Most of our business can be characterized as long-tail. For long-tail business, it will generally be several years between the time the business is written and the time when all claims are settled. Our long-tail exposures include commercial automobile liability, workers' compensation, general liability, medical professional liability, other professional liability and management liability coverages, assumed reinsurance run-off and products liability. Short-tail exposures include property, commercial automobile physical damage, marine, surety and warranty. Specialty, Commercial and International contain both long-tail and short-tail exposures. Corporate & Other contains long-tail exposures.
consideration of several factors, including the impact of inflation on claims costs, the rate at which claims professionals make claim payments and close claims, the impact of judicial decisions, the impact of underwriting changes, the impact of large claim payments and other factors. Claim cost inflation itself may require evaluation of changes in the cost of repairing or replacing property, changes in the cost of medical care, changes in the cost of wage replacement, judicial decisions, legislative changes and other factors. Because this method assumes that losses are paid at a consistent rate, changes in any of these factors can affect the results. Since the method does not rely on case reserves, it is not directly influenced by changes in their adequacy.
Stochastic modeling produces a range of possible outcomes based on varying assumptions related to the particular reserve group being modeled. For some reserve groups, we use models which rely on historical development patterns at an aggregate level, while other reserve groups are modeled using individual claim variability assumptions supplied by the claims department. In either case, multiple simulations using varying assumptions are run and the results are analyzed to produce a range of potential outcomes. The results will typically include a mean and percentiles of the possible reserve distribution which aid in the selection of a point estimate.
Professional liability, management liability and surety products include professional liability coverages provided to various professional firms, including architects, real estate agents, small and mid-sized accounting firms, law firms and other professional firms. They also include directors and officers (D&O), employment practices, fiduciary, fidelity and surety coverages, as well as insurance products serving the healthcare delivery system. The most significant factor affecting reserve estimates for these liability coverages is claim severity. Claim severity is driven by the cost of medical care, the cost of wage replacement, legal fees, judicial decisions, legislative changes and other factors. Underwriting and claim handling decisions such as the classes of business written and individual claim settlement decisions can also affect claim severity. If the estimated claim severity increases by 9%, we estimate that net reserves would increase by approximately $450 million. If the estimated claim severity decreases by 3%, we estimate that net reserves would decrease by approximately $150 million. Our net reserves for these products were approximately $5.0 billion as of December 31, 2017.
The actuarial assumptions that management believes are subject to the most variability are morbidity, persistency, discount rate and anticipated future premium rate increases. Persistency can be affected by policy lapses, benefit reductions and death. Discount rate is influenced by the investment yield on assets supporting long term care reserves which is subject to interest rate and market volatility and may also be affected by changes to the Internal Revenue Code. There is limited historical company and industry data available to us for long term care morbidity and mortality, as only a portion of the policies written to date are in claims paying status. As a result of this variability, our long term care reserves may be subject to material increases if actual experience develops adversely to our expectations.
Annually, management assesses the adequacy of its long term care future policy benefit reserves by performing a gross premium valuation (GPV) to determine if there is a premium deficiency. Management also uses the GPV process to evaluate the adequacy of the claim and claim adjustment expense reserves for structured settlement obligations. Under the GPV, management estimates required reserves using best estimate assumptions as of the date of the assessment without provisions for adverse deviation. The GPV required reserves are then compared to the recorded reserves. If the GPV required reserves are greater than the existing recorded reserves, the existing assumptions are unlocked and future policy benefit reserves are increased to the greater amount. Any such increase is reflected in our results of operations in the period in which the need for such adjustment is determined, and could materially adversely affect our results of operations, equity and business and insurer financial strength and corporate debt ratings. Periodically, management engages independent third parties to assess the appropriateness of its best estimate assumptions and the associated GPV required reserves. The most recent assessment by an independent third party was performed in 2017.
The December 31, 2017 GPV indicated our recorded reserves included a margin of approximately $246 million. A summary of the changes in the estimated reserve margin is presented in the table below:
We expect the overall provisions of the Tax Reform Legislation will have a positive impact on future periods by lowering the effective tax rate and increasing after-tax earnings, primarily due to the reduction in the Federal corporate income tax rate. The reduction in income taxes will also enhance cash flow.
Although the Tax Reform Legislation initially reduced our combined statutory surplus in the period of enactment, statutory surplus remains well above minimum regulatory requirements and dividend capacity was not significantly affected.
The following table includes the consolidated results of our operations including our financial measure, Core income. For more detailed components of our business operations and the core income financial measure, see the segment discussions within this MD&A. For further discussion of Net investment income and Net realized investment results, see the Investments section of this MD&A.
Core income increased $95 million in 2017 as compared to 2016. Core income for our Property & Casualty Operations declined $23 million primarily driven by higher net catastrophe losses partially offset by improved non-catastrophe current accident year underwriting results. Net catastrophe losses were $259 million after tax in 2017 as compared to $111 million after tax in 2016. Core loss for our operations outside of Property & Casualty Operations improved $118 million driven by lower adverse prior year A&EP reserve development.
Core income increased $309 million in 2016 as compared with 2015. Core results increased $293 million for our operations outside of Property & Casualty Operations primarily as a result of a $198 million after-tax charge in 2015 related to increasing long term care active life and claim reserves. As our active life reserve assumptions were unlocked in 2015, long term care results in 2016 improved significantly. Core income increased $16 million for our Property & Casualty Operations due to higher favorable net prior year reserve development and net investment income, partially offset by an increase in the current accident year loss ratio and higher underwriting expenses. Net catastrophe losses were $111 million after tax in 2016 as compared to $95 million after tax in 2015.
