respectively, over the 2003 totals, primarily reflecting the impact of the merger. New business volume in 2004 declined when compared with the combined new business volume of SPC and TPC in 2003, reflecting the increasingly competitive marketplace and the impact of higher premium flow in 2003 associated with several renewal rights transactions.
In Commercial Other, the 82% and 31% declines in 2005 and 2004 net premium volume, respectively, compared with the respective prior years reflected the intentional non-renewal of business in the runoff operations comprising this category (primarily Gulf). Certain business previously written by Gulf is now being written elsewhere in the Commercial or Specialty segments. The runoff healthcare, reinsurance and international business acquired in the merger produced minimal written premium volume in 2005 and 2004. In 2003, Commercial Other consisted primarily of results from the Gulf operation, which marketed products to national, mid-sized and small customers and distributed them through both wholesale brokers and retail agents and brokers throughout the United States with particular emphasis on management and professional liability coverages and excess and surplus lines of insurance.
The Specialty segment’s results for the twelve months ended December 31, 2004 reflect the results of TPC’s Bond and Construction operations for the twelve months ended December 31, 2004 and the post-merger results of SPC’s specialty operations, including SPC’s Bond and Construction operations for the nine months ended December 31, 2004. Results for 2003 represent TPC’s Bond and Construction operations only.
Operating income of $679 million in 2005 improved by $1.33 billion over the operating loss of $648 million in 2004. The significant improvement in 2005 operating income reflected the absence of net unfavorable prior year reserve development, as well as strong net investment income, improved current accident year results in several domestic businesses (particularly Bond) and lower commission expenses in certain business units. Operating results in 2005 included a cost of catastrophes of $356 million (net of reinsurance and including reinstatement premiums), compared with $220 million of such costs in 2004. The operating loss of $648 million in 2004 was driven by net unfavorable prior year reserve development of $1.43 billion, including significant charges related to the construction and surety reserves acquired in the merger, as well as other reserving actions that are described in the narrative that follows. Operating results in 2004 also included $220 million for the cost of catastrophes resulting from the four hurricanes described previously, whereas 2003 results included no catastrophe losses.
In addition to the discussion in the Critical Accounting Estimates section of this report, other items specifically considered in the process of developing a uniform and consistent approach to estimating the combined company’s loss reserves after the merger included interpreting the actuarial and claim data in a uniform manner and determining an appropriate level of data segmentation for estimation purposes. This type of analysis involves a high degree of judgment and can, and often does, lead to reserve estimates that differ materially from those of prior periods, particularly in low frequency, high severity and complex exposures. In addition, since the reserving process also considers the expectations of future outcomes, the actuaries involved had to analyze their differing views on key assumptions, such as predicting inflation, estimating claim development patterns and determining expectations related to judicial rulings and interpretations, among others. This “informed judgment” is brought into the process by individuals such as actuaries, underwriters, claim adjusters, and company management. Ultimately, this process required an analysis of the varying actuarial judgments and forward-looking assessments. The result was similar to a single, ongoing insurance enterprise obtaining more information in a reporting period than it had previously and identifying a change in estimate in its insurance reserves in that period. Accordingly, the Company recorded a $500 million and $300 million charge for construction and surety, respectively, in the second quarter of 2004.
Construction Reserves. Beginning on April 1, 2004, upon the completion of the merger, personnel from the predecessor companies were able to share detailed policyholder information, claim files and actuarial data related to the acquired construction reserves. This enabled an analysis to be performed in the second quarter of the acquired construction reserves using TPC’s long-established practices that includes evaluating exposures by type of claim (e.g. construction defect, construction wrap-up, other), by type of coverage (e.g. guaranteed cost, loss responsive, other) and by detailed line of business (general liability, commercial auto, etc.), among others. For general liability exposures, which include construction defect and construction wrap-up, interpretation of underlying trends (both present and future) and the related reserve estimation process is highly judgmental due to the low frequency/high severity and complex nature of these exposures. In particular, for construction defect, there is a high degree of uncertainty relating to whether coverage exists, when losses occur, the size of each loss, expectations for future interpretive rulings concerning contract provisions and the extent to which the assertion of these claims will expand geographically. As a result, material variations can and do occur among actuarial reserve estimates for these types of exposures. In a merger, these differences are likely to be even more pronounced. Prior to a merger, each legacy company consistently applies its assumptions, judgments and actuarial methods to estimate reserves. Differences between these assumptions, judgments and actuarial methods need to be understood and reconciled, and a uniform approach needs to be adopted for the merged entity. In this situation, material adjustments can and do occur for reserves related to exposures having a high degree of uncertainty.
Other Reserving Actions. Prior to the merger and beginning in the third quarter of 2003, SPC disclosed that a large construction contractor for which it had written several surety bonds was experiencing financial difficulty. Based upon an analysis of the financial condition of the construction contractor that was performed in the third quarter of 2003, a restructuring plan was adopted by the construction contractor, its banks, and SPC, among others, as a means to minimize estimated losses. SPC monitored the progress of the construction contractor toward meeting the requirements of the restructuring plan throughout subsequent quarters. SPC also estimated and disclosed its estimated ultimate net losses related to this exposure, beginning in the third quarter of 2003 and updated each quarter thereafter, including the effects of advances made or expected to be made to the construction contractor, applicable collateral, co-surety participations and reinsurance. The size and complexity of these particular construction contracts, coupled with the deteriorating credit quality of the construction contractor and the inherent uncertainty as to whether it would meet the obligations of the restructuring plan, resulted in a high degree of judgment in estimating potential losses.
Also during the last half of the second quarter of 2004, a participating co-surety on this exposure announced that insurance regulators had approved its submitted run-off plan. Based upon industry’s knowledge of the co-surety’s run-off plan and the Company’s analysis of its financial condition, the Company concluded that it was unlikely to collect the full amount projected to be owed by the co-surety and established an appropriate level of reserves. In the second quarter of 2005, the Company reached a settlement with the co-surety whereby the co-surety made a payment to the Company and was released from further financial obligations to the Company in connection with the specific construction exposure. The settlement payment, coupled with the previously established co-surety reserves, approximated the current estimate of the co-surety’s share of the bonded losses related to this exposure.
Claim and claim adjustment expenses in 2004 included $209 million of catastrophe losses, compared with no such losses in 2003. Results in 2004 also reflected increased current year loss ratios on portions of the Bond and Construction books of business, and $150 million of unfavorable prior year reserve development recorded in TPC’s Construction operation prior to the merger.
General and administrative expenses in 2005 totaled $893 million, an increase of 15% over the 2004 total of $779 million which primarily reflected the impact of the merger. The 2005 total included the impacts of a decline in commission expenses and expense efficiencies realized as a result of the merger. In 2004, general and administrative expenses of $779 million were significantly higher than the 2003 total of $222 million, reflecting the impact of the merger.
Specialty gross and net written premiums by market were as follows:
Gross and net written premiums in 2005 increased 24% and 20%, respectively, over written premium volume in 2004. The increase in gross and net written premiums in 2005 primarily reflected the impact of the merger. Net written premiums in 2005 were reduced by $48 million of reinstatement premiums related to catastrophe losses that are described in more detail in the “Consolidated Overview” section herein, whereas net written premiums in 2004 were reduced by $76 million of reinstatement premiums primarily related to reserving actions in the Bond operation. Gross written premiums in 2005 were level, and net written premiums were down 2%, compared with 2004 volume on a pro forma combined basis. Contributing to the decline in net written premiums were the sale of certain credit-related personal lines classes of business previously written at the Company’s operations at Lloyd’s, and lower business volumes in Construction related to the now-completed process of aligning the underwriting profile of the two predecessor companies. These declines were partially offset by premium growth in the Financial and Professional Services and several other Domestic Specialty businesses. In addition, the elimination of a reporting lag at the Company’s operations at Lloyd’s resulted in $35 million and $28 million of additional gross and net written premium volume in 2005, respectively. Bond net written premiums in 2005 were level with the 2004 pro forma combined premium volume (excluding the impact of reinstatement premiums in 2004). In 2005, approximately $114 million of gross written premiums previously written in the Company’s Gulf operation in the Commercial segment were written in Financial and Professional Services, compared with $90 million of gross written premiums in 2004.
Net written premiums in 2004 in the majority of the Company’s remaining Domestic Specialty businesses were strong, with retention levels at or above historical levels. Renewal price change increases in these operations moderated throughout the year to the upper single-digit level. New business levels in 2004 were down compared with 2003, when renewal rights transactions contributed to strong growth in new business. The impact of the decline in new business levels in 2004 was partially offset by premium growth resulting from the transfer of certain business from the Company’s Gulf operation, which was placed in runoff in the second quarter of the year. In International Specialty, business retention levels in 2004 (excluding Lloyd’s) were strong relative to pre-merger levels, and new business levels were consistent with the pre-merger levels in 2003. In 2004, the Company continued its focus on retaining its profitable book of existing International Specialty business. At Lloyd’s, premium volume in 2004 was negatively impacted by the non-renewal of certain credit-related personal lines insurance coverages.
Earned premiums of $6.03 billion in 2005 increased $448 million, or 8%, over 2004 earned premiums of $5.58 billion, reflecting continued strong business retention levels, new business volumes and renewal price increases over the prior twelve months. Earned premiums in 2005 were reduced by $21 million of reinstatement premiums described in the “Consolidated Overview” section herein. The $758 million, or 16%, growth in earned premiums in 2004 over 2003 was primarily due to an increase in organic new business volume, new business associated with the Royal & SunAlliance renewal rights transaction entered into in the third quarter of 2003, strong business retention levels and renewal price increases over the prior twelve months.
The loss and loss adjustment expense ratio for 2005 included a 9.3 point impact from catastrophe losses, whereas the comparable 2004 ratio included a 3.4 point impact from catastrophe losses. The impact from net favorable prior year reserve development in 2005 was 6.0 points, compared with 6.8 points in 2004. Excluding the impact of these factors in both years, the 2005 loss and loss adjustment expense ratio was 2.8 points better than the 2004 ratio, reflecting improvement in current accident year non-catastrophe loss experience. The 2003 loss and loss adjustment expense ratio of 69.1 included a 5.2 point impact of catastrophe losses and a 4.4 point benefit from net favorable prior year reserve development. Excluding these factors from both 2004 and 2003, the loss and loss adjustment expense ratio in 2004 improved significantly over 2003, reflecting the earned impact of price increases that continued to exceed loss cost trends and improvement in non-catastrophe loss frequency.
Personal gross and net written premiums by product line were as follows:
Gross and net written premiums in 2005 increased 6% and 5%, respectively, over 2004. Growth in 2005 was concentrated in the Homeowners and Other product line, driven by continued renewal price increases and unit growth. Retention levels in both the Automobile and Homeowners and Other lines of business remained strong, and were consistent with 2004. In the Automobile line, renewal price increases in 2005 remained positive, but declined when compared with 2004. However, new business premiums in 2005 in the Automobile line increased over 2004, primarily due to the introduction of the Company’s new multivariate pricing product in selected states. Net written premiums in 2005 were reduced by $21 million of catastrophe-related reinstatement premiums described in the “Consolidated Overview” section herein.
