Selected financial data for the five years ended December 31, 1998 are incorporated by reference from the Corporation's 1998 Annual Report to Shareholders, pages 38 and 39.
Certain statements in this document, as well as certain statements incorporated by reference herein, may be considered to be "forward looking statements" as that term is defined in the Private Securities Litigation Reform Act of 1995, such as statements that include the words or phrases "will likely result", "are expected to", "will continue", "is anticipated", "estimate", "project" or similar expressions. Such statements are subject to certain risks and uncertainties. The factors which could cause actual results to differ materially from those suggested by any such statements include, but are not limited to, those discussed or identified from time to time in the Corporation's public filings with the Securities and Exchange Commission and specifically to: risks or uncertainties associated with the Corporation's expectations with respect to premium price increases, the non-renewal of underpriced insurance accounts, business profitability or growth estimates, as well as with respect to its activity value analysis program, investment income or cash flow projections, its announced real estate plans, or the timing or earnings impact of the announced Executive Risk transaction, and more generally, to: general economic conditions including changes in interest rates and the performance of the financial markets, changes in domestic and foreign laws, regulations and taxes, changes in competition and pricing environments, regional or general changes in asset valuations, the occurrence of significant natural disasters, the development of major Year 2000 liabilities, the inability to reinsure certain risks economically, the adequacy of loss reserves, Euro or currency conversion transactions, as well as general market conditions, competition, pricing and restructurings.
Operating income from continuing operations, which excludes realized investment gains and losses, was $615 million in 1998 compared with $701 million in 1997 and $434 million in 1996. Operating income in 1998 reflects a first quarter restructuring charge of $26 million after taxes related to the implementation of a cost control initiative. Operating income in 1996 reflects a fourth quarter charge of $160 million after taxes related to the write-down of the carrying value of certain real estate assets.
In May 1997, the Corporation completed the sale of its life and health insurance operations. The life and health insurance operations have been classified as discontinued operations.
Reported net premiums written amounted to $5.5 billion in 1998, an increase of 1% compared with 1997. Reported net premiums written increased 14% in 1997 compared with 1996. Personal coverages accounted for $1.4 billion or 25% of 1998 premiums written and commercial coverages for $4.1 billion or 75%. The reported growth in premiums written in 1998 and 1997 was affected by changes in certain reinsurance agreements, which are discussed below.
After a review of the costs and benefits of our casualty excess of loss reinsurance program, effective January 1, 1996, we modified the program, principally for the excess liability and executive protection classes. The changes included an increase in the initial retention for each loss from $5 million to $10 million and an increase in the initial aggregate amount of losses retained for each year before reinsurance responds. These changes in our casualty reinsurance program increased net premiums written in 1996 by approximately $130 million compared with the prior year. During 1996, we continued to evaluate the relative costs and benefits of the program. As a result, effective January 1, 1997, we again modified the program, increasing the initial retention for each loss from $10 million to $25 million. This change in our casualty reinsurance program increased net premiums written in 1997 by approximately $65 million compared with 1996. These changes have had a positive impact on the cash flows and resulting investment income of the property and casualty subsidiaries.
Our expense ratio was 33.5% in 1998 compared with 32.4% in 1997 and 32.1% in 1996. The increase in the ratio in 1998 was due primarily to an increase in commission expense caused in part by higher contingent payments and also to written premiums growing at a somewhat lesser rate than overhead expenses.
During the fourth quarter of 1997, we began an activity value analysis process to identify and eliminate low-value activities and to improve operational efficiency in order to reduce expenses and redirect resources to those current activities and new initiatives having the greatest potential to contribute to the future results of the Corporation. Implementation began in the first quarter of 1998 and is substantially completed. This cost control initiative has resulted in approximately 500 job reductions in the home office and the branch network through a combination of early retirements, terminations and attrition. Other savings involve vendor management, consulting expenses and other operating costs. The initiative is expected to result in annual cost savings of approximately $150 million, beginning in 1999.
In the first quarter of 1998, we recorded a restructuring charge of $40 million, or $26 million after taxes, related to the implementation of the cost control initiative. The restructuring charge relates primarily to costs associated with providing enhanced pension benefits to employees who accepted an early retirement incentive offer, severance costs and other costs.