Favorable net prior year development of $314 million and $218 million was recorded in 2016 and 2015 related to our Specialty, Commercial, International and Corporate & Other segments. Further information on net prior year development is in Note E to the Consolidated Financial Statements included under Item 8.
Our property and casualty commercial insurance operations are managed and reported in three business segments: Specialty, Commercial and International, which we refer to collectively as Property & Casualty Operations. Specialty provides a broad array of professional, financial and specialty property and casualty products and services through a network of independent agents, brokers and managing general underwriters. Commercial includes property and casualty coverages sold to small businesses and middle market entities and organizations primarily through an independent agency distribution system. Commercial also includes commercial insurance and risk management products sold to large corporations primarily through insurance brokers. International provides management and professional liability coverages as well as a broad range of other property and casualty insurance products and services abroad through a network of brokers, independent agencies and managing general underwriters, as well as the Lloyd’s marketplace.
Effective January 1, 2018, management is changing the segment presentation of our life sciences business and technology and media related errors and omissions (E&O) business within the Specialty and Commercial business segments. Our life sciences business provides product liability and other coverages such as property and workers compensation associated with the life sciences industry. Approximately $100 million of net written premium related to the life sciences business will move from the Specialty business segment to the Commercial business segment. Our technology and media related E&O business provides network security and privacy, media and E&O coverage primarily for technology risks. Approximately $70 million of net written premium related to this business will move from the Commercial business segment to the Specialty business segment. We believe the new management responsibility for these businesses better aligns with line of business underwriting expertise and the manner in which the products are sold. The new classifications will be presented in the Company’s financial statements beginning with the period ending March 31, 2018, and prior periods presented will conform to the new presentation.
What we previously referred to as net operating income (loss) in our public disclosures, we now refer to as core income (loss). The fourth quarter 2017 net deferred tax asset remeasurement was excluded from core income (loss) for the year ended December 31, 2017. Otherwise, there were no changes to the calculation of this measure. We utilize the core income (loss) financial measure to monitor our operations. Core income (loss) is calculated by excluding from net income (loss) the after-tax effects of i) net realized investment gains or losses, ii) income or loss from discontinued operations, iii) any cumulative effects of changes in accounting guidance and iv) deferred tax asset and liability remeasurement as a result of an enacted U.S. Federal tax rate change. The calculation of core income (loss) excludes net realized investment gains or losses because net realized investment gains or losses are generally driven by economic factors that are not necessarily consistent with key drivers of underwriting performance, and are therefore not considered an indication of trends in insurance operations. Management monitors core income (loss) for each business segment to assess segment performance. Presentation of consolidated core income (loss) is deemed to be a non-GAAP financial measure. See further discussion regarding how we manage our business and reconciliations of non-GAAP measures to the most comparable GAAP measures and other information in Note O to the Consolidated Financial Statements included under Item 8.
The loss ratio is the percentage of net incurred claim and claim adjustment expenses to net earned premiums. The expense ratio is the percentage of insurance underwriting and acquisition expenses, including the amortization of deferred acquisition costs, to net earned premiums. The dividend ratio is the ratio of policyholders' dividends incurred to net earned premiums. The combined ratio is the sum of the loss, expense and dividend ratios. In addition we also utilize renewal premium change, rate, retention and new business in evaluating operating trends. Renewal premium change represents the estimated change in average premium on policies that renew, including rate and exposure changes. Rate represents the average change in price on policies that renew excluding exposure change. Retention represents the percentage of premium dollars renewed in comparison to the expiring premium dollars from policies available to renew. Renewal premium change, rate and retention presented for the prior year are updated to reflect subsequent activity on policies written in the period. New business represents premiums from policies written with new customers and additional policies written with existing customers.
Changes in estimates of claim and claim adjustment expense reserves and premium accruals, net of reinsurance, for prior years are defined as net prior year development within this MD&A. These changes can be favorable or unfavorable. Net prior year development does not include the effect of related acquisition expenses. Further information on our reserves is provided in Note E to the Consolidated Financial Statements included under Item 8.
Warranty and Alternative Risks provides extended service contracts and related products that provide protection from the financial burden associated with mechanical breakdown and other related losses, primarily for vehicles and cell phones.
Core income decreased $40 million in 2017 as compared with 2016, primarily due to lower favorable net prior year loss reserve development and higher net catastrophe losses partially offset by improved non-catastrophe current accident year underwriting results and higher net investment income.
The combined ratio decreased 3.7 points in 2016 as compared with 2015. The loss ratio decreased 4.6 points due to higher favorable net prior year reserve development partially offset by a higher current accident year loss ratio. Net catastrophe losses were $18 million, or 0.6 points of the loss ratio, for 2016 as compared to $13 million, or 0.4 points of the loss ratio, for 2015. The expense ratio increased 0.9 points in 2016 as compared with 2015, due to higher employee costs and higher IT spending primarily related to new underwriting platforms.
Net written premiums for Commercial increased $41 million in 2017 as compared with 2016 driven by higher new business within Middle Markets, strong retention and positive renewal premium change. This was partially offset by an unfavorable premium rate adjustment within Small Business that is more fully discussed in Note F to the Consolidated Financial Statements under Item 8. The increase in net earned premium was consistent with the trend in net written premiums.