The net loss for Interest Expense and Other for the year ended December 31, 2004 increased $70 million compared with 2003, primarily reflecting the impact of the merger. Included in the increase was $46 million of incremental interest expense on debt assumed in the merger. The 2004 total also included $9 million of charges related to the merger that were recorded in the second quarter.
Many coverage disputes with policyholders are only resolved through settlement agreements. Because many policyholders make exaggerated demands, it is difficult to predict the outcome of settlement negotiations. Settlements involving bankrupt policyholders may include extensive releases which are favorable to the Company but which could result in settlements for larger amounts than originally anticipated. As in the past, the Company will continue to pursue settlement opportunities.
At December 31, 2005, approximately 75% of the net environmental reserve (approximately $318 million) is carried in a bulk reserve and includes unresolved environmental claims and incurred but not reported environmental claims as well as for the anticipated cost of coverage litigation disputes relating to these claims. The bulk reserve the Company carries is established and adjusted based upon the aggregate volume of in-process environmental claims and the Company’s experience in resolving those claims. The balance, approximately 25% of the net environmental reserve (approximately $107 million), consists of case reserves.
In its review of environmental reserves, the Company considers: the adequacy of reserves for past settlements; changing judicial and legislative trends; the potential for policyholders with smaller exposures to be named in new clean-up action for both on- and off-site waste disposal activities; the potential for adverse development and additional new claims beyond previous expectations; and the potential higher costs for new settlements. Based on these trends, developments and management judgment, the Company increased its IBNR reserves accordingly. In 2004, the Company recorded a pretax charge of $290 million, net of reinsurance, to increase environmental reserves due to revised estimates of costs related to recent settlement initiatives. In 2005, the Company recorded a pretax charge of $30 million, net of reinsurance, primarily for declaratory judgment costs.
The duration of the Company’s investigation and review of these claims and the extent of time necessary to determine an appropriate estimate, if any, of the value of the claim to the Company vary significantly and are dependent upon a number of factors. These factors include, but are not limited to, the cooperation of the policyholder in providing claim information, the pace of underlying litigation or claim processes, the pace of coverage litigation between the policyholder and the Company and the willingness of the policyholder and the Company to negotiate, if appropriate, a resolution of any dispute pertaining to these claims. Because these factors vary from claim-to-claim and policyholder-by-policyholder, the Company cannot provide a meaningful average of the duration of an environmental claim. However, based upon the Company’s experience in resolving these claims, the duration may vary from months to several years.
The Company’s review of policyholders tendering claims for the first time has indicated that they are lower in severity. These policyholders generally present smaller exposures, have fewer sites and are lower tier defendants. Further, regulatory agencies are utilizing risk-based analysis and more efficient clean-up technologies. However, the Company has experienced an increase in the anticipated settlement amounts of certain matters as well as an increase in loss adjustment expenses. There also have been judicial interpretations that, in some cases, have been unfavorable to the industry and the Company.
Gross paid losses were $248 million and $200 million in 2005 and 2004, respectively. The increase in payments over 2004 was due to the inclusion of the SPC business for the entire period in 2005 and a significant settlement with one policyholder in 2005. TPC executed an agreement with this policyholder which resolved all past, present and future hazardous waste and pollution property damage claims, and all related past and pending bodily injury claims. In addition, TPC and this policyholder entered into a coverage-in-place agreement which addressed the handling and resolution of all future hazardous waste and pollution bodily injury claims. Under the coverage-in-place agreement, TPC has no defense obligation, and there is an overall cap with respect to any indemnity obligation that might be owed. The first two of three payments related to this settlement were made during 2005, and the final payment will be made in the first quarter of 2006.
As a result of the processes and procedures described above, management believes that the reserves carried for asbestos and environmental claims at December 31, 2005 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 difficult to determine the ultimate exposure for asbestos and environmental claims and related litigation. As a result, these reserves are subject to revision as new information becomes available and as claims develop. The continuing uncertainties include, without limitation, the risks and lack of predictability inherent in complex 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 and environmental 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
The Company’s invested assets at December 31, 2005 totaled $68.29 billion, of which 93% was invested in fixed maturity and short-term investments, 1% in equity securities, 1% in mortgage loans and real estate and 5% in other investments. Excluding the impact on invested assets of securities lending, unrealized investment gains and losses, receivables for investment sales and payables on investment purchases, the pretax average yield was 4.7%, 4.8% and 5.3% and the after tax average yield was 3.7%, 3.7% and 4.0% for the years ended December 31, 2005, 2004 and 2003, respectively.
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, 2005 totaled $58.98 billion, comprising $58.71 billion of publicly traded fixed maturities and $274 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, 2005 were AA1 and A3, respectively. Included in the fixed maturity portfolio at that date was approximately $1.75 billion of below investment grade securities. During 2005, holdings of tax-exempt securities were increased to $31.46 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 3.9 years as of December 31, 2005 (4.3 years excluding short-term investments), compared with 4.1 years as of December 31, 2004 (4.4 years excluding short-term investments).
The Company’s real estate investments include warehouses and office buildings and other commercial land and properties that are directly owned. The Company’s other investments primarily comprise venture capital, through direct ownership and limited partnerships, private equity limited partnerships, joint ventures, other limited partnerships and trading securities, which are subject to more volatility than the Company’s fixed income investments, but historically have provided a higher return. At December 31, 2005 and 2004, the carrying value of the Company’s other investments was $3.03 billion and $3.43 billion, respectively.
For the year ended December 31, 2004, the Company recognized the following other-than-temporary impairments:
• $25 million in the fixed income portfolio related to various issuers due to credit risk associated with the issuer’s deteriorated financial position.
• $5 million in the equity portfolio when it became apparent that the cost basis of those securities would not be recovered over the expected holding period.
• $40 million in its venture capital portfolio on 16 holdings. Three of the holdings were impaired due to new financings at less than favorable rates. Five holdings experienced fundamental economic deterioration (characterized by less than expected revenues or a fundamental change in product). Eight of the holdings were impaired due to the impending sale, liquidation or shutdown of the entity. The Company continually evaluates current developments in the market that have the potential to affect the valuation of the Company’s investments.
• $10 million in its real estate and other holdings. The losses recorded were the result of falling rental rates and occupancies in three of the Company’s real estate investment holdings.
The specific circumstances that led to the impairments described above did not materially impact other individual investments held during 2005 or 2004.
The following table summarizes for all fixed maturities and equity securities available for sale and for equity securities reported at fair value for which fair value is less than 80% of amortized cost at December 31, 2005, the gross unrealized investment loss by length of time those securities have continuously been in an unrealized loss position:
Following are the pretax realized losses on investments sold during the year ended December 31, 2005:
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. A variety of factors continue to affect the property and casualty insurance market and the Company’s core business outlook for 2006, including increasingly competitive conditions throughout the majority of markets served by the Company’s business segments, loss cost trends (including medical inflation and auto loss costs), asbestos-related developments and rising reinsurance and litigation costs.
The Company expects that the trend of increased severity and frequency of storms experienced in 2005 and 2004 will continue into 2006. Given the increased severity and frequency of storms, the Company is reassessing its definition of and exposure to coastal risks, as well as the impact, if any, on its reinsurance program. Accordingly, the Company is reviewing its pricing, exposures, return thresholds and terms and conditions it offers in coastal areas. In part as a result of the severity and frequency of storms in 2005 and 2004, the Company expects the cost of reinsurance to increase, and there may be reduced availability of reinsurance coverage. To the extent that the Company is not able to reflect the potentially increased costs of increased severity and frequency of storms or reinsurance in its pricing, the Company’s results of operations will be adversely impacted. In particular, in the Personal segment, the Company expects a delay in its ability to increase pricing to offset these potentially increased costs since the Company cannot increase rates to the extent necessary without the approval of the regulatory authorities of certain states. Also, particularly in light of the frequency and severity of storms in the past two years, rating agencies may increase their capital requirements for the Company.
With respect to non-catastrophe claim frequency, the industry has experienced unprecedented low levels over the last several years, a trend that the Company does not expect to change materially in 2006. The Company expects severity trend, the other component of loss trend, to continue to remain stable for non-catastrophe claims. Nevertheless, with continued pressure on pricing, it is possible that margins will contract in certain parts of the Company’s business in 2006.
Some social, economic, political and litigation issues have led to an increased number of legislative and regulatory proposals aimed at addressing the cost and availability of some types of insurance as well as the claim and coverage obligations of insurers. While most of these provisions have failed to become law, these initiatives may continue as legislators and regulators consider responses to consumer concerns about availability, affordability and claims handling and coverage, and the resulting laws and regulations, if any, could adversely affect the Company’s ability to write business with appropriate returns.
On November 26, 2002, the Terrorism Risk Insurance Act of 2002 (the Terrorism Act) was enacted into Federal law and established the Terrorism Risk Insurance Program (the Program), a temporary Federal program in the Department of the Treasury, that provided for a system of shared public and private compensation for insured losses resulting from acts of terrorism or war committed by or on behalf of a foreign interest. The Program was scheduled to terminate on December 31, 2005. On December 22, 2005, the Terrorism Risk Insurance Extension Act of 2005 (the Terrorism Extension Act) was enacted into Federal law, reauthorizing the Program through December 31, 2007, while reducing the Federal role under the Program. In order for a loss to be covered under the Program (subject losses), the loss must meet certain aggregate industry loss minimums that vary by Program year of amounts $100 million or less, and must be the result of an event that is certified as an act of terrorism by the U.S. Secretary of the Treasury. The original Program excluded from participation certain of the following types of insurance: Federal crop insurance, private mortgage insurance, financial guaranty insurance, medical malpractice insurance, health or life insurance, flood insurance, and reinsurance. The Terrorism Extension Act exempted from coverage certain additional types of insurance, including commercial automobile, professional liability (other than directors and officers’), surety, burglary and theft, and farm-owners multi-peril. In the case of a war declared by Congress, only workers’ compensation losses are covered by the Terrorism Act and the Terrorism Extension Act. Both Acts generally require that all commercial property casualty insurers licensed in the United States participate in the Program. Under the Program, a participating insurer is entitled to be reimbursed by the Federal Government for a percentage of subject losses, after an insurer deductible, subject to an annual cap. The Federal reimbursement percentage remains at 90% for 2006, but decreases to 85% in 2007. In each case, the deductible is calculated by applying the deductible percentage to the insurer’s direct earned premiums for covered lines from the calendar year immediately preceding the applicable year. The deductible
under the Program was 7% for 2003, 10% for 2004 and 15% for 2005, and will be 17.5% for 2006 and 20% for 2007. The Company’s estimated deductible under the Program is $1.91 billion for 2006. The annual cap limits the amount of aggregate subject losses for all participating insurers to $100 billion. Once subject losses have reached the $100 billion aggregate during a program year, there is no additional reimbursement from the U.S. Treasury and an insurer that has met its deductible for the program year is not liable for any losses (or portion thereof) that exceed the $100 billion cap. The Company had no terrorism-related losses in 2005, 2004 or 2003.