Net premiums written, as adjusted, increased 10% in 1998 compared with 1997 and 9% in 1997 compared with 1996. We continued to grow our homeowners and other non-automobile business in non-catastrophe prone areas while maintaining our disciplined approach to pricing and risk selection. Personal automobile premiums grew as a result of an increase in the number of in-force policies for high-value automobiles.
Our personal insurance business produced substantial underwriting profits in each of the past three years. The combined loss and expense ratio was 85.6% in 1998 compared with 83.1% in 1997 and 91.7% in 1996.
The profitability of our homeowners business each year is affected substantially by the amount of catastrophe losses we incur. Homeowners results were profitable by a similar margin in 1998 and 1997 as a reduction in the frequency of non-catastrophe related losses in 1998 substantially offset an increase in catastrophe losses. Results for this class were unprofitable in 1996 as catastrophe losses, particularly those caused by the winter storms, adversely affected results. Catastrophe losses represented 8.5 percentage points of the loss ratio for this class in 1998 compared with 2.9 percentage points in 1997 and 16.7 percentage points in 1996.
Other personal coverages, which include insurance for personal valuables and excess liability, were highly profitable in each of the past three years. Personal excess liability profitability increased in 1997 due to favorable loss experience but decreased somewhat in 1998 due to an increase in the frequency of large losses.
Reported premiums from commercial insurance were virtually unchanged in 1998 compared with 1997. Reported premiums in 1997 were 17% higher than in 1996. The effect on net premiums written of the changes to the reinsurance agreement with Sun Alliance was as follows:
Results for our casualty business were similarly unprofitable in each of the past three years. In each year, casualty results were adversely affected by incurred losses relating to asbestos and toxic waste claims, but more so in 1996. The excess liability component of our casualty coverages was slightly unprofitable in 1998 compared with profitable results in 1997 and 1996 due to declining prices and an increase in the frequency of losses. Excess liability results in 1998 benefited from favorable development on certain case reserves set up several years ago. Results for the primary liability component were unprofitable in each of the past three years, but more so in 1997 and 1996 due to a higher frequency of losses in those years. Results in the automobile component were more unprofitable in 1998 than in 1997 compared with breakeven results in 1996. The deterioration in 1997 and again in 1998 was due to an increase in the frequency of large losses.
Workers' compensation results were unprofitable in each of the past three years. Results deteriorated in 1997 and again in 1998 due in large part to the cumulative effect of price reductions over the past several years. Results were also adversely affected in 1998 by several large losses.
Property and marine results were unprofitable in 1998 and 1997, but more so in 1998, compared with profitable results in 1996. Results in 1998 and 1997 were adversely affected by an increase in the frequency of large losses, including several large overseas losses. Results in all three years were adversely affected by catastrophe losses. Catastrophe losses for this class represented 5.7 percentage points of the loss ratio in 1998 compared with 4.9 percentage points in 1997 and 4.5 percentage points in 1996.
During 1998, we experienced overall favorable development of $218 million on loss reserves established as of the previous year-end. This compares with favorable development of $65 million in 1997 and $43 million in 1996. Such redundancies were reflected in operating results in these respective
years. Each of the past three years benefited from favorable claim severity trends for certain liability classes; this was offset each year in varying degrees by losses incurred relating to asbestos and toxic waste claims. The higher favorable development in 1998 compared with the prior years was due to substantially lower incurred losses related to asbestos and toxic waste claims, the continued favorable loss experience for executive protection coverages and favorable development on certain excess liability case reserves set up several years ago.
The process of establishing loss reserves is a complex and imprecise science that reflects significant judgmental factors. This is true because claim settlements to be made in the future will be impacted by changing rates of inflation and other economic conditions, changing legislative, judicial and social environments and changes in our claim handling procedures. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured loss, the reporting of the loss and the settlement of the loss. In fact, approximately 60% of our net loss reserves at December 31, 1998 were for IBNR -- claims that had not yet been reported to us, some of which were not yet known to the insured, and for future development on reported claims.