Core income increased $30 million in 2017 as compared with 2016, due to the favorable period over period effect of net prior year loss reserve development and improved non-catastrophe current accident year underwriting results partially offset by higher net catastrophe losses.
The combined ratio increased 4.3 points in 2016 as compared to 2015. The loss ratio increased 3.6 points due to the unfavorable period over period effect of net prior year reserve development and a higher current accident year loss ratio due to higher large losses. Net catastrophe losses were $116 million, or 4.1 points of the loss ratio, for 2016 primarily driven by U.S. weather-related events, as compared to $101 million, or 3.6 points of the loss ratio, for 2015. The expense ratio increased 0.7 points in 2016 as compared with 2015, due to higher employee costs and higher IT spending primarily related to a new underwriting platform.
International provides property and casualty and specialty coverages on a global basis through its operations in Canada, the United Kingdom, Continental Europe and Singapore, as well as through its presence at Lloyd’s of London.
CNA Europe provides a diverse range of specialty products as well as commercial insurance products primarily in the marine, property, financial services and healthcare & technology industries throughout Europe on both a domestic and cross border basis.
(1) Beginning in 2016, new business includes Hardy. New business for Hardy was $151 million and $133 million for the years ended December 31, 2017 and 2016.
Net written premiums for International in 2016 were consistent with 2015 and includes favorable period over period premium development of $24 million. Excluding the effect of foreign currency exchange rates and premium development, net written premiums increased 1.4% in 2016. Excluding the effect of foreign currency exchange rates and premium development, the increase in net earned premiums was consistent with the trend in net written premiums.
Core income decreased $16 million in 2016 as compared with 2015, primarily due to a lower underwriting profit and foreign currency exchange losses.
Favorable net prior year development of $64 million and $36 million was recorded in 2016 and 2015. Further information on net prior year development is in Note E to the Consolidated Financial Statements included under Item 8.
The Life & Group segment primarily includes the results of our long term care business that is in run-off. Long term care policies were sold on both an individual and group basis. New enrollees in existing groups were accepted through February 1, 2016.
Due to the recognition of the premium deficiency and resetting of actuarial assumptions in the fourth quarter of 2015, the 2016 and 2015 results are not comparable. As a result of the reserve assumption unlocking in 2015, the core results of our long term care business in 2016 reflect the variance between actual experience and the expected results contemplated in our best estimate reserves.
In 2015, we recognized a $198 million after-tax charge relating to a premium deficiency and claim reserve strengthening. The December 31, 2015 GPV indicated a premium deficiency of $296 million. The indicated premium deficiency necessitated a charge to income that was affected by the write off of the entire long term care deferred acquisition cost of $289 million and an increase to active life reserves of $7 million. In 2015, results of our long term care business reflected variances between actual experience and actuarial assumptions that were locked-in at policy issuance.
Corporate & Other primarily includes certain corporate expenses, including interest on corporate debt and the results of certain property and casualty business in run-off, including CNA Re and A&EP.
Core loss increased $41 million in 2016 as compared with 2015. Results in both periods were negatively affected by after-tax charges related to the application of retroactive reinsurance accounting to adverse reserve development ceded under the 2010 A&EP Loss Portfolio Transfer. The Loss Portfolio Transfer drove $18 million of the year over year change. This is further discussed in Note E to the Consolidated Financial Statements included under Item 8.
The significant components of Net investment income are presented in the following table. Fixed income securities, as presented, include both fixed maturity and equity securities, which substantially consist of preferred stock.
Net investment income, after tax, increased $98 million in 2016 as compared with 2015. The increase was driven by limited partnership investments, which returned 6.3% in 2016 as compared with 3.0% in the prior year. Income from fixed income securities, after tax, increased $45 million primarily due to an increase in the invested asset base and a charge in 2015 related to a change in estimate effected by a change in accounting principle. See further discussion of the accounting change in Note A to the Consolidated Financial Statements included under Item 8.
Further information on our realized gains and losses, including our OTTI losses and derivative gains (losses), as well as our impairment decision process, is set forth in Notes A and B to the Consolidated Financial Statements included under Item 8.
As of December 31, 2017 and 2016, only 2% of our fixed maturity portfolio was rated internally.
The duration of the total portfolio is aligned with the cash flow characteristics of the underlying liabilities.
Premiums: Insurance premiums on property and casualty insurance contracts are recognized in proportion to the underlying risk insured and are principally earned ratably over the duration of the policies. Premiums on long term care contracts are earned ratably over the policy year in which they are due. The reserve for unearned premiums represents the portion of premiums written relating to the unexpired terms of coverage.
Claim and claim adjustment expense reserves are presented net of anticipated amounts due from insureds related to losses under deductible policies of $1.2 billion and $1.2 billion as of December 31, 2017 and 2016. A significant portion of these amounts are supported by collateral. The Company has an allowance for uncollectible deductible amounts, which is presented as a component of the allowance for doubtful accounts included in Insurance receivables on the Consolidated Balance Sheets.
Workers' compensation lifetime claim reserves are calculated using mortality assumptions determined through statutory regulation and economic factors. At December 31, 2017 and 2016, workers' compensation lifetime claim reserves are discounted at a 3.5% interest rate. As of December 31, 2017 and 2016, the discounted reserves for workers’ compensation lifetime claim reserves were $346 million and $371 million, net of discount of $190 million and $202 million. For the years ended December 31, 2017, 2016 and 2015 the amount of interest accretion recognized on the discounted reserves of workers’ compensation lifetime claim reserves was $19 million, $17 million and $20 million, respectively. This interest accretion is presented as a component of Insurance claims and policyholders' benefits on the Consolidated Statements of Operations, but is excluded from the Company's disclosure of prior year development.