While the Terrorism Acts provide a Federally-funded “backstop” for commercial property casualty insurers, they also require that insurers offer coverage for insured losses caused by acts of terrorism. The majority of the Company’s Commercial and Specialty policies already included such coverage, although exclusions were added to higher-risk policyholders after September 11, 2001. For those risks considered higher-risk, such as landmark buildings or high concentrations of employees in one location, the Company will continue to either decline to offer a renewal or will offer coverage for losses caused by acts of terrorism on a limited basis, with an explicit charge for the coverage.
Liquidity is a measure of a company’s ability to generate sufficient cash flows to meet the short- and long-term cash requirements of its business operations. The liquidity requirements of the Company’s business have been met primarily by funds generated from operations, asset maturities and income received on investments. Cash provided from these sources is used primarily for claims and claim adjustment expense payments and operating expenses. The timing and amount of catastrophe claims are inherently unpredictable. Such claims, including those associated with Hurricanes Katrina, Rita and Wilma, increase liquidity requirements. The timing and amount of reinsurance recoveries may be affected by reinsurer solvency and reinsurance coverage disputes. Additionally, the volatility of asbestos-related claim payments, as well as potential judgments and settlements arising out of litigation, may also result in increased liquidity requirements. It is the opinion of the Company’s management that the Company’s future liquidity needs will be adequately met from all of the above sources.
Net cash flows provided by operating activities for all three years were negatively impacted by payments for asbestos and environmental liabilities. Cash flows from operating activities in 2005 and 2004 were also negatively impacted by payments related to the Company’s runoff operations. Included in the Company’s structured agreement component of asbestos loss reserves at December 31, 2005 was $404 million (net of reinsurance) for the Company’s single payment contribution to the proposed settlement related to PPG, and $502 million for the Company’s settlement of the Statutory and Hawaii Actions and the Common Law Claims. Although each of these settlements is subject to certain contingencies or final orders and relief as previously discussed, it is possible that these settlement amounts will be paid in 2006.
Net cash flows used in investing activities of continuing operations totaled $3.04 billion, $4.65 billion and $2.48 billion in 2005, 2004 and 2003, respectively. Fixed maturity securities accounted for the majority of investment purchases in all three years. In 2003, cash used in investing activities was partly offset by sales of securities to fund net payment activity related to debt and junior subordinated debt securities held by subsidiary trusts of $772 million.
The Company also invests much smaller amounts in equity securities, venture capital and real estate. These investment classes have the potential for higher returns but also involve varying degrees of risk, including less stable rates of return and less liquidity.
The primary goals of the Company’s asset liability management process are to satisfy the insurance liabilities, manage the interest rate risk embedded in those insurance liabilities, and maintain sufficient liquidity to cover fluctuations in projected liability cash flows. Generally, the expected principal and interest payments produced by the Company’s fixed income portfolio adequately fund the estimated runoff of the Company’s insurance reserves. Although this is not an exact cash flow match in each period, the substantial degree by which the market value of the fixed income portfolio exceeds the present value of the net insurance liabilities, plus the positive cash flow from newly sold policies and the large amount of high quality liquid bonds provides assurance of the Company’s ability to fund the payment of claims without having to sell illiquid assets or access credit facilities.
Net cash flows used in financing activities of continuing operations totaled $473 million, $516 million and $1.10 billion in 2005, 2004 and 2003, respectively. In 2005, the Company repaid $815 million of its outstanding debt, primarily comprised of the following: maturities of $238 million of 7.875% senior notes, $79 million of 7.125% senior notes, and $99 million of medium-term notes bearing interest rates ranging from 6.44% to 7.09%; and a net repayment of commercial paper borrowings of $395 million. In November 2005, the Company issued $400 million of 5.50% senior notes maturing in December 2015. The majority of proceeds was used to fund the repayment of commercial paper borrowings, with the remainder used for general corporate purposes.
The declaration and payment of future dividends to holders of the Company’s common stock will be at the discretion of the Company’s Board of Directors and will depend upon many factors, including the Company’s financial condition, earnings, capital requirements of the Company’s operating subsidiaries, legal requirements, regulatory constraints and other factors as the Board of Directors deems relevant. Dividends would be paid by the Company only if declared by its Board of Directors out of funds legally available, subject to any other restrictions that may be applicable to the Company.
Upon completion of the merger on April 1, 2004, the Company acquired all obligations related to SPC’s outstanding debt, which had a carrying value of $3.68 billion at the time of the merger. In accordance with purchase accounting, the carrying value of the SPC debt acquired was adjusted to market value as of April 1, 2004 using the effective interest rate method, which resulted in a $301 million adjustment to increase the amount of the Company’s consolidated debt outstanding. That fair value adjustment is being amortized over the remaining life of the respective debt instruments acquired. That amortization, which totaled $54 million in 2005 and $55 million in 2004, reduced reported interest expense.
* These senior notes had an interest rate of 5.25% at December 31, 2004. The interest rate was reset to 5.01% in May 2005 pursuant to the remarketing of these notes as described below.
On March 11, 2003, TPC issued $1.40 billion of senior notes comprising $400 million of 3.75% senior notes due March 15, 2008, $500 million of 5.00% senior notes due March 15, 2013 and $500 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, Travelers Insurance Group Holdings, Inc. (TIGHI), so that TIGHI could prepay and refinance $500 million of 3.60% indebtedness to Citigroup and redeem $900 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 million of preferred capital securities on April 9, 2003.
These senior notes were sold to qualified institutional buyers as defined under Rule 144A under the Securities Act of 1933 (the Securities Act) and outside the United States in reliance on Regulation S under the Securities Act. Accordingly, the notes (the restricted notes) were not registered under the Securities Act or any state securities laws and could not be transferred or resold except pursuant to certain exemptions. As part of this offering, TPC agreed to file a registration statement under the Securities Act to permit the exchange of the notes for registered notes (the Exchange Notes) having terms identical to those of the senior notes described above (Exchange Offer). On April 14, 2003, TPC initiated the Exchange Offer pursuant to a Form S-4 that was filed with the Securities and Exchange Commission. Accordingly, each series of Exchange Notes has been registered under the Securities Act, and the transfer restrictions and registration rights relating to the restricted notes do not apply to the Exchange Notes.
Shelf Registration. In December 2005, the Company filed with the Securities and Exchange Commission a shelf registration statement for the potential offering and sale of securities. The Company may offer these securities from time to time at prices and on other terms to be determined at the time of offering.
The following table excludes short-term obligations. The table also excludes estimated cash flows of claim and claim related payments, which are presented in the table that follows. The contractual obligations, which include only liabilities at December 31, 2005 with a cash payment requirement for settlement, were as follows:
(4) In connection with the sale of its insurance brokerage operations, the Company committed to acquire brokerage services from the buyer through 2012. See note 17.
(1) The amounts in “Claims and claim adjustment expenses” in the table above represent the estimated timing of future payments for both reported and unreported claims incurred and related claim adjustment expenses, net of reinsurance recoverables. Therefore, estimated future payments include cash inflows related to reinsurance arrangements that qualify for reinsurance accounting. A reinsurance agreement must indemnify the insurer from insurance risk, i.e., the agreement must transfer amount and timing risk, in order to qualify for reinsurance accounting. Since the timing and amount of cash inflows from such reinsurance agreements are highly correlated to the underlying payment of claims and claim adjustment expenses by the insurer, the analysis above presents the estimated cash outflows for reported and unreported claims incurred and related claim adjustment expense, net of reinsurance. Reinsurance agreements that do not transfer both amount and timing risk are accounted for as deposits and included in “Reinsurance contracts accounted for as deposits” in the table above.
For business underwritten by non-U.S. operations, future cash flows related to reported and unreported claims incurred and related claim adjustment expenses were translated at the spot rate on December 31, 2005.
(5) The amounts in “Payouts from ceded funds withheld” represent estimated payments for losses and return of funds held related to certain reinsurance arrangements whereby the Company holds a portion of the premium due to the reinsurer and is allowed to pay claims from the amounts held.
The Company’s principal insurance subsidiaries are domiciled in the states of Connecticut and Minnesota. The insurance holding company laws of both states applicable to the Company’s subsidiaries requires notice to, and approval by, the state insurance commissioner for the declaration or payment of any dividend, that together with other distributions made within the preceding twelve months, exceeds the greater of 10% of the insurer’s capital and surplus as of the preceding December 31, or the insurer’s net income for the twelve-month period ending the preceding December 31, in each case determined in accordance with statutory accounting practices and by state regulation. This declaration or payment is further limited by adjusted unassigned surplus, as determined in accordance with statutory accounting practices.
The Company considers its most significant accounting estimates to be those applied to claim and claim adjustment expense reserves and related reinsurance recoverables, and investment impairments.
The process of estimating loss reserves involves a high degree of judgment and is subject to a number of variables. These variables can be affected by both internal and external events, such as changes in claims handling procedures, economic inflation, legal trends and legislative changes, among others. The impact of many of these items on ultimate costs for loss and loss adjustment expenses is difficult to estimate. Loss reserve estimation difficulties also differ significantly by product line due to differences in claim complexity, the volume of claims, the potential severity of individual claims, the determination of occurrence date for a claim and reporting lags (the time between the occurrence of the policyholder event and when it is actually reported to the insurer). Informed judgment is applied throughout the process. The Company continually refines its loss reserve estimates in a regular ongoing process as historical loss experience develops and additional claims are reported and settled. The Company rigorously attempts to consider all significant facts and circumstances known at the time loss reserves are established. Due to the inherent uncertainty underlying loss reserve estimates including but not limited to the future settlement environment, final resolution of the estimated liability will be different from that anticipated at the reporting date. Therefore, actual paid losses in the future may yield a materially different amount than currently reserved-favorable or unfavorable.
A portion of the Company’s loss reserves are for asbestos and environmental claims and related litigation which aggregated $4.79 billion at December 31, 2005. While the ongoing study of asbestos claims and associated liabilities and of environmental claims considers the inconsistencies of court decisions as to coverage, plaintiffs’ expanded theories of liability and the risks inherent in complex litigation and other uncertainties, in the opinion of the Company’s management, it is possible that the outcome of the continued uncertainties regarding these claims could result in liability in future periods that differs from current reserves by an amount that could be material to the Company’s future operating results and financial condition. See the preceding discussion of “Asbestos Claims and Litigation” and “Environmental Claims and Litigation.”
The Company acquired SPC’s runoff health care reserves in the merger, which are included in the General Liability product line in the table below. SPC decided to exit this market at the end of 2001 and ceased underwriting new business as quickly as regulatory considerations allowed. SPC had experienced significant adverse loss development on its health care loss reserves both prior to and since its decision to exit this market. The Company continues to utilize specific tools and metrics to explicitly monitor and validate its key assumptions supporting its conclusions with regard to these reserves since management believed that its traditional statistics and reserving methods needed to be supplemented in order to provide a more meaningful analysis. The tools developed track three primary indicators which influence those conclusions and include: newly reported claims; reserve development on known claims; and the “redundancy ratio,” which compares the cost of resolving claims to the reserve established for that individual claim. These three indicators are related such that if one deteriorates, improvement on another is necessary for the Company to conclude that further reserve strengthening is not necessary. The Company’s current view is that it has recorded a reasonable reserve for its medical malpractice exposures as of December 31, 2005.