Judicial decisions and legislative actions continue to broaden liability and policy definitions and to increase the severity of claim payments. As a result of this and other societal and economic developments, the uncertainties inherent in estimating ultimate claim costs on the basis of past experience continue to further complicate the already complex loss reserving process.
We have additional potential asbestos exposure, primarily on insureds for which we wrote excess liability coverages. Such exposure has increased due to the erosion of much of the underlying limits. The number of claims against such insureds and the value of such claims have increased in recent years due in part to the non-viability of other defendants.
Our remaining asbestos exposures are mostly peripheral defendants, including a mix of manufacturers and distributors of certain products that contain asbestos as well as premises owners. Generally, these insureds are named defendants on a regional rather than a nationwide basis. We continue to receive notices of new asbestos claims and new exposures on existing claims as more peripheral parties are drawn into litigation to replace the now defunct mines and bankrupt manufacturers.
There is great uncertainty involved in estimating our liabilities related to these claims. First, the liabilities of the claimants are extremely difficult to estimate. At any given site, the allocation of remediation costs among governmental authorities and the PRPs varies greatly. Second, different courts have addressed liability and coverage issues regarding pollution claims and have reached
inconsistent conclusions in their interpretation of several issues. These significant uncertainties are not likely to be resolved definitively in the near future.
Management believes that the aggregate loss reserves of the property and casualty subsidiaries at December 31, 1998 were adequate to cover claims for losses which had occurred, including both those known to us and those yet to be reported. In establishing such reserves, management considers facts currently known and the present state of the law and coverage litigation. However, given the expansion of coverage and liability by the courts and the legislatures in the past and the possibilities of similar interpretations in the future, particularly as they relate to asbestos and toxic waste claims, as well as the uncertainty in determining what scientific standards will be deemed acceptable for measuring hazardous waste site clean-up, additional increases in loss reserves may emerge which would adversely affect results in future periods. The amount cannot reasonably be estimated at the present time.
The Corporation's property and casualty subsidiaries have an exposure to insured losses caused by hurricanes, earthquakes, winter storms, windstorms and other catastrophic events. The frequency and severity of catastrophes are unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in an area affected by the event and the severity of the event. We continually assess our concentration of underwriting exposures in catastrophe prone areas and develop strategies to manage this exposure through individual risk selection, subject to regulatory constraints, and through the purchase of catastrophe reinsurance. In recent years, we have invested in modeling technologies that allow us to better monitor catastrophe exposures. We also continue to explore and
The effective tax rate on our investment income was 15.3% in 1998 compared with 16.7% in 1997 and 15.8% in 1996. The effective tax rate increased in 1997 and then decreased in 1998 due to changes in the percentage of our investment income subject to tax.
New cash available for investment by the property and casualty subsidiaries was approximately $860 million in 1998 compared with $1,260 million in 1997 and $1,150 million in 1996. New cash in 1997 and 1996 included approximately $330 million and $40 million, respectively, received as the net result of the portfolio transfers of unearned premiums and loss reserves as of January 1 of each year related to the changes to the reinsurance agreements with Sun Alliance. New cash in 1996 also included $191 million received in January as a result of the commutation of a stop loss reinsurance agreement related to medical malpractice unpaid claims arising from business written prior to 1985.
1996. As a result, we recorded an impairment loss of $255 million, or $160 million after taxes, in the fourth quarter of 1996 to reduce the carrying value of these assets to their estimated fair value.
In June 1997, a definitive agreement was reached with the purchaser. In November 1997, the sale of almost all of the properties covered by the agreement reached in June was closed for $737 million, which included $628 million in cash and the assumption of $109 million in debt. The buyer is a joint venture formed by Paine Webber Real Estate Securities Inc., Morgan Stanley Real Estate Fund II, L.P. and Gale & Wentworth, L.L.C. Closing on the one remaining property under the agreement is expected to occur in 1999.
In addition to the sale to the joint venture in November 1997, we sold several other commercial properties as well as residential properties in 1997 and 1998. We are continuing to explore the sale of certain of our remaining properties.