Future policy benefit reserves: Future policy benefit reserves represent the active life reserves related to the Company's long term care policies and are computed using the net level premium method, which incorporates actuarial assumptions as to morbidity, persistency, inclusive of mortality, discount rate, future premium rate adjustments and expenses. Expense assumptions primarily relate to claim adjudication. Actuarial assumptions generally vary by plan, age at issue, policy duration and gender. The initial assumptions are determined at issuance, including a margin for adverse deviation, and are locked in throughout the life of the contract unless a premium deficiency develops. If a premium deficiency emerges, the assumptions are unlocked and deferred acquisition costs, if any, and the future policy benefit reserves are adjusted. The December 31, 2015 gross premium valuation (GPV) indicated a premium deficiency of $296 million. The indicated premium deficiency necessitated a charge to income that was affected by the write off of the entire long term care deferred acquisition cost asset of $289 million and an increase to active life reserves of $7 million. The GPV as of December 31, 2017 and 2016 indicated the carried reserves were sufficient; therefore there was no unlocking of assumptions. Interest rates for long term care active life reserves range from 6.6% to 7.0% as of December 31, 2017 and 2016.
Reinsurance receivables related to paid losses are presented at unpaid balances. Reinsurance receivables related to unpaid losses are estimated in a manner consistent with claim and claim adjustment expense reserves or future policy benefit reserves. Reinsurance receivables are reported net of an allowance for uncollectible amounts on the Consolidated Balance Sheets. The cost of reinsurance is primarily accounted for over the life of the underlying
reinsured policies using assumptions consistent with those used to account for the underlying policies or over the reinsurance contract period. The ceding of insurance does not discharge the primary liability of the Company.
A loss portfolio transfer is a retroactive reinsurance contract. If the cumulative claim and allocated claim adjustment expenses ceded under a loss portfolio transfer exceed the consideration paid, the resulting gain from such excess is deferred and amortized into earnings in future periods in proportion to actual recoveries under the loss portfolio transfer. In any period in which there is a gain position and a revised estimate of claim and allocated claim adjustment expenses, a portion of the deferred gain is cumulatively recognized in earnings as if the revised estimate was available at the inception date of the loss portfolio transfer.
The entire portfolio of life settlement contracts, which is included within the Life & Group segment, was determined to be held for sale as of December 31, 2016 as the Company reached an agreement on terms to sell the portfolio. As such, the Company adjusted the fair value to the estimated sales proceeds less cost to sell. This resulted in a $10 million loss recognized within Net realized investment gains for the year ended December 31, 2016. The definitive Purchase and Sale Agreement (PSA) related to the portfolio was executed on March 7, 2017 (sale date). In connection therewith, the life settlement contracts and related sale proceeds were placed in escrow until the buyer was recognized as the owner and beneficiary of each individual life settlement contract by the life insurance company that issued the policy. All of the contracts have been released from escrow as of December 31, 2017. The Company derecognized the released contracts and recorded the consideration, including a note receivable, which is payable over three years and is carried at amortized cost less any valuation allowance. The note receivable of $46 million is included within Other assets on the December 31, 2017 Consolidated Balance Sheet and interest income is accreted to the principal balance of the note.
The increase in fair value recognized in Other revenues for the years ended December 31, 2016 and 2015 on contracts still held at each respective period-end was $7 million and $1 million. The gains recognized during the years ended December 31, 2017, 2016 and 2015 on contracts that settled were $3 million, $8 million and $24 million.
The cost of fixed maturity securities classified as available-for-sale is adjusted for amortization of premiums and accretion of discounts, which are included in Net investment income on the Consolidated Statements of Operations. The amortization of premium and accretion of discount for fixed maturity securities takes into consideration call and maturity dates that produce the lowest yield. In 2015, the Company changed its accounting principle as previously the amortization of premiums was to maturity. This change in estimate effected by a change in accounting principle was adopted in the fourth quarter of 2015 and decreased Net investment income and the amortized cost of fixed maturity securities by $39 million in the Consolidated Statement of Operations for the year-ended December 31, 2015 and the Consolidated Balance Sheet as of December 31, 2015. The $39 million decrease to Net investment income included a $22 million cumulative adjustment relating to prior periods. The total adjustment decreased Basic and Diluted earnings per share by $0.09 for the year ended December 31, 2015.
prepayments change, the effective yield is recalculated to reflect actual payments to date and anticipated future payments.
To the extent that unrealized gains on fixed income securities supporting long term care products and structured settlements not funded by annuities would result in a premium deficiency if those gains were realized, a related increase in Insurance reserves is recorded, net of tax, as a reduction of net unrealized gains through Other comprehensive income (Shadow Adjustments). Shadow Adjustments, net of tax, increased $397 million and decreased $97 million for the years ended December 31, 2017 and 2016, respectively. As of December 31, 2017 and 2016, net unrealized gains on investments included in Accumulated other comprehensive income (AOCI) were correspondingly reduced by Shadow Adjustments of $1,411 million and $1,014 million.