Most general liability policies are written on an occurrence basis. These policies are subject to substantial loss development over time as facts and circumstances change in the years following the policy issuance. The use of the occurrence form accounts for much of the reserve development in asbestos and environmental exposures, and it is also used to provide coverage for construction general liability, including construction defect. Occurrence based forms of insurance for general liability exposures require substantial projection of various trends, including future inflation and judicial interpretations and societal litigation dynamics, among others.
Actuaries have to exercise a considerable degree of judgment in the evaluation of all these factors in their analysis of reserves. The human element in the application of actuarial judgment is unavoidable when faced with material uncertainty. Different experts will choose different assumptions when faced with such uncertainty, based on their individual backgrounds, professional experiences and areas of focus. Hence, the estimate selected by the various actuaries may differ materially from each other.
General liability is generally 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).
Examples of common risk factors that can change and, thus, affect the required commercial automobile reserves (beyond those included in the general discussion section) include:
Changes in the interpretations and processes of the workers’ compensation commissions’ oversight of claims(1)
Examples of common risk factors that can change and, thus, affect the required International and other reserves (beyond those included in the general discussion section) include:
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, disputes, 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. Changes in these estimates could result in additional income statement charges. The increase in the allowance for uncollectible reinsurance in 2005 was $53 million.
• the financial condition and near-term prospects of the issuer. The issuer may be experiencing depressed and declining earnings relative to competitors, erosion of market share, deteriorating financial position, lowered dividend payments, declines in securities ratings, bankruptcy, and financial statement reports that indicate an uncertain future. Also, the issuer may experience specific events that may influence its operations or earnings potential, such as changes in technology, discontinuation of a business segment, catastrophic losses or exhaustion of natural resources; and
Equity investments are impaired when it becomes probable that the Company will not recover its cost over the expected holding period. Public equity investments (i.e., common stocks) trading at a price that is less than 80% of cost for more than one quarter are reviewed for impairment. Investments accounted for using the equity method of accounting are evaluated for impairment any time the investment has sustained losses and/or negative operating cash flow for a period of nine months or more. Events triggering the other-than-temporary impairment analysis of public and non-public equities may include the following, in addition to the considerations noted above for debt securities:
• 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; and
• factors that raise doubts about the investee’s ability to continue as a going concern, such as negative cash flows from operations, working-capital deficiencies, investment advisors’ recommendations, or non-compliance with regulatory capital requirements or debt covenants;
For fixed maturity 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;
• the investment is performing as expected and is current on all expected payments;
• specific, recognizable, short-term factors have affected the market value; and
• whether or not the valuations have declined significantly in the entity’s market sector;
• whether or not we have the ability and intent to hold the security for a period of time sufficient to allow for recovery, enabling us to receive value equal to or greater than our cost.
For a discussion of other risks and uncertainties that could impact the Company’s results of operations or financial condition, see note 17 of notes to the Company’s consolidated financial statements and “Item 1A - Risk Factors.”
This report may contain, and management may make, 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 may make forward-looking statements about the Company’s results of operations (including, among others, premium volume, income from continuing operations, net and operating income and return on equity), financial condition and liquidity; the sufficiency of the Company’s asbestos and other reserves (including, among others, asbestos claim payment patterns); the post-merger integration (including, among others, expense savings); the cost and availability of reinsurance coverage; and strategic initiatives. Such statements are subject to risks and uncertainties, many of which are difficult to predict and generally beyond the Company’s control, that could cause actual results to differ materially from those expressed in, or implied or projected by, the forward-looking information and statements.
Consolidated Statement of Changes in Shareholders’ Equity for the years ended December 31, 2005, 2004 and 2003
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The St. Paul Travelers Companies, Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.
The consolidated financial statements include the accounts of The St. Paul Travelers Companies, Inc. (together with its subsidiaries, the Company). On April 1, 2004, Travelers Property Casualty Corp. (TPC) merged with a subsidiary of The St. Paul Companies, Inc. (SPC), as a result of which TPC became a wholly-owned subsidiary of The St. Paul Travelers Companies, Inc. For accounting purposes, this transaction was accounted for as a reverse acquisition with TPC treated as the accounting acquirer. Accordingly, this transaction was accounted for as a purchase business combination, using TPC’s historical financial information and applying fair value estimates to the acquired assets, liabilities and commitments of SPC as of April 1, 2004. (See note 2 for a description of the fair value adjustments recorded). Beginning on April 1, 2004, the results of operations and financial condition of SPC were consolidated with TPC’s results of operations and financial condition. Accordingly, all financial information presented herein for the twelve months ended December 31, 2005 reflects the consolidated accounts of SPC and TPC. The financial information presented herein for the twelve months ended December 31, 2004 reflects only the accounts of TPC for the three months ended March 31, 2004 and the consolidated accounts of SPC and TPC for the nine months ended December 31, 2004. The financial information presented herein for 2003 reflects the accounts of TPC. Certain reclassifications have been made to prior years’ financial statements to conform to the current year’s presentation. Significant intercompany transactions and balances have been eliminated.
In 2005, the Company and Nuveen Investments, Inc. (Nuveen Investments), the Company’s asset management subsidiary, jointly announced that the Company would implement a program to divest its 78% equity interest in Nuveen Investments, which constituted the Company’s Asset Management segment and was acquired as part of the merger on April 1, 2004. The Company completed the divestiture through a series of transactions in 2005. The Company’s share of Nuveen Investments’ results was classified as discontinued operations on the consolidated statement of income, and the Company’s results for prior periods were reclassified to be consistent with the 2005 presentation. The Company’s ownership in Nuveen Investments’ assets and liabilities as of December 31, 2004 were netted and reported as “Net assets of discontinued operations” on the Company’s consolidated balance sheet. See note 3.
In December 2004, the FASB issued Revised Statement of Financial Accounting Standards No. 123, Share-Based Payment (FAS 123R), an amendment to FAS 123 and a replacement of APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. FAS 123R requires public entities to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award, and to recognize that cost over the requisite service period.
In addition, the accounting for certain grants of equity awards to individuals who are retirement eligible on the date of grant has been clarified. FAS 123R states that an employee’s share-based award becomes vested at the date that the employee’s right to receive or retain equity shares is no longer contingent on the satisfaction of a market, performance or service condition. Accordingly, awards granted to retirement eligible employees are not contingent on satisfying a service condition and therefore are recognized at fair value on the date of the grant. Additionally, the period over which cost is recognized for awards granted to those who become retirement eligible before the vesting date, will be from the grant date to the retirement eligible date rather than to the vesting date. This guidance is to be applied prospectively to new or modified awards granted upon adoption of FAS 123R.
In September 2005, the Accounting Standards Executive Committee (AcSEC) issued Statement Of Position 05-1, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts (SOP 05-1). SOP 05-1 provides guidance on accounting by insurance enterprises for deferred acquisition costs (DAC) on internal replacements of insurance and investment contracts other than those specifically described in FAS 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments. SOP 05-1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract.
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, credited or charged directly to other comprehensive income.
The carrying value of real estate properties are reviewed for impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable. The review for impairment includes an estimate of the undiscounted cash flows expected to result from the use and eventual disposition of the real estate property. An impairment loss is recognized if the expected future undiscounted cash flows are less than the carrying value of the real estate property.
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, impairment is taken if the carrying value of the property exceeds its current fair value less estimated costs to sell. The Company had no real estate held for sale at December 31, 2005 or 2004.
Other investments include: venture capital investments, through direct ownership and limited partnerships; private equity limited partnerships; joint ventures, other limited partnerships, and trading securities. Certain venture capital investments that are controlled by the Company are consolidated in the Company’s financial statements. The Company uses the equity method of accounting for joint ventures, limited partnerships and certain private equity securities. Undistributed income is reported in net investment income. Trading securities are marked to market with the change in fair value recognized in net investment income during the current period.
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. Indefinite-lived intangible assets are tested for impairment at least annually. Impairment is recognized only if the carrying amount of the intangible asset exceeds its fair value.
Other intangible assets that are not deemed to have an indefinite useful life are amortized over their useful lives. The carrying amount of intangible assets that are not deemed to have an indefinite useful life is regularly reviewed for indicators of impairments in value. Impairment is recognized only if the carrying amount of the intangible asset is not recoverable from its undiscounted cash flows and is measured as the difference between the carrying amount and the fair value of the asset.
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% of total Company net written premiums for each of the years ended December 31, 2005, 2004 and 2003. Policyholder dividends are accrued against earnings using best available estimates of amounts to be paid. The liability accrued for policyholder dividends totaled $30 million and $28 million at December 31, 2005 and 2004, respectively.
The Company’s insurance subsidiaries, domiciled principally in the states of Connecticut and Minnesota, prepare statutory financial statements in accordance with the accounting practices prescribed or permitted by the insurance departments of the states of domicile. Prescribed statutory accounting practices are those practices that are incorporated directly or by reference in state laws, regulations, and general administrative rules applicable to all insurance enterprises domiciled in a particular state. Permitted statutory accounting practices include practices not prescribed by the domiciliary state, but allowed by the domiciliary state regulatory authority. The impact of any permitted accounting practices on statutory surplus of the Company is not material.
Other revenues include revenues from premium installment charges, which are recognized as collected, revenues of noninsurance subsidiaries other than fee income and gains and losses on dispositions of assets and other miscellaneous revenues.
The Company has an employee stock incentive compensation plan that includes stock-based awards of stock options, restricted stock and deferred stock.
For stock-based employee awards granted, modified, or settled after December 31, 2002, the Company applies the FAS 123 fair value method of accounting. Under this method, compensation cost is measured at the grant date based on the fair value of the award and recognized ratably over the vesting period. For restricted stock awards, the fair value is measured at the market price of a share on the grant date while for stock option awards the fair value is derived by the application of an option pricing model at date of grant.
In connection with the merger in April 2004, the Company assumed 23 million outstanding SPC stock options, of which 4 million remained unvested and assumed approximately 240,000 of outstanding SPC restricted stock awards related to SPC equity-based compensation plans. These stock options and restricted stock awards retained the same terms and conditions that were applicable prior to the merger. At April 1, 2004, the estimated fair values of the unvested stock option awards and the restricted stock awards were $35 million and $9 million, respectively, and were included in unearned compensation as a separate component of equity. The unearned compensation expense is being recognized as a charge to income over the remaining vesting period.
The Company may use derivative financial instruments, including interest rate swaps, equity swaps, credit derivatives, options, forward contracts and financial futures, as a means of hedging exposure to interest rate, equity price change and foreign currency risk. The Company’s insurance subsidiaries do not hold or issue derivative instruments for trading purposes. The Company recognizes all derivatives, including certain derivative instruments embedded in other contracts, as either assets or liabilities in the consolidated balance sheet and measures those instruments at fair value. Where applicable, hedge accounting is used to account for derivatives. To qualify for hedge accounting, the changes in value of the derivative must be expected to substantially offset the changes in value of the hedged item. Hedges are monitored to ensure that there is a high correlation between the change in the value of the derivative instruments and the change in value of the hedged investment. Derivatives that do not qualify for hedge accounting are carried at fair value with the changes in fair value reflected in the consolidated statement of income in net realized investment gains (losses).