Loans receivable, which were issued in connection with our joint venture activities and other property sales, are primarily purchase money mortgages. Such loans, which amounted to $105 million at December 31, 1998, are generally collateralized by buildings and, in some cases, land. We continually evaluate the ultimate collectibility of such loans and establish appropriate reserves.
Real estate activities were funded in the past with short-term credit instruments, primarily commercial paper, and debt issued by Chubb Capital Corporation as well as with term loans and mortgages. Proceeds from the November 1997 sale were used to repay the outstanding short-term debt and certain term loans and mortgages as well as to reduce intercompany borrowings from Chubb Capital. In February 1998, the remaining $300 million of intercompany borrowings from Chubb Capital was converted into preferred stock of the real estate subsidiary. In 1998, the interest rate on the remaining term loan approximated 7 1/2% and for mortgages the range of interest rates was 6% to 12%.
Market risk represents the potential for loss due to adverse changes in the fair value of financial instruments. The market risks related to financial instruments of the Corporation and its property and casualty subsidiaries primarily relate to the investment portfolio, which exposes the Corporation to risks related to interest rates and, to a lesser extent, credit quality, prepayment, foreign currency exchange rates and equity prices. Analytical tools and monitoring systems are in place to assess each of these elements of market risk.
Interest rate risk is the price sensitivity of a fixed income security to changes in interest rates. We view these potential changes in price within the overall context of asset and liability management. Our actuaries estimate the payout pattern of our liabilities, primarily our property and casualty loss reserves, to determine their duration, which is the present value of the weighted average payments expressed in years. We set duration targets for our fixed income investment portfolios after consideration of the duration of these liabilities and other factors, which we believe mitigates the overall effect of interest rate risk for the Corporation and its property and casualty subsidiaries.
liquid markets and market value information is readily available from broker/dealers. An additional 40% of our mortgage-backed securities were call protected AAA rated commercial securities. The remaining mortgage-backed holdings were all investment grade commercial mortgage-backed securities.
Foreign currency risk is the sensitivity to foreign exchange rate fluctuations of the market value and investment income related to foreign currency denominated financial instruments. The functional currency of our foreign operations is generally the currency of the local operating environment since their business is primarily transacted in such local currency. We reduce the risks relating to currency fluctuations by maintaining investments in those foreign currencies in which we have unpaid claims and other liabilities. Such investments have characteristics similar to our liabilities in those currencies. At December 31, 1998, the property and casualty subsidiaries held foreign investments of $1.2 billion supporting their international operations. Such foreign investments have quality and maturity characteristics similar to our domestic portfolio. The principal currencies creating foreign exchange rate risk for the property and casualty subsidiaries are the Canadian dollar and the British pound sterling. The table below provides information about those fixed maturity investments included in the table on page 28 that are denominated in these two currencies. The table presents cash flows of principal amounts in U.S. dollar equivalents by expected maturity dates at December 31, 1998 and 1997. Actual cash flows could differ from the expected amounts.
The Year 2000 issue relates to the inability of certain information technology (IT) systems and applications as well as non-IT systems, such as equipment with imbedded chips and microprocessors, to properly process data containing dates beginning with the year 2000. The issue exists because many
The team performed an inventory and assessment of our mainframe systems to determine which must be retired, renovated or rewritten as a result of Year 2000 issues. As of December 31, 1998, we completed remediation and testing procedures on 95% of our mainframe IT systems, including all mission critical systems except one. We expect to complete the remediation and testing of all remaining systems by June 1999.
We have also completed an inventory and assessment of all our personal computers, servers and other non-mainframe computers. We expect that all such computers and related software will be Year 2000 ready by the third quarter of 1999. We have also assessed our non-IT systems and believe that the failure of any of these systems would have minimal impact on our operations.
We believe that we are taking the necessary measures to address Year 2000 issues that may arise and that our internal systems will be compliant. Notwithstanding such efforts, significant Year 2000 problems could arise. In particular, the prolonged failure of power and telecommunications systems could have a material adverse effect on our operations. Similarly, Year 2000 related difficulties experienced by our producers or financial institutions have the potential to materially disrupt our business. Given the uncertain nature of Year 2000 problems that may arise, management cannot determine at this time whether the consequences of Year 2000 related problems will have a material impact on the Corporation's financial position or results of operations.