The Company's carrying value of investments in limited partnerships is its share of the net asset value of each partnership, as determined by the general partner. Certain partnerships for which results are not available on a timely basis are reported on a lag, primarily three months or less. Changes in net asset values are accounted for under the equity method and recorded within Net investment income on the Consolidated Statements of Operations.
Mortgage loans are commercial in nature, are carried at unpaid principal balance, net of unamortized fees and any valuation allowance, and are recorded once funded. Interest income from mortgage loans is recognized on an accrual basis using the effective yield method. Mortgage loans are considered to be impaired loans when it is probable that contractual principal and interest payments will not be collected. The Company evaluates loans for impairment on a specific loan basis and identifies loans for evaluation of impairment based on the collection experience of each loan and other credit quality indicators such as debt service coverage ratio and the creditworthiness of the borrower or tenants of credit tenant loan properties. Accrual of income is generally suspended for mortgage loans that are impaired and collection of principal and interest payments is unlikely. Mortgage loans are considered past due when full principal or interest payments have not been received according to contractual terms. As of December 31, 2017 and 2016, there were no loans past due or in non-accrual status, and no valuation allowance was recorded.
Purchases and sales of all securities are recorded on the trade date, except for private placement debt securities, including bank loan participations, which are recorded once funded. Realized investment gains and losses are determined on the basis of the cost or amortized cost of the specific securities sold.
In the normal course of investing activities, the Company enters into relationships with variable interest entities (VIEs), as both an investor in limited partnerships and asset-backed securities issued by third-party VIEs. The Company is not the primary beneficiary of these VIEs, and therefore does not consolidate them. The Company determines whether it is the primary beneficiary of a VIE based on a qualitative assessment of the relative power and benefits of the Company and the other participants in the VIE. The Company’s maximum exposure to loss with respect to these investments is limited to the investment carrying values included in the Company’s Consolidated Balance Sheets and any unfunded commitments.
The Company applies the same impairment model as described above for the majority of its non-redeemable preferred stock securities on the basis that these securities possess characteristics similar to debt securities. For all other equity securities, in determining whether the security is other-than-temporarily impaired, the Company considers a number of factors including, but not limited to: (a) the length of time and the extent to which the fair value has been less than amortized cost, (b) the financial condition and near term prospects of the issuer, (c) the intent and ability of the Company to retain its investment for a period of time sufficient to allow for an anticipated recovery in value and (d) general market conditions and industry or sector specific outlook.
Foreign currency translation gains and losses are reflected in Stockholders' equity as a component of AOCI. The Company's foreign subsidiaries' balance sheet accounts are translated at the exchange rates in effect at each reporting date and income statement accounts are either translated at the exchange rate on the date of the transaction or at the average exchange rates. Foreign currency transaction gains (losses) of $27 million, $(9) million and $(11) million were included in determining Net income (loss) for the years ended December 31, 2017, 2016 and 2015.
Cash payments made for interest were $155 million, $157 million and $152 million for the years ended December 31, 2017, 2016 and 2015. Cash payments made for income taxes were $152 million, $170 million and $310 million for the years ended December 31, 2017, 2016 and 2015.
In January 2016, the FASB issued ASU No. 2016-01, Financial Instruments-Overall (Subtopic 825-10): Recognition and Measurement of Financial Assets and Financial Liabilities. The updated accounting guidance requires changes to the reporting model for financial instruments. The guidance is effective for interim and annual periods beginning after December 15, 2017. The Company expects the primary change to be the requirement for equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. The Company will recognize a cumulative effect adjustment to Retained earnings and AOCI for the net of tax amount of unrealized investment gains and losses related to available-for-sale equity securities at the date of adoption. At adoption, the Company estimates this new guidance will result in an after-tax increase to Retained earnings and a decrease to AOCI of $28 million. Subsequent to adoption, changes in the fair value of equity securities will be reported as Net realized investment gains (losses) in the Company's Consolidated Statement of Operations, which will introduce additional volatility in the Company's results of operations.
The following table presents the activity related to the pretax credit loss component reflected in Retained earnings on fixed maturity securities still held as of December 31, 2017, 2016 and 2015 for which a portion of an OTTI loss was recognized in Other comprehensive income (loss).
The carrying value of limited partnerships as of December 31, 2017 and 2016 was $2,369 million and $2,371 million, which includes undistributed earnings of $539 million and $523 million. Limited partnerships comprising 61% of the total carrying value are reported on a current basis through December 31, 2017 with no reporting lag, 18% are reported on a one month lag and the remainder are reported on more than a one month lag. The number of limited partnerships held and the strategies employed provide diversification to the limited partnership portfolio and the overall invested asset portfolio.
As of December 31, 2017, the Company had committed approximately $384 million to future capital calls from various third-party limited partnership investments in exchange for an ownership interest in the related partnerships.
Securities with carrying values of approximately $2.6 billion and $2.3 billion were deposited by the Company’s insurance subsidiaries under requirements of regulatory authorities and others as of December 31, 2017 and 2016.
Securities may be transferred in or out of levels within the fair value hierarchy based on the availability of observable market information and quoted prices used to determine the fair value of the security. The availability of observable market information and quoted prices varies based on market conditions and trading volume. During the year ended December 31, 2017 there were $10 million of transfers from Level 1 to Level 2 and no transfers from Level 2 to Level 1. During the year ended December 31, 2016 there were no transfers between Level 1 and Level 2. The Company's policy is to recognize transfers between levels at the beginning of quarterly reporting periods.