Invested and other assets and net investment income (NII) of historical TPC had been specifically identified by reporting segment prior to the merger. Beginning in the second quarter of 2004, the Company developed a methodology to allocate NII and invested assets to the identified segments. This methodology allocates pretax NII based upon an investable funds concept, which takes into account liabilities (net of non-invested assets) and appropriate capital considerations for each segment. The investment yield for investable funds reflects the duration of the loss reserves’ future cash flows, the interest rate environment at the time the losses were incurred and A+ rated corporate debt instruments. This duration yield is compared to the average portfolio yield and a new average yield is determined. It is this average yield that is used in the calculation of NII on investable funds. Yields are updated annually. Invested assets are allocated to segments in proportion to the pretax allocation of NII. It is not practicable to apply this methodology to historical businesses and, as such, actual (versus allocated) NII is included in revenues and operating income of the restated segments for periods prior to the merger. The Company believes that the differences are not significant to a comparison with the new segment presentation. It is also not practicable to present total assets for restated Commercial and Specialty segments for periods prior to the merger.
• Commercial Accounts serves primarily mid-sized businesses for casualty products and large and mid-sized businesses for property products. In addition to the traditional middle market, Commercial Accounts includes seven units dedicated to unique business needs.
• National Accounts comprises three distinct business units. The largest provides casualty products and services to large companies, with particular emphasis on workers’ compensation, general liability and automobile liability. National Accounts also includes the commercial residual market business, which primarily offers workers’ compensation products and services to the involuntary market. National Accounts also includes Discover Re, which provides unbundled property and casualty insurance products to insureds who utilize programs such as self-insurance, collateralized deductibles and captive reinsurers.
Commercial also includes the Special Liability Group (which manages the Company’s asbestos and environmental liabilities); the assumed reinsurance, health care, and certain international and other runoff operations; and policies written by the Company’s Gulf operation (Gulf), which was placed into runoff during the second quarter of 2004. These operations are collectively referred to as Commercial Other.
• International Specialty includes coverages marketed and underwritten to several specialty customer groups within the United Kingdom, Canada and the Republic of Ireland and the Company’s participation in Lloyd’s.
Terrorism Risk Insurance Act of 2002 and Terrorism Risk Insurance Extension Act of 2005
The stock price used in determining the purchase price was based on an average of the closing prices of SPC common stock for the two trading days before through the two trading days after SPC and TPC announced their merger agreement on November 17, 2003. The purchase price also included the fair value of the SPC stock options, the fair value adjustment to SPC’s preferred stock, and other costs of the transaction. The purchase price was approximately $8.76 billion, and was calculated as follows:
(3) Represents certain adjustments to conform SPC’s accounting policies to those of TPC’s that affected the purchase price allocation.
(4) Represents a deferred tax liability associated with adjustments to fair value of all assets and liabilities included herein excluding goodwill, as this transaction is not treated as a purchase for tax purposes.
(7) An adjustment has been applied to SPC’s claims and claim adjustment expense reserves and reinsurance recoverables at the acquisition date to estimate their fair value. The fair value adjustment of $191 million was based on management’s estimate of nominal claim and claim expense reserves and reinsurance recoverables (after adjusting for conformity with the acquirer’s accounting policy on discounting of workers’ compensation reserves), expected payment patterns, the April 1, 2004 U.S. Treasury spot rate yield curve, a leverage ratio assumption (reserves to statutory surplus), and a cost of capital expressed as a spread over risk-free rates. The method used calculates a risk adjustment to a risk-free discounted reserve that will, if reserves run off as expected, produce results that yield the assumed cost-of-capital on the capital supporting the loss reserves. The fair value adjustment is reported as an intangible asset on the consolidated balance sheet, and the amounts measured in accordance with the acquirer’s accounting policies for insurance contracts are reported as part of the claims and claim adjustment expense reserves and reinsurance recoverables. The intangible asset will be recognized into income over the expected payment pattern. Because the time value of money and the risk adjustment (cost of capital) components of the intangible asset run off at different rates, the amount recognized in income may be a net benefit in some periods and a net expense in other periods.
(b) See item 7 of the allocation of the purchase price previously presented.
The allocated purchase price calculated above results in an estimate of the fair value of assets acquired and liabilities assumed as of the merger date, as follows:
The assets and liabilities related to Nuveen Investments were removed from the respective lines of the Company’s consolidated balance sheet and reported under the caption “Net assets of discontinued operations” in the consolidated balance sheet at December 31, 2004. The current and deferred tax liabilities generated by the difference between the Company’s tax basis and the GAAP basis of its investment in Nuveen Investments are reported on the Company’s consolidated balance sheet as part of the Company’s current and deferred tax liabilities and are not included in the “Net assets of discontinued operations” line item of the consolidated balance sheet.
In 2005, the Company has separately disclosed the operating, investing and financing cash flows attributable to its discontinued operations (Nuveen Investments), which in prior quarters were reported as components of cash flows from continuing operations. The consolidated cash flow statement for the year ended December 31, 2004 has been revised to be consistent with the 2005 presentation.
The following presents a summary of the Company’s intangible assets by major asset class as of December 31, 2005 and 2004:
(1) The time value of money and the risk margin (cost of capital) components of the intangible asset runoff at different rates, and as such, the amount recognized in income may be a net benefit in some periods and a net expense in other periods. See note 2 for further information on the fair value adjustment on claims and claim adjustment expense reserves and reinsurance recoverables.
The following table presents the carrying amount of the Company’s goodwill by segment at December 31, 2005 and 2004:
(1) Operating revenues exclude net realized investment gains (losses) and revenues from discontinued operations. Operating income (loss) equals net income (loss) excluding the after-tax impact of net realized investment gains (losses) and the after-tax impact of discontinued operations.
(1) The primary component of Interest Expense and Other is after-tax interest expense of $186 million, $151 million and $105 million in 2005, 2004 and 2003, respectively.
Revenues from internal customers for the years ended December 31, 2005, 2004 and 2003 were not significant. Foreign assets at December 31, 2005 and 2004 also were not significant. The Company does not have revenue from transactions with a single customer amounting to 10 percent or more of its revenues.
At December 31, 2005 and 2004, the Company held CMOs classified as available for sale with a fair value of $3.43 billion and $3.30 billion, respectively (excluding Commercial Mortgage-Backed Securities of $1.16 billion and $953 million, respectively). Approximately 43% and 53% of the Company’s CMO holdings are guaranteed by or fully collateralized by securities issued by GNMA, FNMA or FHLMC at December 31, 2005 and 2004, respectively. In addition, the Company held $4.83 billion and $4.66 billion of GNMA, FNMA, FHLMC or FHA mortgage-backed pass-through securities classified as available for sale at December 31, 2005 and 2004, respectively. Virtually all of these securities are rated Aaa.
At December 31, 2005 and 2004, the Company had $2.67 billion and $2.60 billion, respectively, of securities on loan as part of a tri-party lending agreement. At December 31, 2005 and 2004, respectively, $119 million and $32 million of securities were subject to dollar-roll repurchase agreements.
The Company’s subsidiaries, Unionamerica and St. Paul Re-U.K., and the Company’s operations at Lloyd’s are required, as accredited U.S. reinsurers, to hold certain investments in trust in the United States. These trust funds had a fair value of $374 million and $359 million at December 31, 2005 and 2004, respectively. Additionally, Unionamerica, St. Paul Re-U.K. and Discover Re have funds deposited with third parties to be used as collateral to secure various liabilities on behalf of insureds, cedants and other creditors. These funds had a fair value of $43 million and $55 million at December 31, 2005 and 2004, respectively. The Company also had $85 million of other investments being used to secure obligations under a series of insurance transactions, and $312 million of other investments pledged as collateral securing outstanding letters of credit.
Proceeds from the sale of real estate investments totaled $37 million in 2005. Gross gains of $15 million and no gross losses were realized on those sales in 2005. The Company did not sell any real estate investments in 2004 or 2003.
Future minimum rental income expected on operating leases relating to the Company’s real estate properties is $93 million, $84 million, $70 million, $52 million, $37 million, and $40 million for 2006, 2007, 2008, 2009, 2010 and 2011 and thereafter, respectively.
• The Company also has a significant variable interest in Camperdown UK Limited, which SPC sold in December 2003. The Company’s variable interest results from an agreement to indemnify the purchaser in the event a specified reserve deficiency develops, a reserve-related foreign exchange impact occurs, or a foreign tax adjustment is imposed on a pre-sale reporting period. The maximum amount of this indemnification obligation is $172 million. The fair value of this obligation as of December 31, 2005 and 2004 was $66 million and $44 million, respectively. See “Guarantees” section of note 17.
• to seek capital appreciation by investing and trading in securities including, without limitation, investments in common stock, bonds, notes, debentures, investment contracts, partnership interests, options and warrants;
• to sell securities short primarily to exploit arbitrage opportunities in a broad range of equity and fixed income markets.
The carrying values of real estate properties are reviewed for impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable. The review for impairment includes an estimate of the undiscounted cash flows expected to result from the use and eventual disposition of the real estate property. An impairment loss is recognized if the expected future undiscounted cash flows are less than the carrying value of the real estate property.
Other investments include venture capital investments, which are generally non-publicly traded instruments in early-stage companies and, historically, having a holding period of four to seven years. These investments have primarily been made in the health care, software and computer services, and networking and information technologies infrastructures industries. The Company typically is involved with venture capital companies early in their formation, as they are developing and determining the viability of, and market demand for, their product. Generally, the Company does not expect these venture
• whether or not the internal valuation committee believes it is probable that the issuer will need financing within six months at a lower price than our carrying value; and
• whether or not the Company has the ability and intent to hold the security for a period of time sufficient to allow for recovery, enabling it to receive value equal to or greater than our cost.
The following tables summarize, for all investment securities in an unrealized loss position at December 31, 2005 and 2004, the aggregate fair value and gross unrealized loss by length of time those securities have been continuously in an unrealized loss position.
Aggregate annual maturities on mortgage loans are $42 million, $5 million, $9 million, $2 million, and $87 million for 2006, 2007, 2008, 2009 and 2010 and thereafter, respectively.
At December 31, 2005 and 2004, the Company had concentrations of credit risk in tax-exempt investments of the state of Texas of $3.27 billion and $2.30 billion, respectively, of the state of Illinois of $1.84 billion and $1.50 billion, respectively, and of the state of New York of $1.67 billion and $1.44 billion, respectively.
Included in fixed maturities are below investment grade assets totaling $1.75 billion and $1.78 billion at December 31, 2005 and 2004, 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.
The weighted average number of common shares outstanding applicable to basic and diluted EPS for all periods prior to April 1, 2004 were restated to reflect the exchange of each share of TPC common stock for 0.4334 shares of the Company’s common stock.
In 2004, the Company implemented the provisions of FASB EITF 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share, which provided new guidance on the dilutive effect of contingently convertible debt instruments. The Company has one debt instrument outstanding to which the new guidance applied - its $893 million, 4.50% convertible junior subordinated notes convertible into 16.7 million shares of the Company’s common stock. Income from continuing operations per diluted share for the year ended December 31, 2004 excluded the weighted average effects of these notes as the impact would have been anti-dilutive. For the year ended December 31, 2003, the application of the new guidance resulted in the restatement of diluted income from continuing operations per share from the previously reported $3.88 to $3.80.