We expect that the cost to address the Year 2000 IT systems issue, including compensation of employees and the cost of consultants, will approximate $36 million. Approximately $30 million was incurred as of December 31, 1998, of which $14 million was incurred in 1998. These amounts do not include the cost of computer equipment purchased to replace equipment that would have been upgraded in the normal course of business, but not necessarily prior to January 2000.
We have identified the systems and operational issues related to the impact of the adoption of the euro on our European property and casualty operations. We were prepared to transact euro denominated business as of January 1, 1999. We will address additional systems issues over the three year transition period. The adoption of the euro is not expected to have a material effect on the Corporation's financial position or results of operations.
In February 1994, the Board of Directors authorized the repurchase of up to 10,000,000 shares of common stock. Through March 1997, the Corporation had repurchased 6,851,600 shares under the 1994 share repurchase authorization. In March 1997, the Board of Directors replaced the 1994 authorization with a new authorization to repurchase up to 17,500,000 shares of common stock. On July 24, 1998, the Board of Directors authorized the repurchase of up to an additional 12,500,000 shares. Through December 31, 1998, the Corporation had repurchased 17,994,900 shares under the 1997 and 1998 authorizations. As of December 31, 1998, 12,005,100 shares remained under the current share repurchase authorizations. In the aggregate, the Corporation repurchased 8,203,000 shares in open-market transactions in 1998 at a cost of $609 million, 12,940,500 shares in 1997 at a cost of $828 million and 1,700,000 shares in 1996 at a cost of $83 million.
The Corporation also has outstanding $30 million of unsecured 8 3/4% notes due in 1999. Chubb Capital has outstanding $100 million of 6 7/8% notes due in 2003. The Chubb Capital notes are unsecured and are guaranteed by the Corporation.
In July 1997, the Corporation entered into two credit agreements with a group of banks that provide for unsecured borrowings of up to $500 million in the aggregate. The $200 million short term revolving credit facility, which terminated on July 10, 1998, was extended to July 7, 1999, and may be renewed or replaced. The $300 million medium term revolving credit facility terminates on July 11, 2002. On the respective termination dates, any loans then outstanding become payable. There have been no borrowings under these agreements. These facilities are available for general corporate purposes and to support Chubb Capital's commercial paper borrowing arrangement.
On February 8, 1999, the Corporation announced that it entered into a definitive merger agreement under which it would acquire Executive Risk Inc. Executive Risk is a specialty insurance company offering directors and officers, errors and omissions and professional liability coverages. Executive Risk's gross and net written premiums for 1998 were approximately $500 million and $280 million, respectively.
The acquisition will be accounted for using the purchase method of accounting. The agreement provides that Executive Risk shareholders will receive 1.235 shares of the Corporation's common stock for each outstanding common share of Executive Risk. The agreement contemplates that approximately 13,730,000 shares of common stock of the Corporation will be issued to Executive Risk shareholders and approximately 2,300,000 shares of common stock of the Corporation will be reserved for issuance upon exercise of Executive Risk stock options. The total value of the transaction is expected to be approximately $850 million. Completion of the acquisition is subject to approval by Executive Risk shareholders and various regulatory authorities. Closing is expected in the second quarter of 1999.
The Corporation has agreed to purchase a 27% interest in Hiscox plc, a leading U.K. personal and commercial specialty insurer, for approximately $140 million. Closing of this transaction is subject to regulatory approvals which are pending.
In March 1998, the American Institute of Certified Public Accountants issued Statement of Position (SOP) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. This SOP requires that certain costs incurred to develop or obtain computer software for internal use should be capitalized and amortized over the software's expected useful life. Currently, we expense all development costs of internal use computer software. SOP 98-1 is effective for the Corporation on January 1, 1999 and is to be applied prospectively. The adoption of SOP 98-1 will increase the Corporation's net income in 1999 by an amount that has not yet been quantified. The effect on net income will decrease in future years as the new method of accounting is phased in.