Level 1 equity securities include publicly traded securities valued using quoted market prices. Level 2 securities are primarily non-redeemable preferred stocks and common stocks valued using pricing for similar securities, recently executed transactions and other pricing models utilizing market observable inputs. Level 3 securities are primarily priced using broker/dealer quotes and internal models with inputs that are not market observable.
Historically, the fair value of life settlement contracts was determined as the present value of the anticipated death benefits less anticipated premium payments based on contract terms that are distinct for each insured, as well as the Company's own assumptions for mortality, premium expense and the rate of return that a buyer would require on the contracts. As discussed in Note A, Summary of Significant Accounting Policies, as of December 31, 2016 the Company reached an agreement on terms to sell the portfolio and the PSA related to the portfolio was executed on March 7, 2017. At December 31, 2016, the valuation of the life settlement contracts was based on the terms of the sale of the contract to a third party. Despite the sale, the contracts were classified as Level 3 as there is not an active market for life settlement contracts.
Level 2 investments primarily include the embedded derivative on the funds withheld liability. The embedded derivative on funds withheld liability is valued using the change in fair value of the assets supporting the funds withheld liability, which are fixed maturity securities valued with observable inputs.
The following tables present quantitative information about the significant unobservable inputs utilized by the Company in the fair value measurements of Level 3 assets. Valuations for assets and liabilities not presented in the tables below are primarily based on broker/dealer quotes for which there is a lack of transparency as to inputs used to develop the valuations. The quantitative detail of these unobservable inputs is neither provided nor reasonably available to the Company. The valuation of life settlement contracts was based on the terms of the sale of the contracts to a third party; therefore, the contracts are not included in the table below.
For the years ended December 31, 2017, 2016 and 2015, the Company paid $127 million, $142 million and $256 million to Loews related to federal income taxes.
The Securities and Exchange Commission issued Staff Accounting Bulletin No. 118 (SAB 118) to provide guidance on accounting for the income tax effects of the Tax Reform Legislation. SAB 118 describes scenarios where the measurement of the income tax effects is complete, incomplete, or incomplete but for which a reasonable provisional amount can be estimated, and provides a twelve month measurement period from December 22, 2017 to complete the accounting for the income tax effects. Any future measurement period effects will be recognized when certain clarification of the Tax Reform Legislation is issued.
The Company has re-computed its insurance reserves and the transition adjustment from existing law. The effect of any measurement period adjustments will not impact the effective tax rate.
The Company has not recorded current or deferred taxes with respect to the international provisions since it does not expect to have inclusions in U.S. taxable income for certain earnings of foreign subsidiaries in future years. The effect of any measurement period adjustments would impact the effective tax rate.
The following table presents the current and deferred components of the Company's income tax expense.
Total income tax presented above includes foreign tax (expense)/benefit of approximately $1 million, $(9) million and $(14) million related to pretax income from foreign operations of approximately $39 million, $51 million and $71 million for the years ended December 31, 2017, 2016 and 2015.
The table below reconciles the net liability for unpaid claim and claim adjustment expenses for the property and casualty segments to the amount presented in the Consolidated Balance Sheets.
(1) The Life & Group segment amount is primarily related to long term care claim reserves, but also includes amounts related to unfunded structured settlements arising from short duration contracts. Long term care policies are long duration contracts.
(3) The Corporate & Other Reinsurance receivables are primarily related to A&EP claims covered under the Loss Portfolio Transfer.
The following table presents a reconciliation between beginning and ending claim and claim adjustment expense reserves, including claim and claim adjustment expense reserves of the Life & Group segment.
Reserves for policyholder benefits for our Life & Group segment, which primarily includes long term care, are based on actuarial assumptions which include estimates of morbidity, persistency, inclusive of mortality, discount rates, future premium rate increases and expenses over the life of the contracts. Under GAAP, the best estimates of the actuarial assumptions at the date the contract was issued are locked-in throughout the life of the contract, unless a premium deficiency develops, which occurred in 2015. As a result, the Company updated the assumptions
to represent management’s best estimates at the time of the premium deficiency and these revised assumptions are locked-in unless another premium deficiency is identified.
Our mass tort and A&EP reserving methodologies are similar as both are based on detailed account reviews of large accounts with estimates based on ultimate payments considering the applicable law and coverage litigation. These reserves are subject to greater inherent variability than is typical of the remainder of the Company’s reserves due to, among other things, a general lack of sufficiently detailed data, expansion of the population being held responsible for these exposures and significant unresolved legal issues such as the existence of coverage and the definition of an occurrence.
The loss reserve development tables presented herein illustrate the change over time of reserves established for claim and allocated claim adjustment expenses arising from short duration insurance contracts for certain lines of business within our property & casualty segments. Not all lines of business or segments are presented based on their context to the Company's overall loss reserves, calendar year reserve development, or calendar year net earned premiums. Insurance contracts are considered to be short duration contracts when the contracts are not expected to remain in force for an extended period of time. The Cumulative Net Incurred Claim and Allocated Claim Adjustment Expenses tables, reading across, show the cumulative net incurred claim and allocated claim adjustment expenses relating to each accident year at the end of the stated calendar year. Changes in the cumulative amount across time are the result of the Company's expanded awareness of additional facts and circumstances that pertain to the unsettled claims. The Cumulative Net Paid Claims and Allocated Claim Adjustment Expenses tables, reading across, show the cumulative amount paid for claims in each accident year as of the end of the stated calendar year. The Net Strengthening or (Releases) of Prior Accident Year Reserves tables, reading across, show the net increase or decrease in the cumulative net incurred accident year claim and allocated claim adjustment expenses during each stated calendar year and indicates whether the reserves for that accident year were strengthened or released.