The Company’s consolidated financial statements reflect the effects of assumed and ceded reinsurance transactions. Assumed reinsurance refers to the acceptance of certain insurance risks that other insurance companies have underwritten. Ceded reinsurance involves transferring certain insurance risks (along with the related written and earned premiums) the Company has underwritten to other insurance companies who agree to share these risks. The primary purpose of ceded reinsurance is to protect the Company from potential losses in excess of the amount it is prepared to accept. 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.
The Company is also required to participate in various involuntary reinsurance arrangements through assumed reinsurance, principally with regard to residual market mechanisms in workers’ compensation. The Company provides services for several of these involuntary arrangements (“mandatory pools and associations”) under which it writes such residual market business directly, then cedes 100% of this business to the mandatory pool. Such servicing arrangements are arranged to protect the Company from any credit risk, as any ceded balances are jointly backed by all the pool members.
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, disputes, applicable coverage defenses and other relevant factors. Accordingly, the establishment of reinsurance recoverables and the related allowance for uncollectible reinsurance recoverables is an inherently uncertain process involving estimates. Amounts deemed to be uncollectible, including amounts due from known insolvent reinsurers, are written off against the allowance for estimated uncollectible reinsurance recoverables. Any subsequent collections of amounts previously written off are reported as part of underwriting results.
The allowance for estimated uncollectible reinsurance recoverables was $804 million and $751 million at December 31, 2005 and December 31, 2004, respectively.
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 $346 million and $405 million at December 31, 2005 and 2004, respectively.
In 2004, the Company entered into commutation agreements with a major reinsurer, resulting in a charge of $153 million for amounts received less than the reinsurance recoverable balances of approximately $1.26 billion. In connection with the commutation, the Company also entered into a new reinsurance agreement effective April 1, 2004, that provides $300 million aggregate coverage for the 2000 accident year exposures written by SPC. Because the new agreement is for events occurring prior to the effective date of the agreement, the resulting $59 million gain was deferred and will be recognized in earnings as amounts are recovered from the reinsurer. Under the terms of these agreements, the Company received net cash of approximately $867 million in 2004.
The Specialty segment recorded net favorable prior year reserve development of $9 million in 2005, driven by lower than expected severity for property-related exposures.
In the Personal segment, net favorable prior year reserve development in 2005 totaled $360 million, driven by lower than expected frequency and severity of losses in the automobile line of business, as well as a decline in the frequency of non-catastrophe homeowners’ losses.
Primarily all of the asbestos and environmental charges in 2004 were recorded in the Commercial segment and are discussed in more detail in the following “Asbestos and Environmental Reserves” section. Also included in net unfavorable prior year reserve development in the Commercial segment in 2004 was $38 million related to the commutation of agreements with a major reinsurer along with a strengthening of Gulf reserves, which was more than offset by other favorable prior year reserve development in core Commercial operations due to lower than expected frequency of non-catastrophe related losses.
In the Personal segment, net favorable prior year reserve development in 2004 was $378 million, driven by lower than expected frequency of non-catastrophe homeowners’ losses, as well as a reduction in the frequency and severity of losses in the automobile line of business.
For each of the years ended December 31, 2005, 2004 and 2003, changes in allocations between accident 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.
At December 31, 2005 and 2004, the Company’s claims and claim adjustment expense reserves included $4.79 billion and $4.57 billion, respectively, for asbestos and environmental-related claims, net of reinsurance.
judicial rulings and legislative actions. The asbestos provision in 2005 resulted, in part, from higher than expected defense costs due to increased trial activity for seriously impaired plaintiffs and prolonged litigation before cases are settled or dismissed. The 2005 provision also considered the January 2006 court decision voiding, on procedural grounds, the previously rendered favorable arbitration decision in the ongoing ACandS litigation (described in more detail in note 17). The asbestos provision recorded in 2004 primarily resulted from an increase in litigation costs and activity surrounding peripheral defendants.
As a result of the processes and procedures described above, management believes that the reserves carried for asbestos and environmental claims at December 31, 2005 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 determine the ultimate exposure for asbestos and environmental claims and related litigation. As a result, these reserves are subject to revision as new information becomes available and as claims develop. The continuing uncertainties include, without limitation, the risks and lack of predictability inherent in complex 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. In addition, the Company’s asbestos-related loss and loss expense experience has been impacted by the exhaustion or unavailability due to insolvency of other insurance potentially available to policyholders along with the insolvency or bankruptcy of other defendants. 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. As part of its continuing analysis of asbestos reserves, which includes an annual ground-up review of asbestos policyholders, the Company continues to study the implications of these and other developments.
On April 1, 2004, The St. Paul Travelers Companies, Inc. fully and unconditionally guaranteed the payment of all principal, premiums, if any, and interest on certain debt obligations of its subsidiaries TPC and Travelers Insurance Group Holdings Inc. (TIGHI). The guarantees pertain to the $150 million 6.75% Notes due 2006, the $400 million 3.75% Notes due 2008, the $500 million 5.00% Notes due 2013, the $200 million 7.75% Notes due 2026, the $893 million 4.5% Convertible Notes due 2032 and the $500 million 6.375% Notes due 2033.
5.50% Senior Notes-In November 2005, the Company issued $400 million of 5.50% senior notes due December 1, 2015. The notes pay interest semi-annually on June 1 and December 1 of each year, beginning June 1, 2006, are senior unsecured obligations and rank equally with all of the Company’s other senior unsecured indebtedness. The Company may redeem some or all of the notes prior to maturity at a redemption price equal to the greater of: 100% of the principal amount of senior notes to be redeemed; or the sum of the present values of the remaining scheduled payments of principal and interest on the senior notes to be redeemed (exclusive of interest accrued to the date of redemption) discounted to the date of redemption on a semiannual basis at the then current Treasury Rate plus 20 basis points. The majority of the proceeds from the issuance of the 5.50% senior notes was used to pay down the Company’s commercial paper outstanding, with the remainder used for general corporate purposes.
Zero Coupon Convertible Notes-The zero coupon convertible notes mature in 2009, but are redeemable at the option of the Company for an amount equal to the original issue price plus accreted original issue discount. Each note is convertible at the option of the holder at any time on or prior to maturity, unless previously redeemed by the Company, into common stock of the Company at a conversion rate of 16.6433 shares for each $1,000 principal amount of notes.
4.50% Convertible Junior Subordinated Notes-In March 2002, the Company issued $893 million aggregate principal amount of 4.5% convertible junior subordinated notes, which will mature on April 15, 2032, unless earlier redeemed, repurchased or converted. Interest is payable quarterly in arrears. The Company has the option to defer interest payments on the notes for a period not exceeding 20 consecutive interest periods nor beyond the maturity of the notes. During a deferral period, the amount of interest due to holders of the notes will continue to accumulate, and such deferred interest payments will themselves accrue interest. Deferral of any interest can create certain restrictions for the Company. Unless previously redeemed or repurchased, the notes are convertible into shares of 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 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 common stock at a conversion rate of 0.4684 shares of common stock for each $25.00 principal amount of notes (equivalent to an initial conversion price of $53.37 per share of common stock), subject to adjustment in certain events. On or after April 18, 2007, the notes may be redeemed at the Company’s option. The Company 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 the Company’s current or future subsidiaries.
The Company maintains an $800 million commercial paper program with back-up liquidity consisting of a bank credit agreement. In June 2005, the Company entered into a $1.0 billion, five-year revolving credit agreement with a syndicate of financial institutions. The new credit agreement replaced and consolidated the Company’s three prior bank credit agreements that had collectively provided the Company access to $1.0 billion of bank credit lines. Pursuant to covenants in the new credit agreement, the Company must maintain an excess of consolidated net worth over goodwill and other intangible assets of not less than $10 billion at all times. The Company must also maintain a ratio of total consolidated debt to the sum of total consolidated debt plus consolidated net worth of not greater than 0.40 to 1.00. In addition, the credit agreement contains other customary restrictive covenants as well as certain customary events of default, including with respect to a change in control. At December 31, 2005, the Company was in compliance with these covenants and all other covenants related to its respective debt instruments outstanding. Pursuant to the terms of the credit agreement, the Company has an option to increase the credit available under the facility, no more than once a year, up to a maximum facility amount of $1.5 billion, subject to the satisfaction of a ratings requirement and certain other conditions. There was no amount outstanding under the credit agreement as of December 31, 2005.
In December 2005, the Company filed with the Securities and Exchange Commission a shelf registration statement for the potential offering and sale of securities. The Company may offer these securities from time to time at prices and on other terms to be determined at the time of offering.
If the Company determines that any of its deferred tax assets will not result in future tax benefits, a valuation allowance must be established for the portion of these assets that are not expected to be realized. The net change in the valuation allowance for deferred tax assets was a decrease of $30 million and an increase of $128 million for December 31, 2005 and 2004, respectively, in each year relating to foreign operations. Based predominantly upon a review of the Company’s anticipated future taxable income, and also including all other available evidence, both positive and negative, the Company’s management concluded that it is more likely than not that the net deferred tax assets will be realized.
For tax return purposes, as of December 31, 2005, the Company had a net operation loss (NOL) carryforward that expires, if unused, in 2017-2018. The amount and timing of realizing the benefit of NOL carryforwards depends on future taxable income and limitations imposed by tax laws. The approximate amounts of those NOLs on a regular tax basis and an alternative minimum tax (AMT) basis were $114 million and $81 million, respectively. The benefit of the NOL carryforward has been recognized in the consolidated financial statements.
The Company’s intercompany tax sharing agreement was amended to include the SPC companies effective with their acquisition on April 1, 2004.
In September 2005, the SOP was merged into the St. Paul Travelers 401(k) Savings Plan. See note 14.
The Company’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 $2.56 billion is available in 2006 for such dividends without prior approval of the Connecticut Insurance Department for Connecticut-domiciled subsidiaries and the Minnesota Department of Commerce for Minnesota-domiciled subsidiaries. The Company received $968 million of dividends from its insurance subsidiaries in 2005.
The Company, following the merger, adopted The St. Paul Travelers Companies, Inc. 2004 Stock Incentive Plan (the 2004 Incentive Plan) in July 2004. The purposes of the 2004 Incentive Plan are to reward the efforts of the Company’s non-employee directors, executive officers and other employees and to attract new personnel by providing incentives in the form of stock-based awards. The 2004 Incentive Plan permits grants of nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock, deferred stock, stock units, performance awards and other stock-based or stock-denominated awards with respect to the Company’s common stock. The number of shares of the Company’s common stock authorized for grant under the 2004 Incentive Plan is 35 million shares, subject to additional shares that may be available for awards as described below.
The 2004 Incentive Plan is the only plan pursuant to which future stock-based awards may be granted. In addition to the 35 million shares initially authorized for issuance under the 2004 Incentive Plan, the following will not be counted towards the 35 million shares available and will be available for future grants under the 2004 Incentive Plan: (i) shares of common stock subject to an award that expires unexercised, that is forfeited, terminated or canceled, that is settled in cash or other forms of property, or otherwise does not result in the issuance of shares of common stock, in whole or in part; (ii) shares that are used to pay the exercise price of stock options and shares used to pay withholding taxes on awards generally; and (iii) shares purchased by the Company on the open market using cash option exercise proceeds; provided, however, that the increase in the number of shares of common stock available for grant pursuant to such market purchases shall not be greater than the number that could be repurchased at fair market value on the date of exercise of the stock option giving rise to such option proceeds.
Except for shares delivered to or retained in the legacy TPC 2002 Incentive Plan in connection with the withholding of taxes applicable to the exercise of outstanding options that have reload features, the provisions of the preceding paragraph that result in shares becoming available for future grants under the 2004 Incentive Plan also apply to any awards granted under the legacy SPC 1994 Stock Plan and the legacy TPC 2002 Incentive Plan that were outstanding on the effective date of the 2004 Incentive Plan.
The Company established an Equity Awards program under the 2004 Incentive Plan, pursuant to which the Company may issue stock option awards to eligible officers and key employees. Under the Equity Awards program, stock option awards are granted having a ten-year term with an exercise price equal to the fair market value of the Company’s common stock on the date of grant. The stock options granted under this program through 2005 generally vest over a four year period, with 50% of the option shares vesting on the 2nd anniversary of the date of grant, and 25% of the option shares vesting on each of the 3rd and 4th anniversaries of the grant date. Beginning in 2006, stock option awards granted under this program will generally vest in full after a three-year period from date of grant. Except as the Compensation Committee of the Board may allow in the future, stock options cannot be sold or transferred by the participant.
The TPC stock options awards granted under the legacy TPC 2002 Incentive Plan have a ten-year term with an exercise price equal to the fair value of the Company’s common stock on the date of grant (as adjusted to reflect the merger). Stock options granted under this plan prior to April 27, 2004, generally vest 20% each year over a five-year period. Stock options granted under this plan from April 27, 2004 until the plan termination on July 28, 2004, generally vest over a four-year period, with 50% of the option shares vesting on the 2nd anniversary of the date of grant, and 25% of the option shares vesting on each of the 3rd and 4th anniversaries of the grant date. Prior to January 23, 2003, certain stock option awards granted under the TPC 2002 Incentive Plan permitted an employee exercising an option to be granted a new option (a reload option) in an amount equal to the number of shares of the TPC common stock used to satisfy both the exercise price and withholding taxes due upon exercise of an option. Prior to the merger, the reload options were granted at an exercise price equal to the fair market value of TPC’s common stock on the date of grant, and after the merger the reload options will be granted at an exercise price equal to the fair market value of the Company’s common stock on the date of grant. The reload options vest six months after the grant date and are exercisable for the remaining term of the related original option.
(1) 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.
On October 25, 2005, the Company approved a Performance Share Awards Program pursuant to the 2004 incentive plan. Under the program, the Company may issue performance share awards to certain employees of the Company who hold positions of Vice President (or its equivalent) or above. The performance awards represent target shares that provide the recipient the right to earn shares of the Company’s common stock based upon the Company’s attainment of certain performance goals. The program becomes effective beginning in 2006. The performance goals for performance awards granted in 2006 are based on the Company’s adjusted return on equity over a three-year performance period. If performance falls short of targeted performance, none or only a portion of the shares will vest after the three-year performance period from date of grant. If performance exceeds targeted performance, more than 100% (up to a maximum of 160%) of target shares will vest after the three-year performance period from date of grant.
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 $40 million, $26 million and $17 million for the years ended December 31, 2005, 2004 and 2003, respectively.
The Company sponsors a qualified non-contributory defined benefit pension plan, which covers substantially all employees and provides benefits under a cash balance formula, except that employees satisfying certain age and service requirements remain covered by a prior final pay formula. Prior to December 31, 2004, both TPC and SPC sponsored qualified noncontributory defined benefit pension plans. These plans were merged to form one Company plan on December 31, 2004. In addition, the Company and TPC sponsor nonqualified defined benefit pension plans which cover certain highly-compensated employees and also sponsor postretirement health and life insurance benefit plans for employees satisfying certain age and service requirements and for certain retirees.
The total accumulated benefit obligation for the Company’s defined benefit pension plans was $1.88 billion and $1.70 billion at December 31, 2005 and 2004, respectively. The Qualified Domestic Plan accounted for $1.69 billion and $1.54 billion of the total accumulated benefit obligation at December 31, 2005 and 2004, respectively, whereas the Non-Qualified and Foreign Plans accounted for $0.19 billion and $0.16 billion of the total accumulated benefit obligation at December 31, 2005 and 2004, respectively.
For pension plans with an accumulated benefit obligation in excess of plan assets, the aggregate projected benefit obligation and the aggregate accumulated benefit obligation were $186 million and $185 million, respectively, at December 31, 2005 and $102 million and $99 million at December 31, 2004, respectively. The fair value of plan assets for the above plans was $88 million and $23 million at December 31, 2005 and 2004, respectively.
As an indicator of sensitivity, increasing the assumed health care cost trend rate by 1% would have increased the accumulated postretirement benefit obligation by $47 million at December 31, 2005, and the aggregate of the service and interest cost components of net postretirement benefit expense by $4 million for the year ended December 31, 2005. Decreasing the assumed health care cost trend rate by 1% would have decreased the accumulated postretirement benefit obligation at December 31, 2005 by $38 million and the aggregate of the service and interest cost components of net postretirement benefit expense by $3 million for the year ended December 31, 2005.
The following table summarizes the components of net benefit expense recognized in the consolidated statement of income for the benefit plans for the years ended December 31, 2005, 2004 and 2003.
Weighted average target asset allocations at December 31, 2005 by asset category were as follows:
The Company’s other post-retirement benefit plan weighted-average asset allocations at December 31, 2005 and 2004 by asset category were as follows:
To finance the preferred stock purchase for future allocation to qualified employees, the SOP borrowed $150 million at 9.4% from a primary U.S. underwriting subsidiary. As the principal and interest of the trust’s loan was paid, a pro rata amount of preferred stock was released for allocation to participating employees. Each share of preferred stock pays a dividend of $11.72 annually and is currently convertible into eight shares of the Company’s common stock. Preferred stock dividends on all shares held by the trust were used to pay a portion of the SOP obligation. In addition to dividends paid to the trust, additional cash contributions were made to the SOP as necessary in order to meet the SOP’s debt obligation. The SOP’s debt obligation was paid off in January 2005 with a final payment of $5 million; consequently, all preferred stock dividends are now paid to preferred stockholders. The SOP allocated the final 71,346 preferred shares in 2004. The SOP has no preferred shares available for future allocations.
The Company may use derivative financial instruments, including interest rate swaps, equity swaps, credit derivatives, options, financial futures and forward contracts, as a means of hedging exposure to interest rate, equity price change and foreign currency risk. The Company’s insurance subsidiaries do not hold or issue derivatives for trading purposes.
The following section describes the major pending legal proceedings, other than ordinary routine litigation incidental to the business, to which the Company or any of its subsidiaries is a party or to which any of the Company’s property is subject.
In the ordinary course of its insurance business, the Company receives claims for insurance arising under policies issued by the Company asserting alleged injuries and damages from asbestos, hazardous waste and other toxic substances which are the subject of related coverage litigation, including, among others, the litigation described below. The Company continues to be subject to aggressive asbestos-related litigation. The conditions surrounding the final resolution of these claims and the related litigation continue to change.
TPC is involved in three significant proceedings (including a bankruptcy proceeding) relating to ACandS, Inc. (ACandS), formerly a national distributor and installer of products containing asbestos. The proceedings involve disputes as to whether and to what extent any of ACandS’ potential liabilities for current or future bodily injury asbestos claims are covered by insurance policies issued by TPC. The status of the various proceedings is described below.
ACandS filed for bankruptcy in September 2002 (In re: ACandS, Inc., pending in the U.S. Bankruptcy Court for the District of Delaware). In its proposed plan of reorganization, ACandS sought to establish a trust to pay asbestos bodily injury claims against it and sought to assign to the trust its rights under the insurance policies issued by TPC. The proposed plan and disclosure statement filed by ACandS claimed that ACandS had settled the vast majority of asbestos-related bodily injury claims currently pending against it for approximately $2.80 billion. ACandS asserts that, based on a prior agreement between TPC and ACandS and ACandS’ interpretation of the July 31, 2003 arbitration panel ruling described below, TPC is liable for 45% of the $2.80 billion. On January 26, 2004, the bankruptcy court issued a decision rejecting confirmation of ACandS’ proposed plan of reorganization. The bankruptcy court found, consistent with TPC’s objections to ACandS’ proposed plan, that the proposed plan was not fundamentally fair, was not proposed in good faith and did not comply with Section 524(g) of the Bankruptcy Code. ACandS has filed a notice of appeal of the bankruptcy court’s decision and has filed objections to the bankruptcy court’s findings of fact and conclusions of law in the United States District Court. TPC has moved to dismiss the appeal and objections and has also filed an opposition to ACandS’ objections.
An arbitration was commenced in January 2001 to determine whether and to what extent ACandS’ financial obligations for bodily injury asbestos claims are subject to insurance policy aggregate limits. On July 31, 2003, the arbitration panel ruled in favor of TPC that asbestos bodily injury claims against ACandS are subject to the aggregate limits of the policies issued to ACandS, which have been exhausted. In October 2003, ACandS commenced a lawsuit seeking to vacate the arbitration award as beyond the panel’s scope of authority (ACandS, Inc. v. Travelers Casualty and Surety Co., U.S.D.Ct. E.D. Pa.). On September 16, 2004, the district court entered an order denying ACandS’ motion to vacate the arbitration award. On January 19, 2006, the United States Court of Appeals for the Third Circuit reversed the district court’s decision and declared the arbitration award void on procedural grounds. On February 8, 2006, TPC filed a motion to stay the issuance of the Third Circuit’s mandate in anticipation of TPC’s petition for a writ of certiorari to the United States Supreme Court.
In the other proceeding, a related case pending before the same court and commenced in September 2000 (ACandS v. Travelers Casualty and Surety Co., U.S.D.Ct., E.D. Pa.), ACandS sought a declaration of the extent to which the asbestos bodily injury claims against ACandS are subject to occurrence limits under insurance policies issued by TPC. TPC filed a motion to dismiss this action based upon the July 31, 2003 arbitration decision described above. The district court found the dispute was moot as a result of the arbitration panel’s decision. The district court, therefore, based on the arbitration panel’s decision, dismissed the case. If the January 19, 2006 ruling of the Third Circuit described in the paragraph above survives further appeal, this case will be reinstated.