In the loss reserve development tables, IBNR includes reserves for incurred but not reported losses and expected development on case reserves. The Company does not establish case reserves for ALAE, therefore ALAE reserves are also included in the estimate of IBNR.
Changes in estimates of claim and claim adjustment expense reserves and premium accruals, net of reinsurance, for prior years are defined as net prior year development. These changes can be favorable or unfavorable. The following tables and discussion present the net prior year development recorded for Specialty, Commercial, International and Corporate & Other segments.
Favorable net prior year development of $79 million, $45 million and $50 million was recorded in the Life & Group segment for the years ended December 31, 2017, 2016 and 2015. The favorable net prior year development for the year ended December 31, 2017 was driven by lower than expected claim severity.
Premium development can occur in the property and casualty business when there is a change in exposure on auditable policies or when premium accruals differ from processed premium. Audits on policies usually occur in a period after the expiration date of the policy. See further information on the premium development in the Commercial segment for the years ended December 31, 2017 and 2016 within the Small Business discussion in Note F.
The following table presents further detail of the development recorded for the Commercial segment.
Unfavorable development for workers' compensation was primarily due to higher than expected severity for Defense Base Act contractors that largely resulted from a reduction of expected future recoveries from the US Department of Labor under the War Hazard Act. Further unfavorable development was due to the impact of recent Florida court rulings for accident years 2008 through 2015. These were partially offset by favorable development related to lower than expected frequencies related to our ongoing Middle Market and Small Business results for accident years 2009 through 2014.
The year ended December 31, 2015 also included unfavorable loss development related to extra contractual obligation losses and losses associated with premium development.
The following table presents further detail of the development recorded for the International segment.
Favorable development for other professional liability was primarily due to better than expected emergence in the Canadian run-off business in accident years 2014 and prior, several favorable settlements relating to large claims in the Europe Professional Indemnity portfolio, and lower than expected large loss frequency in the Europe Financial Institutions portfolio. This was partially offset by higher than expected severity in accident year 2015 arising from the management liability business.
Favorable development in medical professional liability was due to better than expected frequency of losses in accident years 2011 to 2013.
Favorable development in other professional liability was due to better than expected large loss emergence in accident years 2011 and prior.
Unfavorable development in other is due to higher than expected large losses in financial institutions and political risk, primarily in accident year 2014.
Subsequent to the effective date of the LPT, the Company recognized adverse prior year development on its A&EP reserves which resulted in additional amounts ceded under the LPT. As a result, the cumulative amounts ceded under the LPT exceeded the $2.2 billion consideration paid, resulting in the NICO LPT moving into a gain position, requiring retroactive reinsurance accounting. Under retroactive reinsurance accounting, this gain is deferred and only recognized in earnings in proportion to actual paid recoveries under the LPT. Over the life of the contract, there is no economic impact as long as any additional losses incurred are within the limit of the LPT. In a period in which the Company recognizes a change in the estimate of A&EP reserves that increases the amounts ceded under the LPT, the proportion of actual paid recoveries to total ceded losses is affected and the change in the deferred gain is recognized in earnings as if the revised estimate of ceded losses was available at the effective date of the LPT. The effect of the deferred retroactive reinsurance benefit is recorded in Insurance claims and policyholders' benefits in the Consolidated Statement of Operations.
Based upon the Company's annual A&EP reserve review, net unfavorable prior year development of $60 million, $200 million and $150 million was recognized before consideration of cessions to the LPT for the years ended December 31, 2017, 2016 and 2015. The 2017 unfavorable development was driven by modestly higher anticipated payouts on claims from known sources of asbestos exposure. The 2016 unfavorable development was driven by an increase in anticipated future expenses associated with determination of coverage, higher anticipated payouts associated with a limited number of historical accounts having significant asbestos exposures and higher than expected severity on pollution claims. The 2015 unfavorable development was recorded to reflect a decrease in anticipated future reinsurance recoveries related to asbestos claims and higher than expected severity on pollution claims. While the unfavorable development in these years was ceded to NICO under the LPT, the Company’s Net income in the periods was negatively affected due to the application of retroactive reinsurance accounting.
NICO established a collateral trust account as security for its obligations to the Company. The fair value of the collateral trust account was $3.1 billion and $2.8 billion as of December 31, 2017 and 2016. In addition, Berkshire Hathaway Inc. guaranteed the payment obligations of NICO up to the aggregate reinsurance limit as well as certain of NICO’s performance obligations under the trust agreement. NICO is responsible for claims handling and billing and collection from third-party reinsurers related to the Company’s A&EP claims.
Through mediation, the plaintiff, Defendants and the Plan's fiduciary insurance carriers reached an agreement in principle to settle this matter. Upon completion of a definitive settlement agreement, plaintiff and Defendants will propose a class settlement for court approval. Based on the agreement in principle, management has recorded its best estimate of the Company's probable loss and does not believe that the ultimate resolution of this matter will have a material impact on the Company’s results of operations or financial position.