In October 2001 and April 2002, two purported class action suits (Wise v. Travelers and Meninger v. Travelers), were filed against TPC and other insurers (not including SPC) in state court in West Virginia. These cases were subsequently consolidated into a single proceeding in the Circuit Court of Kanawha County, West Virginia. Plaintiffs allege that the insurer defendants engaged in unfair trade practices by inappropriately handling and settling asbestos claims. The plaintiffs seek to reopen large numbers of settled asbestos claims and to impose liability for damages, including punitive damages, directly on insurers. Lawsuits similar to Wise were filed in Massachusetts and Hawaii (these suits are collectively referred to as the “Statutory and Hawaii Actions”). Also, in November 2001, plaintiffs in consolidated asbestos actions pending before a mass tort panel of judges in West Virginia state court moved to amend their complaint to name TPC as a defendant, alleging that TPC and other insurers breached alleged duties to certain users of asbestos products. In March 2002, the court granted the motion to amend. Plaintiffs seek damages, including punitive damages. Lawsuits seeking similar relief and raising allegations similar to those presented in the West Virginia amended complaint are also pending in Ohio state court against TPC and SPC, in Texas state court against TPC and SPC, and in Louisiana state court against TPC (the claims asserted in these suits, together with the West Virginia suit, are collectively referred to as the “Common Law Claims”).
Three other actions against the Company and certain of its current and former officers and directors are pending in the United States District Court for the District of Minnesota. Two of these actions, which were originally captioned Kahn v. The St. Paul Travelers Companies, Inc., et al. (Nov. 2, 2004) and Michael A. Bernstein Profit Sharing Plan v. The St. Paul Travelers Companies, Inc., et al. (Nov. 10, 2004), are putative class actions brought by certain shareholders of the Company against the Company and certain of its current and former officers and directors. These actions have been consolidated as In re St. Paul Travelers Securities Litigation II, and a lead plaintiff and lead counsel have been appointed. On July 11, 2005, the lead plaintiff filed an amended consolidated complaint. The amended consolidated complaint alleges violations of federal securities laws in connection with the Company’s alleged failure to make disclosure relating to the practice of paying brokers commissions on a contingent basis, the Company’s alleged involvement in a conspiracy to rig bids and the Company’s allegedly improper use of finite reinsurance products. On September 26, 2005, the Company and the other defendants in In re St. Paul Travelers Securities Litigation II moved to dismiss the amended consolidated complaint for failure to state a claim. In the third of these actions, an alleged beneficiary of the Company’s 401(k) savings plan commenced a putative class action against the Company and certain of its current and former officers and directors captioned Spiziri v. The St. Paul Travelers Companies, Inc., et al. (Dec. 28, 2004). The complaint alleges violations of the Employee Retirement Income Security Act based on allegations similar to those in In re St. Paul Travelers Securities Litigation I. On June 1, 2005, the Company and the other defendants in Spiziri moved to dismiss the complaint. On January 4, 2006, the parties in Spiziri entered into a stipulation of settlement. The settlement remains subject to court approval.
In addition, two derivative actions have been brought in the United States District Court for the District of Minnesota against all of the Company’s current directors and certain of the Company’s former Directors, naming the Company as a nominal defendant: Rowe v. Fishman, et al. (Oct. 22, 2004) and Clark v. Fishman, et al. (Nov. 18, 2004). The derivative actions have been consolidated for pretrial proceedings as Rowe, et al. v. Fishman, et al. and a consolidated derivative complaint has been filed. The consolidated derivative complaint asserts state law claims, including breach of fiduciary duty, based on allegations similar to those alleged in In re St. Paul Travelers Securities Litigation I and II described above. On June 10, 2005, the Company and the other defendants in Rowe moved to dismiss the complaint. Oral argument on the motion to dismiss was presented on September 19, 2005.
The Company is cooperating with these subpoenas and requests for information. In addition, outside counsel, with the oversight of the Company’s Board of Directors, has been conducting an internal review of certain of the Company’s business practices. This review initially focused on the Company’s relationship with brokers and was commenced after the announcement of litigation brought by the New York Attorney General’s office against a major broker.
The internal review was expanded to address the various requests for information described above and to verify whether the Company’s business practices in these areas have been appropriate. The Company’s review has been extensive, involving the examination of e-mails and underwriting files, as well as interviews of current and former employees. The Company also continues to receive and respond to additional requests for information and will expand its review accordingly.
Six putative class action lawsuits and two individual actions were brought against a number of insurance brokers and insurers, including the Company and/or certain of its affiliates, by plaintiffs who allegedly purchased insurance products through one or more of the defendant brokers. Plaintiffs allege that various insurance brokers conspired with each other and with various insurers, including the Company and/or certain of its affiliates, to artificially inflate premiums, allocate brokerage customers and rig bids for insurance products offered to those customers. Five of the class actions were filed in federal district court, and the complaints are captioned: Shell Vacations LLC v. Marsh & McLennan Companies, Inc., et al. (N.D. Ill. Jan. 14, 2005), Redwood Oil Company v. Marsh & McLennan Companies, Inc., et al. (N.D. Ill. Jan. 21, 2005), Boros v. Marsh & McLennan Companies, Inc., et al. (N.D. Cal. Feb. 4, 2005), Mulcahey v. Arthur J. Gallagher & Co., et al. (D.N.J. Feb. 23, 2005) and Golden Gate Bridge, Highway, and Transportation District v. Marsh & McLennan Companies, Inc., et al. (D.N.J. Feb. 23, 2005). The plaintiff in one of the five actions, Shell Vacations LLC, later voluntarily dismissed its complaint. To the extent they were not originally filed there, the federal class actions were transferred by the Judicial Panel on Multidistrict Litigation to the United States District Court for the District of New Jersey and have been consolidated with other class actions under the caption In re Insurance Brokerage Antitrust Litigation, a multidistrict litigation proceeding in that District. On August 1, 2005, nineteen plaintiffs, including the four named plaintiffs in the above-referenced class actions, filed an amended consolidated class action complaint naming various brokers and insurers, including the Company and certain of its affiliates, on behalf of a putative nationwide class of policyholders. The complaint includes causes of action under the Sherman Act, the Racketeer Influenced and Corrupt Organizations Act, state common law and the laws of the various states prohibiting antitrust violations. Plaintiffs seek monetary damages, including punitive damages and trebled damages, permanent injunctive relief, restitution, including disgorgement of profits, interest and costs, including attorneys’ fees. On November 29, 2005, all defendants moved to dismiss the complaint for failure to state a claim. On February 13, 2006, the named plaintiffs moved to certify a nationwide class consisting of all persons who between August 26, 1994, and the date of class certification engaged the services of a broker defendant (or related entity) in connection with the procurement or renewal of insurance and who entered into or renewed a contract of insurance with one or more of the insurer defendants, including the Company. One individual
action naming various brokers and insurers, including several of the Company’s affiliates, was filed in federal district court and is captioned Delta Pride Catfish, Inc. v. Marsh USA, Inc., et al. (D. Miss. Sept. 13, 2005). That action has also been transferred to the District of New Jersey and is being coordinated with In re Insurance Brokerage Antitrust Litigation. On January 17, 2006, all defendants moved to dismiss the complaint in Delta Pride Catfish, Inc. for failure to state a claim. One other putative class action, Bensley Construction, Inc. v. Marsh & McLennan Companies, Inc., et al. (Mass. Super. Ct. May 16, 2005), and one other individual action, Office Depot, Inc. v. Marsh & McLennan Companies, Inc., et al. (Fla. Cir. Ct. June 22, 2005), have been filed in state court and assert claims that are similar to those asserted in In re Insurance Brokerage Antitrust Litigation against various brokers and insurers, including the Company and/or certain of its affiliates, but have not been consolidated with In re Insurance Brokerage Antitrust Litigation. Certain defendants in Bensley Construction, Inc., including the Company, have removed the action to the United States District Court for the District of Massachusetts. On February 13, 2006, the action was transferred to the District of New Jersey for coordination with In re Insurance Brokerage Antitrust Litigation. Office Depot, Inc. was brought in Florida state court and names several of the Company’s subsidiaries. On November 9, 2005, the court entered an order staying Office Depot pending resolution of In re Insurance Brokerage Antitrust Litigation. The plaintiff in Office Depot, Inc. has appealed. The Company believes that these lawsuits have no merit and intends to defend vigorously.
Investment Commitments-The Company has long-term commitments to fund venture capital investments through its subsidiary, St. Paul Venture Capital VI, LLC, through new and existing partnerships and certain other venture capital entities. The Company’s total future estimated obligations related to its venture capital investments were $128 million and $289 million at December 31, 2005 and 2004, respectively. The Company also has unfunded commitments to partnerships, joint ventures and certain private equity investments in which it invests. These additional commitments were $803 million and $483 million at December 31, 2005 and 2004, respectively.
In the ordinary course of selling business entities to third parties, the Company has agreed to indemnify purchasers for losses arising out of breaches of representations and warranties with respect to the business entities being sold, covenants and obligations of the Company and/or its subsidiaries following the close, and in certain cases obligations arising from undisclosed liabilities, adverse reserve development or certain named litigation. Such indemnification provisions generally survive for periods ranging from 12 months following the applicable closing date to the expiration of the relevant statutes of limitations, or in some cases agreed upon term limitations. As of December 31, 2005, the aggregate amount of the Company’s obligation for those indemnifications that are quantifiable related to sales of business entities was $1.82 billion. Certain of these contingent obligations are subject to deductibles which have to be incurred by the obligee before the Company is obligated to make payments. Included in the indemnification obligations at December 31, 2005 was $172 million related to the Company’s variable interest in Camperdown UK Limited, which SPC sold in December 2003. The Company’s variable interest results from an agreement to indemnify the purchaser in the event a specified reserve deficiency develops, a reserve-related foreign exchange impact occurs, or a foreign tax adjustment is imposed on a pre-sale reporting period. The fair value of this obligation as of December 31, 2005 was $66 million, which was included in “Other Liabilities” on the Company’s consolidated balance sheet.
In July 2002, concurrent with the issuance of 17.8 million of SPC common shares in a public offering, SPC issued 8.9 million equity units, each having a stated amount of $50, for gross consideration of $442 million. Each equity unit initially consisted of a forward purchase contract for the Company’s common stock, which matured in August 2005, and an unsecured $50 senior note of the Company (maturing in 2007). Total annual distributions on the equity units were at the rate of 9.00%, consisting of interest on the note at a rate of 5.25% and fee payments under the forward contract of 3.75%. Holders of the equity units had the opportunity to participate in a required remarketing of the senior note component. The initial remarketing date was May 11, 2005. On that date, the notes were successfully remarketed, and the interest rate on the notes was reset to 5.01%, from 5.25%, effective May 16, 2005. The remarketed notes mature on August 16, 2007. There were no other significant noncash financing or investing activities during the year ended December 31, 2005.
There were no significant noncash financing or investing activities during the years ended December 31, 2004 and 2003, other than the acquisition of SPC in 2004 (see note 2).
The amounts shown in the “TPC” and “Other Subsidiaries” columns in the following consolidating financial statements are not directly comparable between 2005 and 2004. During 2005, the Company combined the previously separate St. Paul Insurance Group and Travelers Property Casualty reinsurance pools, forming the new St. Paul Travelers Reinsurance Pool effective July 1, 2005, retroactive to January 1, 2005. As a result, the “TPC” and “Other Subsidiaries” columns of the consolidating financial statements for 2005 reflect the impact of allocations of revenues, losses and expenses made pursuant to the respective entities’ participation level in the newly combined pool.
(1) Due to the averaging of shares, quarterly earnings per share may not add to the total for the full year. Historical earnings per share data for the first quarter of 2004 were restated to reflect the impact of the merger with SPC.