The policyholder refunds for the multi-peril package product were issued in the third quarter of 2017. The policyholder refunds for workers’ compensation policies are expected to be refunded in 2018. The estimated refund liability, including interest, for the workers' compensation policies as of December 31, 2017 was $60 million. Any fines or penalties related to the foregoing are reasonably possible, but are not expected to be material to the Company's results of operations or financial position.
As of December 31, 2017 and 2016, the Company had recorded liabilities of approximately $5 million related to guarantee and indemnification agreements and management believes that it is not likely that any future indemnity claims will be significantly greater than the amounts recorded.
The Company's largest recoverables from a single reinsurer as of December 31, 2017, including ceded unearned premium reserves, were approximately $2,100 million from a subsidiary of Berkshire Hathaway Insurance Group, $395 million from the Gateway Rivers Insurance Company and $230 million from subsidiaries of Wilton Re. These amounts are substantially collateralized. The recoverable from the Berkshire Hathaway Insurance Group includes amounts related to third-party reinsurance for which NICO has assumed the credit risk under the terms of the LPT as discussed in Note E to the Consolidated Financial Statements.
During 2015, the Company entered into a five-year $250 million senior unsecured revolving credit facility with a syndicate of banks which may be used for general corporate purposes. At the Company's election, the commitments under the credit agreement may be increased from time to time up to an additional aggregate amount of $100 million. The credit agreement includes several covenants, including maintenance of a minimum consolidated net worth and a defined ratio of consolidated indebtedness to consolidated total capitalization. The minimum consolidated net worth, as defined as of December 31, 2017, was $8.7 billion. As of December 31, 2017 and 2016, the Company had no outstanding borrowings under the credit agreements.
The Company's debt obligations contain customary covenants for investment grade issuers. The Company was in compliance with all covenants as of and for the years ended December 31, 2017 and 2016.
The combined aggregate maturities for debt as of December 31, 2017 are presented in the following table.
In 2016, the CNA Retirement Plan paid $88 million to settle its obligation to certain retirees through the purchase of a group annuity contract from a third party insurance company. This transaction reduced the plan’s projected benefit obligation by $86 million.
The table below presents the estimated amounts to be recognized from AOCI into net periodic cost (benefit) during 2018.
The limited partnership investments held within the plan are recorded at fair value, which represents the plan's share of net asset value of each partnership, as determined by the general partner. Limited partnerships comprising 85% and 86% of the carrying value as of December 31, 2017 and 2016 employ hedge fund strategies that generate returns through investing in marketable securities in the public fixed income and equity markets and the remainder were primarily invested in private debt and equity. Within hedge fund strategies, approximately 62% were equity related, 32% pursued a multi-strategy approach and 6% were focused on distressed investments as of December 31, 2017.
In 2018, CNA expects to contribute $18 million to its pension plans and $2 million to its postretirement health care benefit plans.
Benefit expense for the Company's savings plans was $76 million, $75 million and $71 million for the years ended December 31, 2017, 2016 and 2015.
In 2016, CNA granted Special Supplemental Equity Awards (SSE). The awards consist of restricted stock units subject to both Company performance in 2016 and service-based vesting up to two years. Payments made under the PSP and SSE are made entirely in shares of common stock, except for awards made to foreign participants, which are paid in cash.
The Company occupies office facilities under lease agreements that expire at various dates. In addition, data processing, office and transportation equipment is leased under agreements that expire at various dates. Most leases contain renewal options that provide for rent increases based on prevailing market conditions. Lease expense for the years ended December 31, 2017, 2016 and 2015 was $66 million, $60 million and $46 million.
The table below presents the expected future minimum lease payments to be made under non-cancelable operating leases as of December 31, 2017.
Dividends from CCC are subject to the insurance holding company laws of the State of Illinois, the domiciliary state of CCC. Under these laws, ordinary dividends, or dividends that do not require prior approval by the Illinois Department of Insurance (the Department), are determined based on the greater of the prior year's statutory net income or 10% of statutory surplus as of the end of the prior year, as well as timing and amount of dividends paid in the preceding twelve months. Additionally, ordinary dividends may only be paid from earned surplus, which is calculated by removing unrealized gains from unassigned surplus. As of December 31, 2017, CCC is in a positive earned surplus position. The maximum allowable dividend CCC could pay during 2018 that would not be subject to the Department’s prior approval is $1,073 million, less dividends paid during the preceding twelve months measured at that point in time. CCC paid dividends of $955 million in 2017. The actual level of dividends paid in any year is determined after an assessment of available dividend capacity, holding company liquidity and cash needs as well as the impact the dividends will have on the statutory surplus of the applicable insurance company.
(1) Information derived from the statutory-basis financial statements to be filed with insurance regulators.
The tables below displays the changes in Accumulated other comprehensive income (loss) by component.
The Company's operations outside of Property & Casualty Operations are managed and reported in two segments: Life & Group and Corporate & Other. Life & Group primarily includes the results of the individual and group long term care businesses that are in run-off. Corporate & Other primarily includes certain corporate expenses, including interest on corporate debt, and the results of certain property and casualty business in run-off, including CNA Re and A&EP.
Approximately 7.7%, 7.9% and 8.0% of the Company's direct written premiums were derived from outside the United States for the years ended December 31, 2017, 2016 and 2015.
(2) Net income (loss) in the fourth quarter of 2017 included a one-time non-cash increase to Income tax expense of $83 million as a result of Tax Reform Legislation.
CNAF's independent registered public accountant, Deloitte & Touche LLP, has issued an audit report on the Company's internal control over financial reporting. This report appears on page 129.